Credit cards and credit scores

We live in a credit based culture. Many Americans are saddled with so much debt that they can’t keep up with the bills or save for retirement. Any margin for ‘savings’ is being consumed by interest on debt every month.

If consumers funneled the sum total of interest paid to creditors into some form of retirement vehicle (IRA, 401K, CD, money market, mutual funds, checking/savings, etc.) monthly, there would be no need for social security for many, if not most, Americans. Unfortunately credit card debt has increased steadily since the 1990s and savings has declined.

Perhaps a financial management class should have been required in high school. Basic economics seems more pertinent than home economics in today’s world. The topics could include checking accounts, savings accounts, IRA/401k, budgeting, rudimentary economics, understanding stock market basics, investing, credit scores, managing credit and basic Excel skills.

With credit cards, student loans, auto financing, home financing, business financing and some employers checking credit, it would be helpful if more consumers understood how they were being assessed by the credit bureaus as well as being aware of potential risks/costs associated with obtaining credit.

The credit bureaus determine credit scores by analyzing several variables:

Approximately 1/3 of the score represents payment history. Late payments and defaults will impact this part of the score.
Approximately another 1/3 is based on current debts and the ratio of debt to the amount of available credit. Keeping all of your credit cards at or near the limits will deteriorate this score.
The remaining 1/3 is based on length of credit history, recent credit applications and the type of overall credit in your history. The length of the credit history is given the most weight. A history of repaying debt fortifies this portion of the score. Numerous recent applications for credit implies that the individual is strapped for cash and, therefore, more of a liability.

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During a recession, we are encouraged to spend to stimulate business, create jobs and get the gears of economics cranking again. Economic recovery slows when consumers consume less. However, high unemployment means that fewer consumers have money in their pockets. Purchasing power is curtailed once the pockets are empty and the credit lines are maxxed out. As a result unemployment often has a negative impact on your credit rating, especially if credit balances are pushed to the limit and remain high for a sustained period of time. If finance charges push the balance over the limit, the interest rate will promptly be increased.

Many credit card companies have been reticent to extend new credit lines since the onset of the credit crisis. Others have reduced credit lines due to concerns about credit viability, which can instantly push consumers over the maximum balance, leaving them with no credit availability and marring their credit scores.

Whereas credit cards can be an effective financial management tool for some, they are a disastrous temptation to others. Credit card companies realize that consumers are less aware of buying things on credit than purchasing with cash. They have capitalized on this psychological trait.

With credit guidelines tightening, consumers need to be aware of how purchasing decisions today could impact credit scores and, therefore, access to credit (and associated cost). PBS presented an outstanding documentary, Secret History of the Credit Card, which details techniques utilized by the industry to urge consumers to take on more debt. It provides a lot of valuable consumer information.

When utilizing credit cards, there are a few things that you should keep in mind:

Don’t pay up front fees to get a credit card. Legitimate credit card issuers don't ask for money up front, unless you're applying for a secured card. If you are applying for a secured card, make sure you understand how your deposit will be used.
When you utilize your cards for day to day expenses, it is easy to become disconnected from your expenditures. Credit cards should be utilized for emergencies and paid in full every month (if possible).
There is no limit on the amount a credit card company can charge a cardholder for being late on a payment.
There is no federal limit on the interest rate that a credit card company can charge.
Read the fine print on the credit card contract. You need to make sure that you understand the interest rate, the terms and any ‘teasers’ built into the initial offer. Shopping is a good idea when procuring a new card, because interest rates and terms vary dramatically from one company to the next.
Avoid using more than 10% of the balance to circumvent the negative impact on your credit score.
When utilizing cards with an introductory 0% APR, keep an eye on the balance. If you are late on your payment or exceed the maximum balance, the APR will immediately soar.
Check your credit report regularly to make sure that there are no errors. Freecreditreport.com or annualcreditreport.com will provide you with a copy free of charge, though they do not include scores.
Create a 3-6 month emergency cash reserve to avoid relying too heavily on credit cards. If you do not have cash reserves, you should not be making discretionary purchases.
With credit guidelines tightening, the credit scores determine whether you can obtain mortgage financing and how much you will be charged for it. A lower score is deemed higher risk by financial institutions, which means they charge a higher interest rate. Many consumers make the mistake of using their credit heavily or making a large purchase right before or during a refinance, which can cause major problems. For example, let’s say you have credit cards and you are considering refinancing to get rid of them, but something unexpected occurs this month, which you charge on the credit card, thinking you are going to refinance and get rid of everything anyway. If the amount charged reduces your ‘available credit’ significantly, it could mar your credit. The increase in the payment could increase your debt to income ratio over tolerable levels. If you are over 10% of the available balance, the credit score may be impacted. If you are at the maximum balance on the credit cards, expect the impact to be more severe. Whereas you may only lose a few points, those few points could be enough to drop you just beneath one of the credit tiers utilized by lenders to determine interest rate. In this example, the damage could be significant if that ‘few’ points reduces the credit score below 700, 660 or 620 before the credit report is issued for refinancing. At a minimum, the interest rate would be higher. At a 619, it might be difficult to obtain financing.

We are acclimated to living beyond our means at a very early age. Much of our motivation and drive is based on the diligent pursuit of that which we do not have. However the tendency to live beyond our means today, especially when resources are depleted, makes it more difficult to flourish financially in the future.

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