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Ask YOUNG MONEY: Can you build good credit with a low spending limit?

Q: I’ve got a simple question that I just can’t find the answer to. I have only one credit card and it has a very low limit and I am trying to build up my credit. My question is, can you build up good credit with a low spending limit on your credit card or does one’s limit need to be very high in order to improve your credit rating?

DebtBuster: This is a good question and one that many people ask. I am glad you are asking now while you are still in control of your credit.

There are many myths about what helps people improve their credit. Some think getting a better paying job, or somehow coming into a large sum of money will help improve the credit score. Others think that having high available balances or having lots of credit card accounts will give them a higher credit score.

What’s Included in a Credit Score Formula?

Fair Isaac, the company that created the FICO credit score, has recently released some information about the key items that go into the credit score formula. Not surprisingly, the item that carries the most weight, 35 percent, is your payment history. How you handle the credit you have regardless of how much or how little credit it is.

Most people start with smaller balances as they prove to creditors they can handle larger amounts. Making late payments on any credit account, whether it is an account with a $250 available balance or an account with a $10,000, is not good for the credit score. So the old advice still is best; "Make on-time payments all of the time."

The next key input into your credit score is how much you owe which accounts for 30 percent of the credit score calculation. If you are close to maxing out the available balances on your credit accounts, even if the accounts have a relatively low available balance, this will bring down your credit score.

The less available balance you have, the more difficult it is to keep what is called the "usage ratio," which represents the percentage of your available credit you are using, below 50 percent. Keeping your balances low on credit cards helps improve your credit score.

The length of your credit history is another important factor affecting about 15 percent of the credit score calculation. This is a main reason why many people, like yourself who are just starting to build credit, may have lower credit scores even though you may have never been late with any payments in the past.

It takes patience to improve a credit score. A credit score neither declines drastically nor improves drastically overnight. It takes time to affect one’s credit rating. Part of that time is simply having accounts open in good standing for many months and years.

This is one reason that the decision to close accounts, especially accounts that have been in good standing for a number of years is not a decision that should be made lightly. Closing long standing accounts could actually hurt a consumer’s credit score so care should be taken when making the decision to close accounts.

The next key to the credit score calculation is the type of credit a consumer uses. Using just one type of credit such as credit cards can lower a credit score. Managing a variety of credit accounts including credit cards, retail accounts, installment loans, mortgage loans, consumer finance accounts such as automobile loans, and others, shows you can handle various types of credit and helps improve your credit score.

Build Credit History With Different Types of Credit Accounts

The need to build a credit history does not give you a license to go out today and apply for ten different types of credit accounts. That will not do your score any good as you will learn below. It does mean that you should pay attention to the kinds of credit you currently have and make a plan to eventually, over time, add different types of credit accounts to your portfolio.

This often takes care of itself as you naturally move from renter to homeowner, purchase an automobile or take out other types of loans as life goes on. No need to try and rush things.

Finally, applying for new credit and/or having relatively new credit accounts contributes to 10 percent of the credit score calculation. One of the most well known facts about credit reports and credit scores by consumers is that having too many creditor inquiries reported on your credit report can negatively affect your credit score. This is true.

If you are shopping for credit and filling out lots of applications for credit, each time a company reviews your credit report in order to decide whether or not to approve your application, that review is listed on your credit report as an inquiry and having too many inquiries within a short period of time can lower the credit score.

Having new credit accounts that have been recently opened can also work against you and your goal of improving your credit score. Having the account is step one. Making on-time payments over a long period will contribute positively to your credit score.

If done properly you can create a very strong credit file that will open the doors of opportunity for you financially. Opportunity should not be confused with overuse of credit.

To me, financial opportunity means having access to the lowest interest rates on loans and other credit tools when a consumer wishes to borrow money, such as when they need to borrow money to purchase a home, obtain a small business loan or some other worthy reason.

Be careful. Someone in your position might find they are inundated with credit card offers since you appear to have good credit at this point. Since you are seeking to grow your creditworthiness, it would be easy to justify accepting all of the credit being thrown at you because you may think that having lots of credit card accounts is a sign of good credit. As you have read, this is not true. It is the proper use of the credit we have that plays the biggest role in helping us improve our credit reports and scores.

Best of luck to you.

Mike Schiano

Mike "The DebtBuster" Schiano is a nationally syndicated radio talk show host and book author. His show can be heard via the Web at www.inchargeradio.com. Send your personal finance questions to "Ask the DebtBuster" at mike@askthedebtbuster.com.

Copyright ©2008, Young Money Media, LLC

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