Story time:
If you’ve read any of my blogs or research in the past, you know I’m conservative when it comes to money. I’ve just always been a cash only or “only buy it if you can afford it” type of person. That was until last year when I tried to buy my first home, in hopes that I’d fix it up and sell during a scolding hot housing market that was surely right around the corner. I do want to point out that I was spot on with my guess of there being a scolding hot housing market—homes have sold in my area for roughly 40% over asking price, on average.
However, this isn’t a triumphant story of making a ton of money at closing, it’s where I tell you I was denied a loan from multiple lenders because I had no credit at all. My income was just fine, but I hadn’t built any credit whatsoever because I had avoided credit cards and any other type of consumer debt because I didn’t want it touching my cash flow.
Now, to be fair, this won’t be an article encouraging you to take on consumer debt. Rather, I want to highlight some common mistakes people make with credit cards that can have them playing catch-up for years.
Carrying a Large Balance
There are two main issues with carrying a large balance on your credit card, both harmful to your overall credit history and real time credit—abusing your credit utilization rate/ratio and/or lost interest to drawing out the overall payment of the loan.
1. Credit Utilization Rate/Ratio
Simply put, your credit utilization rate—or often referred to as your credit utilization ratio—is the is the amount of revolving credit you're currently using divided by the total amount of revolving credit you have available. In other words, it's how much you currently owe divided by your credit limit. You can calculate your credit utilization rate by taking your total debt and dividing it by your total available credit.
So, for instance, let’s say your available credit is $100,000 and your total debt balance is $40,000—your credit utilization rate would be 40%.
Ideally, the lower your credit utilization rate is, the more favorable you’ll appear to creditors because you’re effectively lowering your balance. In most cases, a 20% credit utilization rate or lower is the “sweet spot.” Not to mention, you’re also effectively extending the amount of available credit you have to you which in turn can be an advantageous place to be, in the event you want to use that credit to invest-- nonetheless, the lower, the better!
2. Lost Interest
As is with every debt that carries interest, the longer you’re paying into these debts, the more interest you’ll effectively accumulate, the more money that comes out of your pocket. Humans innately put things off for as long as they can before they address a certain issue. Why do you think so many credit card companies and partnerships offer 0% interest for 12 months?
Because they know that 90% of the consumers that take that offer won’t pay off the entire card before 12 months.
Just for context, let’s look at a small $5,000 credit card that you diligently pay off right on time, with minimum monthly payments.
- Credit Card Balance: $5,000
- Credit Card Interest Rate: 18%
- Monthly Minimum: $120
- Months Paid: 66
- Total Interest Paid: $2,905
Of course, the larger the balance, the more interest you’ll pay, the longer you’ll pay it. This isn’t meant to scare you away from credit cards—it’s meant to remind you what credit cards can do if you don’t have control over them.
Late Payments
One-hundred points-- that’s how much your credit score can drop if you miss a minimum payment by thirty days. On the bright side, if you make the minimum payment before the thirty days, by federal law your credit score won’t be affected. In my experience, late payments happen because consumers aren’t aware of what day their payment is, and/or they don’t set up automatic payments to cover them.
Here’s a few quick tips that can help you avoid late payments and improve your credit score:
- Select a payment date—most creditors allow you to do this. I personally pay all my debts on the 8th and 28th of each month
- Set up text alerts—this is available with most creditors, or you can download the credit card’s app and you can set up an alert for when a payment is due
- Automatic payments—if you can avoid overdrafts with your bank, automatic payments act a lot like automatic 401k contributions—out of sight, out of mind
- Consider paying multiple times a month—this is a great strategy because you’re constantly minimizing your credit utilization rate and you’re likely paying less interest (over the long run) as well if you pay twice during a given month.
Payment history accounts for about 30% of your overall credit score, so it’s important to have a plan when using credit cards. Be diligent to your debts and your cash flow will be diligent to you back!
Avoiding Credit Cards
I know, I know, this isn’t what you thought I’d say, but seriously—don’t avoid credit cards because they are intimidating or certain “money experts” say they’re bad. One of the worst things you can do for you credit score is not have any credit at all.
About 10% of your overall credit is based off “credit diversification.”
This means that having a diverse set of credit is generally effective toward building a strong credit and FICO score.
This doesn’t mean you should go sign up for every credit card offer known to man. However, it does mean that you should consider the long-term effects of not having diversified your credit if you’re ever looking to take on a large loan such as a mortgage or business loan. As is with everything, if you have a plan in place to tackle paying down your outstanding loan(s), you’ll be fine in the long run. Where people get in trouble with not just credit cards, but consumer debt in general, is that they go about it in a way that doesn’t benefit them in the long run and only hurts their cash flow in the short-term.
Wrap Up
Credit cards can be beneficial to consumers who carefully plan how and when they’ll be used. In my experience with clients—and my younger self—it’s when you don’t have a plan and/or you use a credit card to make a vanity purchase that inevitably puts you in a bind.
Don’t devalue the importance of credit cards because certain talking heads in the financial world flat out say they are bad. Credit cards can be a useful tool to help you increase your credit score, invest in businesses, and push you through a difficult time, if needed.
Design your plan, execute on the plan, and keep your financial goals in mind as you make your decisions with credit cards, and you’ll be just fine!
For more information, go to www.lyvfin.com to consult with a professional.
Comments