Are you in the market for a new or new-to-you car? If so, you’ve probably wondered “How much car can I afford?”
While your local car dealership might be happy to tell you the sky’s the limit regarding your car purchase, your personal budget might be telling you a different story. Spending more than you can afford on a car turns that car from a blessing into a burden.
Deciding how much to spend on a car starts with knowing your current financial numbers. You'll need to know your current income, expenses, and savings amounts.
There are several financial factors that can influence how much you should spend on a car. The amount of money you earn, of course, needs to be taken into account.
When determining how much you earn, always use your net take-home pay to start with. From there, factor in the other financial obligations you have.
In other words, look at your budget. If you don’t normally use one, now is a good time to start. Having a clear view of all other monthly financial obligations will help you better determine how much you can afford.
The 50-30-20 budget plan can be helpful. In short, the 50-30-20 budget plan works like this:
There are many ways to design a budget, but the 50-30-20 budget gives you a good place to start. It will certainly point out of there are any areas that are totally out of whack.
Having a healthy savings account balance is important when making a car purchase as well. If you don’t have an emergency fund with a balance equal to three to six months’ worth of expenses, building that emergency fund up should be a priority.
If you don’t have an emergency fund with a balance equal to three to six months’ worth of expenses, building that emergency fund up should be a priority.
With an added car payment, having a plush savings balance will help you ensure you can cover the new payment even if you hit a financial bump. Or, for instance, if the car needs repairs.
Once you have looked at your budget and determined the amount of money per month you are comfortable spending on a car you'll want to be clear on the total car costs before you make your purchase. Affording a new car isn’t simply about the payment.
There are several other costs associated with car ownership, such as:
You can call your insurance company ahead of time and get a quote for the new vehicle you're considering. If you are still trying to narrow down what type of car you want, check out this list of the most and the least expensive cars to insure.
Call your insurance company ahead of time and get a quote for the new vehicle you're considering.
Fuel costs are fairly easy to determine. A Google search will give you the MPGs of any car you could think of. Compare that to your current car to see if your costs will change.
Maintenance and repair costs can be harder to determine but you can get an idea by using averages across a brand. Here's an article from Autowise that displays the cheapest and most expensive cars to maintain.
Be sure to factor in an accurate estimate of these additional car ownership costs as you determine a purchase price and payment amount you’re comfortable with.
Doing your due diligence as you shop for a car loan is important as well. You do not have to get financing through the dealership. You will likely do better getting a loan yourself through your bank. At the very least, have an understanding of what rate you would qualify for before heading into the dealership so you know if they are offering you a fair rate.
Continue reading on Wallet Hacks.
“Is it better to pay off student loans or a mortgage first? I’m asking for my brother, who took out $80,000 in student loans about 20 years ago and has only paid off about $10,000. He recently bought a home in Southern California and took out a 30-year mortgage that might be as much as $400,000. I don’t know the interest rates he’s paying on these debts. I think he should pay off his student loans first because the total debt is smaller, older, and can’t be discharged in a bankruptcy. What do you think?”
Thanks for your question, Maya! This dilemma is common, especially now that most federal student loans are in automatic forbearance from March 13 to September 30, 2020, due to coronavirus-related economic relief. That means millions of student loan borrowers suddenly have the option to stop making payments without adverse financial consequences, such as hurting their credit or getting charged additional interest or fees.
If you have qualifying student loans and you're dealing with financial hardship due to the pandemic or another challenge, you may be grateful to have your payments suspended. But if your finances are in good shape and you don’t have any dangerous debts, such as high-rate credit cards or loans, you may be wondering what to do with the extra money. Should you send it to your student loans despite the forbearance, to your mortgage, or to some other account?
RELATED: 10 Things Student Loan Borrowers Should Know About Coronavirus Relief
Let's take a look at how to prioritize your finances and use your resources wisely during the pandemic. This six-step plan will help you make smart decisions and reach your financial goals as quickly as possible.
While many people begin by asking which debt to pay off first, that’s not necessarily the right question. Instead, zoom out and consider your financial life's big picture. An excellent place to start is to review your emergency savings.
If you’ve suffered the loss of a job or business income during the pandemic, you’re probably very familiar with how much or how little savings you have. But if you haven’t thought about your cash reserve lately, it’s time to reevaluate it.
Having emergency money is so important because it keeps you from going into debt in the first place. It keeps you safe during a rough financial patch or if you have a significant unexpected expense, such as a car repair or a medical bill.
How much emergency savings you need is different for everyone. If you’re the sole breadwinner for a large family, you may need a bigger financial cushion than a single person with no dependents and plenty of job opportunities.
If you’re the sole breadwinner for a large family, you may need a bigger financial cushion than a single person with no dependents and plenty of job opportunities.
A good rule of thumb is to accumulate at least 10% of your annual gross income as a cash reserve. For instance, if you earn $50,000, make a goal to maintain at least $5,000 in your emergency fund.
You might use another standard formula based on average monthly living expenses: Add up your essential costs, such as food, housing, insurance, and transportation, and multiply the total by a reasonable period, such as three to six months. For example, if your living expenses are $3,000 a month and you want a three-month reserve, you need a cash cushion of $9,000.
If you have zero savings, start with a small goal, such as saving 1 to 2% of your income each year. Or you could start with a tiny target like $500 or $1,000 and increase it each year until you have a healthy amount of emergency money. In other words, it might take years to build up enough savings, and that’s okay—just get started!
Your financial well-being depends on having cash to meet your living expenses comfortably, not on paying a lender ahead of schedule.
Unless Maya’s brother has enough cash in the bank to sustain him and any dependent family members through a financial crisis that lasts for several months, I wouldn’t recommend paying off student loans or a mortgage early. Your financial well-being depends on having cash to meet your living expenses comfortably, not on paying a lender ahead of schedule.
If you have enough emergency savings to feel secure for your situation, keep reading. Working through the next four steps will help you decide whether to pay down your student loans or mortgage first.
In addition to saving for potential emergencies, it’s critical to save regularly for your retirement before paying down a student loan or mortgage early. So, if Maya’s brother isn’t contributing regularly to meet a retirement goal, that’s the next priority I’d recommend for him.
Consider this: If you invest $500 a month for 35 years and have an average 8% return, you’ll end up with an impressive retirement nest egg of more than $1.2 million! But if you wait until 10 years before retirement to start saving, you’d have to invest over $5,000 a month to have $1 million in the bank. When it comes to your retirement savings, procrastinating can make the difference between scraping by or have a comfortable lifestyle down the road.
When it comes to your retirement savings, procrastinating can make the difference between scraping by or have a comfortable lifestyle down the road.
A good rule of thumb is to invest at least 10% to 15% of your gross income for retirement. For instance, if you earn $50,000, make a goal to contribute at least $5,000 per year to a tax-advantaged retirement account, such as an IRA or a retirement plan at work, such as a 401(k) or 403(b).
For 2020, you can contribute up to $19,500, or $26,000 if you’re over age 50, to a workplace retirement account. Anyone with earned income (even the self-employed) can contribute up to $6,000 (or $7,000 if you’re over 50) to an IRA.
The earlier you make retirement savings a habit, the better. Not only does starting sooner give you more time to contribute money, but it leverages the power of compounding, which allows the growth in your account to earn additional interest. That’s when you’ll see your retirement account value mushroom!
In addition to building an emergency fund and saving for retirement, an essential part of taking control of your finances is having adequate insurance. Many people get into debt in the first place because they don’t have enough of the right kinds of coverage—or they don’t have any insurance at all.
Without enough insurance, a catastrophic event could wipe out everything you’ve worked so hard to earn.
As your career progresses and your net worth increases, you’ll have more income and assets to protect from unexpected events. Without enough insurance, a catastrophic event could wipe out everything you’ve worked so hard to earn.
Make sure you have enough health insurance to protect yourself and those you love from an illness or accident jeopardizing your financial security. Also, review your auto and home or renters insurance coverage. And by the way, if you rent and don’t have renters insurance, you need it. It’s a bargain for the protection you get; it only costs $185 per year on average.
And if you have family who would be hurt financially if you died, you need life insurance to protect them. If you’re in relatively good health, a term life insurance policy for $500,000 might only cost a couple of hundred dollars per year. You can get free quotes for many different types of insurance using sites like Bankrate.com or Policygenius.com.
If Maya’s brother is missing critical types of insurance for his lifestyle and family situation, getting it should come before paying off a student loan or mortgage early. It’s always a good idea to review your insurance needs with a reputable agent or a financial advisor who can make sure you aren’t exposed to too much financial risk.
But what about other goals you might have, such as saving for a child’s education, starting a business, or buying a home? These are wonderful if you can afford them once you’ve accounted for your emergency savings, retirement, and insurance needs.
Make a list of your financial dreams, what they cost, and how much you can afford to spend on them each month. If they’re more important to you than paying off student loans or a mortgage early, then you should fund them. But if you’re more determined to become completely debt-free, go for it!
Once you’ve hit the financial targets we’ve covered so far, and you have money left over, it’s time to consider the opportunity costs of using it to pay off your student loans or mortgage. Your opportunity cost is the potential gain you’d miss if you used your money for another purpose, such as investing it.
A couple of benefits of both student loans and mortgages is that they come with low interest rates and tax deductions, making them relatively inexpensive. That’s why other high-interest debts, such as credit cards, personal loans, and auto loans, should always be paid off first. Those debts cost more in interest and don’t come with any money-saving tax deductions.
Especially in today’s low interest rate environment, it’s possible to get a significantly higher return even with a reasonably conservative investment portfolio.
But many people overlook the ability to invest extra money and get a higher return. For instance, if you pay off the mortgage, you’d receive a 4% guaranteed return. But if you can get 6% on an investment portfolio, you may come out ahead.
Especially in today’s low-interest-rate environment, it’s possible to get a significantly higher return even with a reasonably conservative investment portfolio. The downside of investing extra money, instead of using it to pay down a student loan or mortgage, is that investment returns are not guaranteed.
If you decide an early payoff is right for you, keep reading. We’ll review several factors to help you know which type of loan to focus on first.
Once you have only student loans and a mortgage and you’ve decided to prepay one of them, consider these factors.
The interest rates of your loans. As I mentioned, you may be eligible to claim a mortgage interest tax deduction and a student loan interest deduction. How much savings these deductions give you depends on your income and whether you use Schedule A to itemize deductions on your tax return. If you claim either type of deduction, it could reduce your after-tax interest rate by about 1%. The debt with the highest after-tax interest rate is typically the best one to pay off first.
The amounts you owe. If you owe significantly less on your student loans than your mortgage, eliminating the smaller debt first might feel great. Then you’d only have one debt left to pay off instead of two.
You have an interest-only adjustable-rate mortgage (ARM). With this type of mortgage, you’re only required to pay interest for a period (such as several months or up to several years). Then your monthly payments increase significantly based on market conditions. Even if your ARM interest rate is lower than your student loans, it could go up in the future. You may want to pay it down enough to refinance to a fixed-rate mortgage.
You have a loan cosigner. If you have a family member who cosigned your student loans or a spouse who cosigned your mortgage, they may influence which loan you tackle first. For instance, if eliminating a student loan cosigned by your parents would help improve their credit or overall financial situation, you might prioritize that debt.
You qualify for student loan forgiveness. If you have a federal loan that can be forgiven after a certain period (such as 10 or 20 years), prepaying it means you’ll have less forgiven. Paying more toward your mortgage would save you more.
Being completely debt-free is a terrific goal, but keeping inexpensive debt and investing your excess cash for higher returns can make you wealthier in the end.
As you can see, the decision to eliminate debt and in what order, isn’t clear-cut. Mortgages and student loans are some of the best types of debt to have—they allow you to build wealth by accumulating equity in a home, getting higher-paying jobs, and freeing up income you can save and invest.
In other words, if Maya’s brother uses his excess cash to prepay a low-rate mortgage or a student loan, it may do more harm than good. So, before you rush to prepay these types of debts, make sure there isn’t a better use for your money.
Being completely debt-free is a terrific goal, but keeping inexpensive debt and investing your excess cash for higher returns can make you wealthier in the end. Only you can decide whether paying off a mortgage or student loan is the right financial move for you.
The coronavirus economic relief package for workers and small businesses can be confusing. Who qualifies for what programs? How do you apply successfully?
If you’ve been laid off or had your work hours cut due to the pandemic, you're eligible for both state and federal unemployment compensation. That’s a pretty straightforward situation.
If you run a business that’s been hurt by the economic downturn and you have employees, you qualify for the Paycheck Protection Program (PPP). It’s a loan backed by the Small Business Administration (SBA) that offers relief if you want to continue paying your employees, even if they can’t do their jobs during the health crisis. If you use PPP funds for approved business expenses, such as payroll, rent, and utilities, you don’t have to repay the loan.
Additionally, there are other types of loans you can get through the SBA, such as the Economic Injury Disaster Loan (EIDL). It comes with potentially higher loan amounts than the PPP but must be repaid. You may also qualify for an Economic Injury Disaster Grant (EIDG), which pays businesses $1,000 per employee, up to a $10,000 maximum, and doesn’t have to be repaid.
Whether you call yourself a full or part-time freelancer, gig worker, or an independent contractor, you’re still a small business. If you’ve suffered financially due to the pandemic, you have several options to get relief.
But what’s been unclear are the options for the self-employed who have no employees except themselves. Whether you call yourself a full or part-time freelancer, gig worker, or an independent contractor, you’re still a small business. If you’ve suffered financially due to the pandemic, you have several options to get relief.
I interviewed Gerri Detweiler, a nationally recognized financing and credit expert with more than 20 years of experience. She’s the Education Director for Nav, a trusted financing partner for more than 1.2 million businesses. Gerri gives Nav’s customers certainty in an uncertain world through expertise and actionable advice.
On the Money Girl podcast, Gerri and I cut through the confusion to help businesses of any size, including solopreneurs, understand how to get economic relief during the coronavirus crisis. We cover a variety of topics, including:
Listen to the interview using the embedded audio player or on Apple Podcasts, SoundCloud, Stitcher, and Spotify.
If you’re a struggling entrepreneur, check out these resources to understand your options:
11 Options If Your Small Business Can’t Pay Its Bills Due to Coronavirus
Applying for a Business Loan Is Changing Due to COVID-19: Here’s What It Means
How to Apply for a Payroll Protection Program (PPP) Loan
Maria O. says:
I’m a huge fan of the Money Girl Podcast and am also a Get Out of Debt Fast student. I’ve taken your financial advice and am glad to say that my husband and I are in a much better financial situation now.
We both have travel rewards credit cards with zero balances that we haven’t used in over a year. We know that canceling cards isn’t advisable, but we really want to stop paying the $95 annual fee. My husband’s credit score is 780 and mine is 818. What do you recommend?
Maria, thanks so much for your question and for being a part of the Money Girl community!
Before you cancel a credit card, it’s critical to understand how it will affect your entire financial life. Whether you should get rid of a card depends on a variety of factors, including your future financial goals.
In this post, I’ll cover 10 dos and don’ts for when to cancel a credit card. You’ll learn how to manage these accounts wisely so they improve your finances and don’t hurt them.
Before I cover each of these dos and don’ts, here’s an overview of why building good credit and using credit cards the right way is so important.
Having good credit simply means that you have a reliable financial track record according to the data in your credit history with the nationwide credit bureaus: Equifax, Experian, and TransUnion. Different credit scoring models use that data to calculate credit scores, which act as shortcuts for various businesses to evaluate you quickly.
When you have high credit scores, potential lenders and merchants have more confidence that you’ll be a good customer who pays their bills on time. That’s an incentive for them to give you top-tier offers, which saves you money.
Having good credit scores allows you to get the most competitive interest rates and terms when you borrow money using credit cards, mortgages, car loans, student loans, and personal loans. For instance, paying just 1% less for a mortgage could save you over $100,000 on the cost of a 30-year, fixed-rate loan, depending on the total amount you borrow.
However, even if you never borrow money to finance a home or charge a vacation to a credit card, having good credit gives you other significant benefits, including:
RELATED: 12 Credit Myths and Truths You Should Know
The only way to build credit is to have active credit accounts in your name and to use them responsibly over time. That’s where credit cards come into play.
One of the biggest factors in how credit scores are calculated is called your credit utilization ratio. It only applies to revolving accounts, such as credit cards and lines of credit, which don’t have a fixed term. Credit utilization isn’t measured for installment loans, such as mortgages and car loans, because they do have a set ending or maturity date.Credit utilization is a simple formula that equals your total account balance divided by your total credit limit. For example, if you have a credit card with a balance of $1,000 and a credit limit of $2,000, your utilization ratio is 50% ($1,000 / $2,000 = 0.50).
Keeping a low utilization, such as below 20%, is optimal for good credit.
Keeping a low utilization, such as below 20%, is optimal for good credit. So, by paying down your balance on the card to $400, you could reduce your utilization ratio to 20% ($400 / $2,000 = 0.20) and boost your credit scores.
A low utilization ratio says that you’re using credit responsibly. A high ratio indicates that you may be maxed out and even getting close to missing a payment.
Many people mistakenly believe that getting rid of their credit cards will automatically improve their credit. The surprising truth is that canceling credit cards usually hurts it because your available credit on the card plunges to zero, which instantly increases your utilization and causes your credit scores to drop right away.
However, whether closing a card is right for you really depends on your current and future financial situation. Use the following do and don’ts to know when ditching a card is best and how to do it with minimal damage to your credit.
RELATED: 5 Ways to Get a Loan With Bad Credit
If you’re like Maria and have great credit with an unused card that’s costing you money, you may want to consider canceling it. Many rewards cards come with an annual fee, especially when they offer cashback, airline miles, or points for merchandise. In some cases, using the rewards easily offsets the annual fee.
If you won’t use the card or can’t afford the annual fee, common sense should be the deciding factor, not your credit score.
However, if you won’t use the card or can’t afford the annual fee, common sense should be the deciding factor, not your credit score. However, one option is to replace a card that charges an annual fee with another card that doesn’t, ideally before you cancel the first one. That allows you to swap out one credit limit for another one and avoid any damage to your credit.
I also don’t recommend keeping a credit card if it tempts you to overspend. Taking a temporary hit to your credit might be worth it to prevent bigger problems in your financial life.
If you’ve missed payments or can’t keep up with transactions because you have too many cards, it might be worth it to strategically cancel one or more credit cards. Keep reading for tips to minimize the potential damage to your credit.
If you cancel a credit card, choosing one with a higher credit limit poses more of a threat than getting rid of one with a smaller limit. The lower your credit limit on a card, the less closing it could negatively affect your credit.
As I previously mentioned, for optimal credit, it’s best to never carry a balance that exceeds 20% of your available credit limit. If you’re not sure what your credit limits are, you can review them by getting a free copy of your credit report at annualcreditreport.com.
A common credit dilemma is what to do after opening a new credit card that you felt pressured into at a retail store. Sales clerks make getting a huge discount with a new card signup sound too good to pass up. In some cases, you may not even realize that what you’re signing up for is a credit card.
If you’re loyal to a store and make frequent purchases there, having its branded credit card can give you nice savings and promotional benefits that make it worthwhile. While you can’t erase the card from your credit history, if you decide that you’d rather not have the account, closing it sooner rather than later is better for your credit.
Free Resource: Credit Score Survival Kit - a video tutorial, e-book, and audiobook to help build credit fast!
In addition to maintaining low credit utilization, the health of your credit depends on having a mix of credit accounts. That shows you can handle different types of credit, such as installment loans and revolving accounts. But if you cancel your only credit card, that would leave you deficient in the revolving credit category.
It’s better to spread out your balances on multiple cards and maintain low utilization on each of them, rather than have one card that you charge to the limit.
Therefore, I don’t recommend canceling a credit card if it’s your only one. Having at least one card in the mix rounds out your credit file. Ideally, you would have a total of two or three cards that come from different issuers, such as Visa, Mastercard, American Express, or Discover.
If you have more than one line of credit or credit card, most credit scoring models calculate your utilization ratio for each account and collectively on all your accounts. So, it’s better to spread out your balances on multiple cards and maintain low utilization on each of them, rather than have one card that you charge to the limit.
Depending on the types of charges you make, you may need a low-rate card for times when you must carry a balance and a higher-rate rewards card for charges that you always pay off each month. No annual fee cards are best, but as I previously mentioned, rewards cards that come with a fee may be worth it.
As if credit utilization and having a mix of credit accounts weren’t enough, a canceled credit card hurts your credit in other ways. Another factor that’s used in calculating credit scores is how long you’ve had credit accounts.
Having a long, rich credit history boosts your scores and makes you appear less risky to potential lenders and merchants. Canceling a long-standing credit card causes your average age of credit history to decrease, which hurts your credit. So, value credit cards that you’ve had for a long time more than those you’ve recently opened.
If you have more than one credit card that you want to cancel, don’t shut them all down at the exact same time. It’s better to space out cancellations over time, such as one every six months, to minimize the damage to your credit health.
If you’re planning to finance a big purchase, such as a home or vehicle, in the next three to six months, it’s not wise to cancel any credit cards. If your utilization rate increases and your credit scores suddenly take a dive during the application process, you may ruin your chances of getting a low-interest loan.
If you’re planning to finance a big purchase, such as a home or vehicle, in the next three to six months, it’s not wise to cancel any credit cards.
Maria didn't mention if she's looking to use her great credit to borrow money any time soon. But it's an important issue that I recommend she consider.
Never cancel a credit card with negative information, such as late payments or being in collections, thinking that it will disappear from your credit file. All credit accounts stay on your credit report for seven years from the date you became delinquent, even after you or a card issuer closes it. Accounts with only positive information remain in your credit file longer, for up to 10 years
If you or Maria go through these dos and don’ts and decide that it’s better not to cancel a credit card, use it occasionally to make small purchases that you pay off in full. That keeps it active and allows you to continue adding positive information to your credit history.
However, I don’t recommend keeping a credit card that you’re not using responsibly or that tempts you to overspend. Taking a temporary hit to your credit might be worth it to prevent bigger problems in your financial life.
Have you ever wondered, "How many credit cards should I have? Is it wise to have a wallet full of them? Does having multiple credit cards hurt my credit score?"
If you’ve been following this blog or the Money Girl podcast, you know the fantastic benefits of having excellent credit. The higher your credit scores, the more money you save on various products and services such as credit cards, lines of credit, car loans, mortgages, and insurance (in most states).
Even if you never borrow money, your credit affects other areas of your financial life.
But even if you never borrow money, your credit affects other areas of your financial life. For instance, having poor credit may cause you to get turned down by a prospective employer or a landlord. It could also increase the security deposits you must pay on utilities such as power, cable, and mobile plans.
Credit cards are one of the best financial tools available to build or maintain excellent credit scores. Today, I'll help you understand how cards boost your credit and the how many credit cards you should have to improve your finances.
Before we answer the question of how many credit cards you should have in your wallet, it's important to talk about using them responsibly so you're increasing instead of tanking your credit score.
A common misconception about credit is that if you have no debt you must have good credit. That’s utterly false because having no credit is the same as having bad credit. To have good credit, you must have credit accounts and use them responsibly.
Having no credit is the same as having bad credit.
Here are five tips for using credit cards to build and maintain excellent credit scores.
Making timely payments on credit accounts is the most critical factor for your credit scores. Your payment history carries the most weight because it’s an excellent indicator of your financial responsibility and ability to pay what you owe.
Having a credit card allows you to demonstrate your creditworthiness by merely making payments on time, even if you can only pay the minimum. If the card company receives your payment by the statement due date, that builds a history of positive data on your credit reports.
I recommend paying more than your card’s minimum. Ideally, you should pay off your entire balance every month so you don’t accrue interest charges. If you tend to carry a balance from month-to-month, it’s wise to use a low-interest credit card to reduce the financing charge.
Many people start using a credit card by becoming an authorized user on someone else’s account, such as a parent’s card. That allows you to use a card without being legally responsible for the debt.
Some credit scoring models ignore data that doesn’t belong to a primary card owner.
Some card companies report a card owner’s transactions to an authorized user’s credit report. That could be an excellent first step for establishing credit ... if the card owner makes payments on time. Even so, some credit scoring models ignore data that doesn’t belong to a primary card owner.
Therefore, don’t assume that being an authorized user is a rock-solid approach to building credit. I recommend that you get your own credit cards as soon as you earn income and get approved.
A critical factor that affects your credit scores is how much debt you owe on revolving accounts (such as credit cards and lines of credit) compared to your total available credit limits. It's known as your credit utilization ratio, which gets calculated per account and on your accounts' aggregate total.
A good rule of thumb to improve your credit scores is to keep your utilization ratio below 20%.
Having a low utilization ratio shows that you use credit responsibly by not maxing out your account. A high ratio indicates that you use a lot of credit and could even be in danger of missing a payment soon. A good rule of thumb to improve your credit scores is to keep your utilization ratio below 20%.
For example, if you have a $1,000 card balance and a $5,000 credit limit, you have a 20% credit utilization ratio. The formula is $1,000 balance / $5,000 credit limit = 0.2 = 20%.
There's a common misconception that it's okay to max out a credit card if you pay it off each month. While paying off your card in full is smart to avoid interest charges, it doesn't guarantee a low utilization ratio. The date your credit card account balance is reported to the nationwide credit agencies typically isn't the same as your statement due date. If your outstanding balance happens to be high on the date it's reported, you'll have a high utilization ratio that will drag down your credit scores.
If you need more available credit to cut your utilization ratio, there are some easy solutions. One is to apply for an additional credit card, so you spread out charges on multiple cards instead of consistently maxing out one card. That reduces your credit utilization and boosts your credit.
Having the same amount of debt compared to more available credit instantly reduces your utilization and improves your credit.
For example, if you have two credit cards with $500 balances and $5,000 credit limits, you have a 10% credit utilization ratio. The formula is $1,000 balance / $10,000 credit limit = 0.1 = 10%. That’s half the ratio of my previous example for one card.
Another strategy to cut your utilization ratio is to request credit limit increases on one or more of your cards. Having the same amount of debt compared to more available credit instantly reduces your utilization and improves your credit.
Credit card companies are in business to make a profit. If you don't use a card for an extended period, they can close your account or cut your credit limit. You may not mind having a card canceled if you haven't been using it, but as I mentioned, a reduction in your credit limit means danger for your credit scores.
A reduction in your credit limit means danger for your credit scores.
No matter if you or a card company cancels one of your revolving credit accounts, it causes your total amount of available credit to shrink, which spikes your utilization ratio. When your utilization goes up, your credit scores can plummet.
Anytime your credit card balances become a higher percentage of your total credit limits, you appear riskier to creditors, even if you aren't. So, keep your cards open and active, especially if you're considering a big purchase, such as a home or car, in the next six months.
In general, I recommend that you charge something small and pay it off in full several times a year, such as once a quarter, to stay active and keep your available credit limit in place.
If you have a card that you don't like because it charges an annual fee or a high APR, don't be afraid to cancel it. Just replace it with another card, ideally before you cancel the first one. That allows you to swap out one credit limit for another and avoid a significant increase in your credit utilization ratio.
If you're determined to have fewer cards, space out your cancellations over time, such as six months or more.
Now that you understand how credit cards help you build credit, let's consider how many you need. The optimal number for you depends on various factions, such as how much you charge each month, whether you use rewards, and how responsible you are with credit.
There's no limit to the number of cards you can or should have if you manage all of them responsibly.
According to Experian, 61% of Americans have at least one credit card, and the average person owns four. Having more open revolving credit accounts makes you more likely to have higher credit scores, but only when you manage them responsibly.
As I mentioned, having more available credit compared to your balances on revolving accounts is a crucial factor in your credit scores. If you continually bump up against a 20% utilization ratio, you likely need an additional card.
You can keep an eye on your credit utilization and other important credit factors with free credit reporting tools such as Credit Karma or Experian.
Also, consider how different credit cards can help you achieve financial goals, such as saving money on everyday purchases you're already making. Many retailers, big box stores, and brands have cards that reward your loyalty with discounts, promotions, and additional services.
If you continually bump up against a 20% utilization ratio, you likely need an additional card.
I use multiple cards based on their benefits and rewards. For instance, I only use my Amazon card to get 5% cashback on Amazon purchases. I have a card with no foreign transaction fees that I use when traveling overseas. And I have a low-interest card that I only use if I plan to carry a balance on a large purchase for a short period.
There's no limit to the number of cards you can or should have. Theoretically, you could have 50 credit cards and still have excellent credit if you manage all of them responsibly.
My recommendation is to have a minimum of two cards so you have a backup if something goes wrong with one of them. Beyond that, have as many as you're comfortable managing and that you believe will benefit your financial life.