How Will a Line of Credit Affect a Credit Rating?

Many want to improve their credit scores, but with the various criteria credit reporting companies use to determine scores, it's difficult to know what you should be focusing on. Opening a line of credit, whether you're doing it for your first time or fifth, has both positive and negative effects, depending on your personal situation.

Definition

A line of credit is a loan, either secured or unsecured, granted to you by a financial institution. Examples of lines of credit include car loans, student loans, mortgages and credit cards. When you take out a secured line of credit, you have provided collateral to back up your loan in case you can't pay it off in full. An unsecured line of credit, like most credit cards, is a line of credit that doesn't require any collateral upfront.

Credit Ratings

Your credit rating is what lenders use to determine your creditworthiness, or how much of a risk you'll be if they extend a line of credit to you. Your credit rating is made up of both positive and negative aspects. You can access your credit report annually for free online through one of the three main credit reporting companies: Equifax, TransUnion, and Experian.

Positive Impact

A new line of credit can boost a credit rating in three main ways. First, if you don't have a credit history, a new line of credit enables you to build one. Second, if you have a high balance on a card and open a new line of credit to transfer part of your balance, your score may improve. This is because lenders would rather see you have two cards with low balances than one card that's "maxed out." Finally, opening a new line of credit in addition to a couple of accounts in good standing will further increase your score, since it demonstrates your ability to manage multiple accounts.

Negative Impact

A new line of credit isn't always a good thing, depending on your situation. For example, if you already have multiple accounts (especially if many of them have been opened recently, or if many have high balances), your credit rating will drop. If you continually take out new lines of credit to transfer a large balance from one card to another, your score may drop. Closing many accounts in a short period of time adversely affects your score.

Expert Insight

If you're considering taking out a new line of credit to pay off other credit due to overspending, be wary. You can't be certain you won't be tempted again to use your new card for unnecessary purchases, so the Federal Trade Commission recommends instead budgeting your monthly expenses, contacting your creditors to ask for a reduction in monthly payments (or a reduction in interest rates), or even enrolling in a Debt Management Plan to help you repay your debt in a realistic way.