Some financial advisors say you shouldn’t use credit cards or get any type of loan. But I think this is foolish advice. If you don’t use some form of credit, you won’t have a credit score. If you don’t have a credit score, you’ll wind up hurting yourself in a lot of circumstances.
For example, many employers check their applicants credit records before hiring them. I don’t agree with that practice. In fact, some politicians are actually working to make it illegal. People often have poor credit due to medical emergencies that aren’t their fault. And they shouldn’t lose out on employment due to these medical issues.
But I’m not in charge, and this practice is still the norm for the moment. So if you think you’ll ever need to find a new job, you should pay attention to your credit score. And there are many other areas where having no credit or bad credit will hurt you:
- Car insurance (people with bad credit often pay higher rates)
- Getting a home mortgage
- Getting a car loan
- Renting an apartment
So, given that your credit score has an impact on so many areas of your life, it’s important to pay attention to it. You can get a car loan with a low credit score, but you’ll wind up paying much higher interest rates. The highest allowable interest rate for a car loan is 29%. The people with the worst credit will pay this rate.
The Impact of Higher Interest Rates
Let’s say you take out a $20,000 car loan for 5 years at 29%. Your monthly car payment will be $634.84 per month. And you’ll pay $38,090.40 throughout the course of the 5-year loan.
Compare this to the 4.3% interest rates you can get with good credit.1 Your monthly payments under this scenario will be only $371.04. And you’ll pay $22,262.40 throughout the course of the 5 year loan. That’s a difference of $263.80 per month and $15,828 over 5 years! And that’s $15,828 you wouldn’t have to pay if you had a decent credit score.
Getting and Maintaining a Good Credit Score
You can see how important having a good credit score is. But how do you get a good credit score and maintain it? Unfortunately it’s not a straightforward process.
The three main credit bureaus are Experian, Equifax and TransUnion. None of these organizations make their credit score calculation formulas public. This is particularly bad when you consider that people are losing out on jobs because of their credit scores. And we don’t even know how those credit scores are calculated!
I don’t know why we haven’t passed legislation requiring credit bureaus be more transparent. It’s a broken system right now.
But I can still give you some advice. You need to use some form of credit to get a credit score, but you don’t have to use it much. I’ve heard stories about people who get a credit card and only use it a couple of times a year. They pay the credit card off at the end of the billing cycle. And they maintain near-perfect credit scores by doing this.
I only have one credit card at the moment. I have a debit card, but that doesn’t help or hinder my credit score. I don’t have a car loan, a home loan, or any other type of revolving credit. I use my credit card often, as I get cashback points. And I pay the entire balance off at the end of the month, so I never pay any interest. As of the last time I checked, my credit score is 820. Credit scores range from 300 to 850, so I’m quite happy with 820.
Credit Utilization Ratios
A big part of your credit score is your credit utilization ratio. You can calculate your credit utilization ratio by dividing how much you have outstanding in loans/credit by the total amount of credit available to you.2
The one credit card I use has a $16,000 limit, and I spend about $1k per month on it. So, my credit utilization ratio would be $1,000/$16,000, which is 6.3%. 6.3% is considered pretty low, and it’s probably helping my credit score stay so high. A lower utilization ratio results in a higher credit score because it means that you are not using all of the credit available to you. Using all of the credit available to you is often a sign of financial issues.
Raising Your Credit Score
Luckily, if you have a bad credit score, there are ways to rectify it. One of these is simply allowing time to pass.Negative items will fall of your credit report after 7 years. Chapter 13 bankruptcy will fall off after 13 years.
You can also get a secured credit card. A secured credit card is one where you use your own money as collateral to secure your credit card. So, a $500 deposit will give you a $500 line of credit. In some ways, this type of credit card is not really credit at all – it functions more like a debit card. But the key difference is it will help raise your credit score. Once you’ve raised your score sufficiently, you’ll be offered other non-secured credit cards.
And finally, a great way to raise your credit score is to just make sure that you pay all your bills on time. I realize this is easier said than done. But it’s really important. It’s worth eating rice and beans for a month or skipping a vacation.