Our credit score is like our blood pressure. We all have one and without much effort we can find out roughly what it is. We’re told it’s important, and we know a few anecdotal tips to improve it, but beyond that we’re pretty much at a loss. Unlike our weight or our bank balance, the numbers appear arbitrary – unrelated to our everyday life. Because credit seems abstract, we often ignore it - to our peril.
One of the biggest misconceptions is that debt is the enemy of credit. This is (almost) entirely false. While unmanaged debt can hurt credit, debt itself is essential to establishing good credit and improving bad credit. This is because your credit score is not a measure of your debt aversion, earnings, investments or even your total financial acumen. Your credit score is a measure of how you handle debt. Put another way: how good of a borrower are you?
With this critical idea in mind, let’s look at ways that effectively managing (and even increasing) debt can improve your credit score.
Before We Begin: Credit Monitoring
Before you strategize to improve your credit, you need to gather some information. For starters, you don’t just have one credit score. You have a handful. Experian, Equifax and TransUnion are considered the big three credit monitoring agencies. They may each have a slightly different score for you, based on receiving different pieces of information (and at different times).
Subscribe to a free credit monitoring service and check your credit on a weekly basis. Besides providing the score itself, these platforms give tailored advice and help you zero-in on specific corrections to improve your credit.
#1 Credit Age
One of the most important factors in developing a solid credit score is the age of your credit. The more history lenders have to refer to, the greater their confidence will be in extending you loans, credit or advantageous interest rates. This confidence is reflected by a higher credit score.
Only time can improve your credit age. The clock starts the moment you take out a loan or opened a credit card. Your credit score should increase substantially within the first year of responsible credit management.
A critical caveat to the importance of credit age is that this age has to demonstrate the behaviors of a dependable borrower. One of these is payment history. Credit bureaus can report up to 7 years of credit payment history. Missed or late payments are a major red flag to lenders and have an adverse effect on your credit score. Once you’ve missed a credit card or loan payment (by more than 30 days), it will damage your report. Only time will heal this damage.
#2 Increases To Your Available Credit
Potential lenders like to see that other lenders have extended you credit and that you’re using it well. This is reflected in your total amount of available credit. Unused credit is a major positive factor in your credit score.
Credit Utilization Ratio
Your total revolving credit is the amount of credit available to you at a given time. Lenders like to see that you are using a low percentage (< 30% amount available).
Sally has $2,000 total credit and a $500 balance (25% utilization).
Jim has $1,000 total credit and the same $500 balance (50% utilization).
Although Sally and Jim have the same amount of debt, Sally will have a higher credit score because she is utilizing a lower percentage of her available credit.
Number And Diversity Of Accounts
As with the length of your credit history and ratio of utilized credit, a higher number of open accounts (e.g. credit cards, loans, lines of credit) can improve your credit score. It is also advantageous to have a diverse group of accounts. For example, having 5 credit cards is less beneficial than 3 credit cards, an auto loan and a mortgage.
However, don’t jump up and start applying for credit cards. Every time you apply for a credit card or a loan, the credit bureaus register a ‘hard inquiry’ on your account. This is somewhat of a necessary evil, but can actually hurt your score instead of helping it.
#3 Credit Cards
Reckless credit card use can rack up debt, harpoon your credit score and seriously cripple your financial abilities. Used responsibly, credit cards are a crucial building block for credit. They are also one of the quickest ways for a credit novice to establish credit.
Credit Cards With Rewards
Some credit cards entice applicants with offers of 0% APR (interest) for a defined amount of time. For personal use or to finance a small business using a credit card, these offers can be a good way to establish credit without paying interest. However, be careful to make required payments, monitor your credit utilization ratio and reduce your total balance as much as possible before the 0% APR period ends.
Other credit cards offer members rewards like travel benefits and cash back. If your work allows you to put reimbursable expenses on a personal card, using credit cards can generate travel benefits while simultaneously building your personal credit history.
Secured Credit Cards
Secured credit cards are an obscure tool that can get your damaged credit back on track if you cannot be approved for a traditional credit card.
With a secured credit card, you make deposits into an account that is tied to the line of credit, acting as collateral. For instance, you might deposit $1,000 into an account and the bank would extend you a $1,000 line of credit. Essentially, you are borrowing your own money. However, it’s a useful method for reestablishing positive credit history until your score improves enough to satisfy other lenders.
Check Your Approval Odds
Tying into what I mentioned under ‘Number and Diversity of Accounts’, it’s critical to maximize your chances of approval before applying for a new credit card or an increase in a line of credit. If your credit is lukewarm, apply for cards with low credit limits. If you apply for a credit card and get denied, you will have negatively impacted your credit for no advantage. The same platforms that offer credit monitoring will recommend credit sources that have favorable approval odds for your credit score.
#4 Installment Loans
Installment loans are fixed amount, fixed-rate loans that you pay off over a designated period of time, typically on a monthly schedule. Mortgages and Auto Loans are the most common types of installment loans.
This is a great example of how responsible debt management can ultimately improve your credit score. Lenders like to see potential borrowers take out installment loans and pay them off on schedule. Because the initial hurdles are greater, installment loans show an increased level of financial maturity.
Note: Taking out a new installment loan may temporarily cause a decrease in your credit score. This is due to the hard inquiries generated by the loan application process and the lowering of your average account age.
Remember this classic Catch-22? ‘You need a job to get experience and experience to get a job.’ Credit can be like that. It’s hard to get the ball rolling, either with no credit or bad credit. If you have a spouse, parent or other loved one with good credit (and who trusts you), you can try piggybacking as a way to jump-start your own credit.
For instance, you can apply for a loan with this person as a cosigner. Their established credit gives the lender enough confidence to extend the loan. From there, your responsible behavior (e.g. on-time payments) boosts your own score.
In another scenario, an established borrower can add you as an authorized user on their credit card. Keep in mind that any delinquent behavior on your part can hurt the credit of the person giving you a helping hand.
The Bottom Line
I don’t want to sugarcoat or distract from a truth: debt has become a major problem for a lot of people. It can cost a lot of additional money and be a major source of stress. However, debt itself is a necessary part of establishing credit. The higher your credit score, the better your frugal financial opportunities.
One final tip. Don’t ignore your credit score – especially if it makes you uncomfortable. Educate yourself and stay involved in your own financial future. Credit establishment and repair don’t happen quickly, but there is a proven formula. Stick to an informed plan and you will see the results you desire with your fiscal finances.
A firm believer that freedom of information improves business, finance, travel and life, freelance writer Ben Lovell is committed to sharing best practices. Read more of his articles at The Gothic Optimist.
I hope you enjoyed this blog post about why borrowing smart and utilizing debt to improve your frugal finances and fiscal fitness.
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