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In the consumer culture we live in, often our value is perceived in what we own and, to a certain extent, in what we have the ability to own.
This type of mindset drives us to consume, which drives our economy, which incentivizes us to consume. And on and on this cycle perpetuates.
Sometimes, we seek to acquire goods by exchanging what we have. This can only take us so far – and in most cases, that’s not far enough. So to drive our much-needed consumerism farther, we seek to acquire goods, not by what we have, but by leveraging what we can expect to have.
Why wait for the future tomorrow when you can have the future today? This is the type of thinking that birthed credit – leveraging what you expect to be worth down the road in order to acquire things now.
As cynical as this summation may appear, the truth of the matter is that our society, as it is currently constructed, coumdn’t function without credit. Whether you’re a home-owner who needs to have some costly work done on your home -either to maintain an acceptable level of comfort or to maximize the investment value of your property – or you’re a fresh graduate kickstarting your career and you need some capital to make that happen, having borrowing options is of the utmost importance to you.
In order to assess how much credit a seller should extend to an individual, the credit score was invented. This is a number between 300 and 850. The higher the number, the larger line of credit you can hope to obtain. This means lenders and businesses see in you a high likelihood that you will reimburse the debt.
Since the birth of the credit score, a number of falsehoods and misconceptions have begun to circulate as to what goes into formulating that magic number, what we can do to improve on it, and on what we should avoid doing so as not to negatively affect it.
In this short article, we’ll take a look at a few of the more common myths and explain why they aren’t true, why, in most cases, they go against the precise way your credit score is calculated.
Myth #1 – A Lower Credit Score Means Fewer Borrowing Options
When it comes to a lender or a business extending a line of credit, they are not doing this out of a charitable heart. They are trying to make money. Lenders charge an interest rate for the money they lend. In many cases, they expect to recuperate the initial sum they lent out and the interest the borrower has let accrue on the loan. However, this is not always true.
In some instances, the lender has little expectation of recuperating the initial loan. They will still go ahead with the loan because they expect to receive enough interest payments for them to be able to turn a profit.
A lower credit score doesn’t mean fewer lending institutions will open a line of credit for you. It means they will charge a higher interest rate to do so. In fact, many of the more profitable lending institutions make the bulk of their profits by lending to people with relatively low credit scores.
They do this because they can charge a higher interest rate. A higher interest rate means higher profits. And that’s the name of the game.
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Myth #2 – Having Too Many Credit Cards Can Negatively Affect Your Credit Score
Link to the royalty-free image by Mari Gimenez here
There is a popular notion that even if you pay all your credit card bills on time, if you have a high number of credit cards, this could signal a red flag to lending institutions. The truth is that your credit score essentially breaks down into a series of calculations based on 4 components:
- Your payment history – Any loans you’ve defaulted on, any late payments, etc. – this accounts for approximately 35% of your total credit score
- The total amount you owe – This accounts for approximately 30% of your total credit score and is determined by a calculation known as “credit utilization ratio”. In short, this means that a lending institution will look at the total amount of credit that is available to you and divide it by the total amount of credit you are currently using. The lower the percentage, the better.
In simple terms, this means that if you have a number of credit cards in your name, this increases the total amount of credit available to you; And, furthermore, if you choose not to use these credit cards, this means that you will have a lower credit utilization rate. The more credit cards you have – that you are not using! – the better your credit score will be.
- The length of your credit history – The longer you’ve been borrowing, the more data a lending institution has to assess the risk level. All things being equal, lenders will offer people with a long credit history a lower interest rate than they would offer people with a relatively new credit history. The length of your credit history comprises approximately 15% of your total credit score.
- The types of credit in use – This only accounts for 10% of your total credit history. It divides credit into 3 categories: revolving, open, and installment. Having a mix of the three types of credit is beneficial to your credit score. But the percentage is so small it should not be a chief concern of yours.
- Amount of new credit used or applied for – This accounts for approximately 10% of your total credit score, and it is widely misunderstood.
It’s true that applying for credit could adversely affect your credit score. This is based on the assumption that applying for credit implies a cash flow problem. However, any decrease in your credit score caused by applying for new credit will be temporary ( a few months, at most).
Myth #3 – Paying the Minimum on Your Credit Card Bill Will Keep Your Credit Score Up
Paying the minimum on your credit card bill is doing – well, it’s doing the minimum. It will not cause your credit score to go down, but it will do nothing to make it go up.
If you want to increase your credit score, you need to increase the amount of credit available to you and/or decrease the amount of that credit you are using. In simple terms, that means the more you pay off, the more credit you will have and the less of it you will be using – ergo, the higher your credit score will be.
The Bottom Line
The higher your credit card score, the lower the interest rates your offered will be. There are a number of things you can do to improve your credit score. Start by earning more money – though that depends on your career goals and how you define them. Besides earning more money, the next critical factor is what you do with the money you earn – pay your bills.
Thirdly, you will make your credit score higher by extending the amount of credit that is available to you and not using it. It’s a bit of a Catch 22 – you want a higher score because you need credit and don’t want to pay high interest rates. So, to make that happen, you need to get credit and not use it.