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Building Credit | Credit

What Is the Paradox of Credit?

Credit cards were invented in 1950 by Ralph Scheider and Frank McNamara. Credit cards have a bad reputation, but the truth is that they offer an array of advantages if you use them right. From paying off debt to building credit and earning cash back, credit cards offer various benefits that can help you in the long run. Having a higher credit limit means you don’t have to carry cash everywhere you go. Moreover, they work as a source of temporary money in times of emergencies.

Credit scores and ratings pose an interesting paradox. Understanding the fundamental paradoxes of credit in today’s world is important. Before discussing the paradox of credit ratings, let’s talk about what credit is and what is a good credit score. This article also sheds light on why having a good credit score is important and ways you can improve your score.

What is credit?

Think of credit as a part of your financial power. The term “credit” has several meanings in the financial world, but generally, it means receiving something of value now and promising to pay for it later. Simply put, it helps people get the things they need now but don’t have money to pay for, like a loan for a car. When people pay back the loan, they are charged a finance fee that is decided by the lenders.

When it comes to credit cards, there are two important things to consider: credit score and credit report. A credit report is a statement that carries a detailed summary of your personal credit history and current credit situation. Your credit score is a three-digit number that represents a person’s creditworthiness. Credit scores determine the person’s ability to apply for personal loans and borrow money. Credit scoring algorithms take a thorough look at your borrowing/credit utilization, missed payments, and how often you have missed payments.

Many people confuse credit scores with credit ratings. Both credit scores and credit ratings shed light on a person’s ability to borrow money. However, a credit rating conveys the creditworthiness of a business or government, while credit score is the term used for individual consumers and small businesses.

It might come as a shock to you, but about one in five U.S citizens have either no credit history or are unscorable. Credit scores ranging from 580 to 699 are considered fair, 670 to 739 are considered good, 740 to 799 are considered very well, and 800 and up are considered excellent. Credit scores between 300 to 579 are considered poor. The average credit score of U.S citizens is 711, which is considered good. As per the research done by Experian Consumer Credit Review, around 16% of U.S consumers have poor credit.

Benefits of having good credit scores

Renting an apartment becomes easier

We all know that a person’s residence impacts the quality of their life. Healthy homes not only promote good physical health but greatly improve mental health as well. Renting a home is a serious business and a lot of time and effort goes into finding yourself the perfect home. If you are wondering how a good credit score can help you get better housing options, it’s simple: most landlords check credit history as a part of their screening process when you apply to rent a house. You need a minimum credit score of 620 if you want to have more housing options.

A good credit score ensures that you leap over the applicants with average credit scores. Simply put, a good credit score saves you from finding a landlord that would allow you to rent an apartment with bad credit and from paying large security deposits.

You get better rates on car insurance

Many car insurance companies look at credit scores to predict the potential losses and know if a person will be able to repay the debt as promised. The higher your credit score, the more confident insurance companies are that you repay the money on time.

Keep in mind that car insurance companies can use bad credit scores against you. This doesn’t mean that you will be turned down completely on the basis of bad credit. This means that you wouldn’t be able to score good deals with a bad credit history. Apart from auto loans, a good credit score also makes applying for a mortgage, auto loans, and other types of consumer loans fairly easy.

Low-interest rates on credit cards and loans

When you apply for a credit card, the company checks your score to see if you are eligible for qualifying for the best credit cards with low-interest rates. One of the greatest benefits of having a good credit score is that it helps you save money due to lower interest rates.

The difference between the interest rates offered to a person with good credit history and a bad credit report is significant. For example, if someone with bad credit is offered an interest rate of 12%, there’s a high chance that a person with a good credit score will be offered around 3.25%.

Get higher credit limits

Apart from being offered a good interest on your credit card, high credit scores can also help you get higher credit card limits. The higher the credit score, the more are the banks willing to let you borrow more money.

A high credit score demonstrates that you have paid back the borrowed money on time. This leaves a positive impression on lenders and makes borrowing a huge chunk of money possible.

Avoid security deposit on utilities

It might come as a surprise to you, but getting utility services has a lot to do with your credit history. Some utility companies look at credit reports to get a sense of how responsible a person is with paying back the borrowed money on time.

People with poor credit scores usually have to pay a deposit or submit a letter of guarantee. You can ask a friend or a family member to sign the letter of guarantee if the utility company allows you to submit a letter of guarantee instead of paying a security deposit. Signing the letter of guarantee means that the person will have to pay the bill if the primary applicant fails to pay the bill on time.

The security deposit can be anywhere between $100 to $200, which is, to be honest, a lot of money. Good payment history also makes transferring utility services to another location quite easy.

Get better job opportunities

It’s not unlikely of employers to request to see your credit report. Having a high credit score means you don’t have to worry about a low score preventing you from landing a great job. While it’s not entirely impossible to land a job with a less-than-good credit score, but the chances of landing your dream job decreases if the employer finds bankruptcies, foreclosures, student loan, collection accounts, and frequent late payments on your credit report.

Keep in mind that not every employer will request to have a look at your report. Roughly 3 to 4 out of 10 companies have a strict policy of requesting credit reports. Moreover, there are certain fields that demand a credit report, for example, finance.

Ways to build credit fast

There are numerous ways of building credit, but this article sheds light on the most important and proven ways of improving your financial profile.

Not having a good credit score may not allow you to enjoy as many perks as someone with a high credit score. However, the good news is that people with low credit scores are better positioned to increase their scores than people with high credit scores.

While figuring out how to improve your credit score, the first thing you have to do is get a secured credit card. That doesn’t mean that it is the only option you have to build a good credit report.

So, here’s how you can improve and quickly rebuild your credit profile:

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Check your credit report for errors

To improve your credit score, the first thing you have to do is look at your credit report to figure out what might be working against you. According to a report published by the Consumer Financial Protection Bureau, one in five people has an error in at least one of their reports. This is why it is important to pull out copies from all three national credit rating agencies and thoroughly review them for errors.

Credit rating agencies are independent enterprises that assign credit ratings and evaluate the financial standing of issuers of debt instruments. Rating agencies have great market influence and assess the financial strength of companies and government entities.

The five main factors that affect your credit score are payment history, amounts owed, credit history length, new credit, and payment history. Other more uncommon factors include credit age and history, hard credit searches, closing credit accounts, and the number of credit accounts you have.

Pay your bills on time

The factor that affects your credit score the most is your payment history. Payments delayed even by a few days can have a significant impact on your credit score. That is why paying bills on time is important, not just once, but every single time.

To ensure that you don’t miss the due dates, set up reminders for each bill on a calendar or a planner. The other great way of paying bills on time is to set up autopay, through the provider or your financial institution. Most credit card companies, utilities, and loan providers offer automatic payment options to ensure that the payment automatically gets deducted from your checking account.

Late payments are reported to the credit card bureau if they are at least a month late. So, if by any chance you have missed a due date, make sure you clear the payment within 30 days.

Make frequent payments

If it’s possible, try paying every two to three weeks rather than a month. These small payments are called micropayments that help keep your credit card balance down and improve your overall score. After payment history, credit utilization is the second most important factor that significantly affects your score. To increase your credit score, you have to make sure that your credit utilization stays low.

Use less than 30% of your credit card limit

Credit utilization refers to the percentage of credit you are using at any given time. Anything below 30% is considered a good credit utilization ratio. Keep in mind that credit utilization contributes 30% to a FICO Score’s calculation. The best way to increase your credit score is to make sure to stay way below the limit of your credit card. If you want to give your credit score a significant boost, try keeping your spending down to 20% of your credit limit.

Your credit card company telling you that you have a spending limit of $100, doesn’t mean the full amount. To keep your credit utilization in check, it’s good to pay your full credit card balances each month.

Don’t throw away unused credit cards

Closing unused credit cards can do more harm than good. Keep in mind that the longer the credit card history, the better will be the overall score. Closing a credit card means losing its limits, which affects the overall ratio of your credit utilization and results in low scores. Similarly, registering multiple credit card applications within a short span can take your credit score down by a few points.

If you have to close unused credit cards, make sure you close the newer accounts. If you have old credit cards, it’s good to keep on paying bills on time to build a strong and lengthy credit history. Lengthy credit history not only helps to improve your score but also helps to maintain it. It’s good to have at least three credit cards. Before choosing and applying for a credit card, make sure you go do thorough research online regarding what to look for in a credit card company. It’s good to buy a card that offers good perks and points programs. The value of credit card points depends on how the money is spent.

Ask your credit card company for higher limits

You most likely know by now that the credit utilization ratio has a strong impact on your score. The more you are able to restrict your credit usage and stay below the credit limit, the more increase will your credit score experience.

One way to ensure that you stay within the credit limit is to call your credit card company and request to increase the limits. Keep in mind that this might result in a hard credit inquiry, which will decrease credit rating a bit.

Become an authorized user

If you have a poor credit score, one great way of improving it is by becoming an authorized user of a credit card that the cardholder uses responsibly. You can ask a family member or a friend with a good and responsible credit history to add you as an authorizer on their account. They can access credit without applying for a card.

The biggest benefit of becoming an authorized card user is that the account will report to your credit, but you are not responsible for paying back the borrowed money. Before becoming an authorized user, make sure you sit down with the primary account holder and discuss what you can and can’t use the account for.

To process the request of becoming an authorized user, the card issuer will require your personally identifiable information. You can expect a good and significant boost in your score in a few months if the credit card holder has a detailed history with no delayed payments and a low credit utilization score.

Avoid taking too much debt at one time

Note that the number of loans you apply for in a short span should be minimal. One good practice to follow is to never take a second loan if you haven’t paid back the first. Taking multiple loans in a short span shows that you are stuck in a never-ending cycle of taking loans to pay off debt. This can significantly decrease your credit score. However, on the other hand, if you take a loan and responsibly pay it back on time, you will experience a boost in your score in a few months’ time.

Clear the maxed out amount first

This tip is great for people who own multiple credit cards. If the value of money owed on one credit card is closer to the credit limit than the other, a good practice to follow is to pay back the one that is more close to the credit limit. The idea behind this practice is again to ensure that the utilization ratio stays low, and you are able to improve your credit rating quickly.

Try paying out the debt quickly

Taking multiple loans at the same time can badly impact your credit score. But, the good news is that paying off debt quickly can result in a quick increase in your score. One smart way of getting out of debt quickly is to make small payments weekly or biweekly.

As we discussed earlier, you can even schedule automated online payments to ensure that you never miss the monthly due date.

The paradox of credit ratings

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What’s good for your credit is usually not good for your wallet

The first and most interesting paradox is that when it comes to credit, what’s considered good for you is generally not good for your financial profile. When it comes to maintaining a good credit profile, the decisions that don’t look smart are sometimes the best for you to take. Keeping debt in multiple accounts might seem like a bad decision, but the surprising part is that doing so is considered beneficial and important for your financial profile.

So, let’s discuss the elephant in the room: why making decisions that are not good for your wallet but good for your credit are considered good? It all goes down to how your credit score is calculated.

Credit utilization is the leading factor behind this paradox. Utilization is one of the five major factors that have a quick impact on your credit profile. A low credit ratio indicates that you are responsibly managing your credit. Credit utilization is the relationship between the amount of credit you have used and the amount of credit you have been allotted by the lenders.

Take the following measures if you think your credit utilization ratio is keeping your credit score down:

  • One great way to improve your utilization ratio and ultimately increase your credit score is to call your credit issuer and request to increase the limit of your credit card. By increasing the total amount of available credit, it wouldn’t be hard to stay below 30%.
  • This trick especially works for people who have a hard time staying below the 30% threshold. People who have a good credit score and have experienced an increase in their income since they applied for the credit card have good chances of getting the request of increasing the credit limit approved.
  • Reduce your credit card balance by paying more than once a month. It’s recommended to make at least two to three payments a month to decrease your credit utilization ratio.   
  • One quick way of decreasing your utilization score is to decrease your spendings. It’s better not to use your credit cards if you think you can’t pay down credit card payments on time. Keep in mind that credit utilization has a great influence and even greater on the credit score is by payment history. This is why it’s better to not use your credit card for valuable purchases if there’s even the slightest chance that you wouldn’t be able to make partial or full payments early.

They are necessary but easy to misuse

Credit ratings pose an interesting paradox. The first one is that they are necessary but easy to be misused at the same time.

You most likely know by now that the advantages of having credit cards make them necessary to have, but also very easy to use them irresponsibly. Using them carefully and responsibly improves your overall ratings, but on the other hand, not being able to maintain a good credit rating can lead to many roadblocks.

From getting rejected for loans and lines of credit to difficulty getting an apartment rental application approved and not being able to land your dream job, there’s a lot that can happen if you are not able to maintain good ratings.

To get credit, you need credit

Let’s talk about an interesting paradox: gaining credit to get credit. Have you seen that job hunting meme in which Spider-Man and a fake Spider-Man are pointing at each other and the caption says, “You need work experience to get a job and job to get work experience?” It’s the same with credit score because credit is necessary and critical to have but it’s hard to get credit without having a good credit history. It’s an interesting paradox on one hand and a very frustrating situation on the other.

Banks and lenders follow a thorough process to ensure to determine if the person will be able to pay back the loan on time. This results in an endless loop. Figure out yourself, how will you be able to get credit if you don’t have a credit history?

The only way you to get out of this cycle is to get a cosigner with good credit history. A cosigner can not only help you obtain a more favorable interest rate but also build a strong credit history. Cosigning on a loan or credit card means that you are taking the responsibility of paying back the loan if the primary borrower fails to do so.

Do keep in mind that the better your cosigner’s credit history is, the more chances the borrower will have to get a loan approved and obtain better interest rates. However, getting a cosigner comes with a few advantages.

One, even the strongest relationships can come when the cosigning agreement fails due to the irresponsibility of the primary borrower. Also, the credit score of the cosigner becomes yours. So, if you have a poor credit score, you are safe, but if the credit history of your cosigner is not great, the chances of not being able to qualify for a loan or not being offered favorable interest rates are high.

If you don’t have a cosigner or don’t want to risk your relationships over finances, you can either apply for a secured credit card or become an authorized user on a credit card account of a relative or friend with a strong credit profile.

Final thoughts

We hope that you now know more about what credit is, credit paradoxes, why it’s important to have a good credit profile, and ways you can increase improve your credit score. Improving your credit profile might seem a little difficult, but by following the aforementioned tricks, you will experience a significant increase in your score.

Here are a few important takeaways from this article:

  • Credit is an agreement between a borrower and a lender in which the borrower takes money from the lender with the promise of paying it back later with an interest on the outstanding balance
  • No matter how difficult it might seem, there are numerous ways of building a good financial profile
  • To obtain credit, you need to have a good credit history
  • The factor that has the most effect on one’s credit score is the payment history
  • Credit card utilization is the second most important factor that influences the credit score
  • It’s important to ensure that the borrower’s credit utilization ratio stays below 30%
  • One out of five credit card reports have an error which results in the low score
  • There are various benefits of having a good credit profile, including more housing options, being offered low-interest rates, getting better job opportunities, avoiding paying huge security deposits, and getting lower rates on insurance