Holiday shopping season is upon us! Over the next few weeks millions of people will spend billions of dollars buying gifts for their loved ones. Those bright smiling faces sitting around the tree on December 25th are just priceless....unless you are ruining your credit, then they are just pricey. No worries though, The Talented 6 is here to help. Before you go out and swipe your credit card, let's examine how your purchase will effect one of the most important numbers in your life, your credit score. We will start by going over some basics regarding credit and then discuss the credit factor most impacted when you make a purchase, your utilization rate.
WHY CREDIT MATTERS
Your credit score effects how much you pay for every major purchase. Where you live, what you drive, and how much you can borrow all depend on your credit score. When you step back and look at credit through that paradigm, it is apparent how imperative a good score is. Oftentimes, credit is not discussed throughout your academic career, and many people spend the early years of adulthood learning by trial and error. That should not be the case.
INTRODUCTION TO CREDIT
Credit scores range from a minimum of 300 to a maximum of 850. Any major purchase you make requires your credit score to meet a certain standard. For the purpose of this post let's say, a major purchase is a home, car, or any other type of loan (personal, home improvement, student loan). Your credit score is important in relations to loans and new lines of credit because your interest rate (the money you pay in addition to the principal) will vary depending on if your score is closer to the minimum or maximum. The higher your credit score, the lower the interest rate will be on your loan and vice versa.
Your overall credit score is a compilation of several factors. Some factors are high impact, while others have a medium or low impact on your overall credit score. We will examine credit utilization, and let you know what you need to do to have a good or excellent rating.
Credit utilization is a high impact credit factor. Your credit utilization rate equals the amount of credit you are currently using (current balance) divided by the amount of credit available to you (your credit card limit). See FIGURE 1 below detailing how credit bureaus rate credit utilization percentages. For example, if you have a current balance of $500 and there is $10,000 of credit available to you, you have a credit utilization rate of 5% which is excellent. However, if you have a current balance of $6,000 and there is $10,000 of credit available, your 60% utilization rate is poor and your credit score will be adversely effected.
Credit bureaus want borrowers to have a low utilization percentage. A borrower with a low utilization percentage demonstrates several things. One, the discipline to use credit responsibly. An individual may use their credit card for purchases and pay off the balance at the end of each month which keeps utilization low. Two, the borrower is not strangled by debt, if you have a high utilization percentage it is apparent a large percentage of your take home pay is allocated to debt payments and you are in over your head fiscally. If you have high debt payments (which they will determine by your utilization percentage) a lender is less likely to extend a new line of credit to you as you may already be overextended financially.
In the eyes of credit bureaus, your credit utilization rate must be below 30% to be considered good. If there is a period of time where your utilization percentage rises from 10% to 50%, your score will decrease. However, keep in mind that your utilization percentage is fluid, meaning if you pay off a balance you have been carrying for several months your credit score will rise due to your credit utilization percentage decreasing. Do not panic if you have emergencies that require you to use your credit cards. As long as you pay off your balances, or continue to pay off portions of your balance your utilization percentage will decrease and your score will rise to previous levels. Be mindful of your credit limits as well as the amount of credit you are currently using, keep your balance to a minimum and you will maintain a satisfactory utilization percentage.
75% and greater Very Poor
This is an excerpt from an e-book that I wrote – Financial Foundation: a deep dive on credit, saving and budgeting for young adults. It is a good resource for young adults or anyone who desires to learn more about these financial tools. It’s a 30 minute read and contains all the basics and more. If you are interested in learning more about any of these financial factors check out the link below. Thanks!