"I tell you Doris, he was making $150,000 a year and had been working at the same place for a decade and they wouldn't approve his loan! They told him straight up that no credit history means no loan—all because he didn't have a credit card."
It has become a bit of an urban legend, but with the rising prices of houses and the need for almost everyone to carry a mortgage, credit ratings have taken on greater importance. In this article, we will look at credit cards, their relationship to your credit rating, and what you can do about both.
Life in Plastic, It's Fantastic
There is still a sizable amount of the population with no credit cards. According to a 2014 Gallup survey, about 29% of Americans don't have even one credit card. However, this is not the norm. In fact, most individuals have more than one credit card, and the average American has 2.6 cards. Among credit card owners, the average is 3.7 cards.
For many people, credit cards have become a part of everyday life. Those without them, it would seem, are being left behind—but that isn't entirely true. The original appeal of credit cards was the ability to make purchases without carrying cash (that could be stolen) and the protection against unauthorized purchases. These days, however, these benefits can be achieved with a run-of-the-mill debit card. It is in new areas that credit cards have the edge, specifically shopping over the Internet. There are still shopping sites that run C.O.D., but by and large, it's a plastic world.
In short, credit cards aren't necessary, but they are useful. Besides, if the average person only used credit cards for online shopping, one card—rather than five, or 10—would be enough.
Credit Card Reproduction
As you may know, credit cards reproduce rapidly. One minute you have your first credit card in your wallet—the one they weren't going to give you until your parents signed the paper too—and the next thing you know, you have a card for every store you've ever been to (plus three you've never heard of).
The proliferation of credit cards may be one of the most successful PR campaigns in history. Somebody decided to change the definition of credit and made consumers feel that buying on credit was less like a high-interest loan and more like an increase in disposable income.
Unfortunately, no one told the general public about this change, and many consumers were duped into believing they were gaining buying power when they signed up—not more debt. As time passed, the truth was exposed. Instead of giving up the game, credit card companies introduced exclusive benefits and wormed their way into the ominous sounding, "credit rating report."
Therefore, the general consensus is that, without a credit card, you can't have a credit rating; without a credit rating, you can't get a loan; without a loan, you can't get a house, car or flat-screen HDTV; and without these, you are destitute, homeless and worse than dead.
Carrying this further, if one card gives you a credit history and, thus a credit rating, won't 20 credit cards give you 20 times the credit rating? This seems logical, but unfortunately, it is not the case.
The Great Divide
Banks and credit card companies have opposing views on credit card proliferation. For banks, a credit card is fine as long as it gets paid down regularly. A few credit cards are surmountable, but some of these had better have a zero balance and the rest should be heading that way. For banks, having many credit cards is a bad sign that usually points to a potential financial crisis in the making—even if they all have a zero balance.
If a potential client has so many tempting sources of easy (high-interest) credit, the bank begins to wonder which debt is going to be given priority when the chips are down and whether it is even possible for the lender to handle all the different payments. This does not, however, keep banks from issuing cards themselves—after all, money is money and a credit card gives them an interest rate return that they could never get on a regular loan.
In contrast, credit card companies love customers who carry a balance as long as they pay the interest. If you only pay the interest and continue to carry a balance on your card, you will probably be offered a credit limit increase or another card. To a credit card company, the amount you owe is less important than the fact that you pay the interest regularly. Credit cards issued by stores don't even put that fine of a point on it. They issue small debt packages, say $500 per card, and are more concerned about getting a casual customer shifted over to a constant one—the interest payments on the card are icing on the cake. It is best to avoid store cards or, failing that, avoid carrying any kind of a balance on them from one month to another.
Deciphering the Credit Rating Code
Banks want to see a potential borrower who regularly pays the interest and reduces the principal. Credit cards can be a good indicator of whether the potential borrower can service the debt one is requesting.
But credit cards are just one part of your overall credit rating. If you have taken a student loan, car loan, furniture loan, house loan, etc., these will also be part of your credit report. If you paid down these loans in a timely fashion, this will count in your favor. A stable income is also a key factor in deciding whether you qualify for a loan. You can have the best credit in the world, but without regular income, you're usually sunk.
If your credit cards are a significant part of your credit history, there are some things you can do to improve your credit rating. First, you need to keep you credit-debt ratio as low as possible on all of your cards—below 50% for sure, but below 30% would be ideal. And, once you have found a low-interest card you like, keep it. The cards that you have the longest history of regular payments with will help your rating. Pay off and cancel cards that have given you trouble.
If you are carrying a balance of more than 50% on one card and are going in for a credit report, it may be better to split up the balance between two cards. This will improve your debt ratio by increasing your available credit compared to how much debt you are carrying. Basically, you are putting the debt in a bigger box in order to make it look smaller. This strategy works up to a point. Depending on the creditor's attitude, you will hit a tipping point where the number of cards you open to deflate your debt ratio reflects more poorly on your record than the ratio itself.
Your credit rating is only one part of what decides whether you get approved for a loan, and credit cards are only a part of the credit rating. Things like splitting a high balance on one card into two make sense, but if you are holding too much debt on too many cards, you have to consolidate your credit payments on the card with the least interest and get rid of some of the principal. Or, assuming you have the ability to be approved, use a flexible loan instrument like a line of credit to clear your cards every month. This will give you a better interest rate and take away the risk of forgetting to pay a particular card down. Consolidating and eliminating debt is the best way to improve your credit rating—having a good income and well-ordered finances is the best way to get approved for a loan. Having a credit card can't replace that.