How you manage your credit can make or break your personal finances. Credit can be a helpful tool to get the things you need and want, and it can also lead to your financial downfall if you are not careful.
Using credit wisely can provide a lifetime of access to opportunities, but misusing credit or accumulating debts you are unable to pay can hurt you financially and shut doors you may not have even considered. Whether it’s due to youth, inexperience, lack of knowledge, or a personal financial crisis, many people have made regrettable financial missteps over time and find themselves in a bind when it comes to managing their credit.
While you should forgive yourself for getting into a compromised financial situation, the most important thing is to learn from mistakes that have affected your credit so you don’t make them again. And if you’ve been fortunate enough to avoid negative marks on your credit thus far, it’s equally important to understand how to stay out of credit trouble and how to use credit to your advantage.
The bad news is, credit-related blunders can stick with you for years. Poor credit management can wreak havoc on your financial health and reputation. Once debt starts to pile up or negative marks hit your credit report, it can be difficult to dig yourself out of a hole and repair your good standing.
But the good news is, it is possible to recover and get back on track. And the even better news is, you can learn how to manage credit wisely to avoid that trap in the first place or ensure you never find yourself there again.
What is credit management?
In managing your personal finances, your primary credit management objective should be to avoid excessive debt. Put simply, you should not be borrowing any money that you can’t pay back easily without straining your budget or getting behind on payments.
Your mortgage, car financing, credit cards, and other lines of credit are costing you money in terms of interest, but they may be the key to leading a comfortable lifestyle. Even people who can afford to pay for homes, cars, and other expenses in cash often use credit to manage cash flow, keep their assets invested, or take advantage of credit card reward programs.
With responsible credit management, you use credit to your advantage and avoid the possible pitfalls of poor credit management. The key is to follow conservative spending guidelines, using a minimal amount of credit relative to what the banks are willing to lend you. Your income and the amount of money you have available to pay your bills should serve as your compass for how much debt to accrue, not the maximum limit for which you qualify.
Why is it important to manage my credit?
Far too often, people allow lifestyle spending to get out of hand, bloating their budgets, living beyond their means, and overextending their credit. Whether resulting from unexpected job loss, sudden illness or injury, a major financial blow, or out of control spending, the damage that comes from overextended credit can hit you quickly and have long-lasting effects.
Having damaged credit is a dangerous situation to be in and can lead to troubles nobody wants to face, including foreclosure, repossession, paycheck garnishment, asset seizure, bankruptcy, and even homelessness.
What you may not realize is having negative marks on your credit or a low credit score can restrict your life in a number of ways. A lower credit score means the lender is taking a greater risk. It may prevent you from qualifying for a mortgage or even an apartment rental. It requires you to pay large deposits or down-payments and dramatically higher rates for access to simple things, such as utilities, a mobile phone plan, or car insurance. You may not be able to get a credit card or a bank account. It can even prevent you from passing a background check to get a job.
The objective of credit management is to demonstrate that you are trustworthy, reliable, and responsible with money. Although major medical expenses or other unforeseen circumstances that are outside of your control happen, it’s always important to do whatever you can to prepare for the unexpected and protect your finances as much as possible. Careful credit management is a big part of that equation.
What is the difference between a credit score and a credit report?
Credit management involves both careful use of your credit and close watch of your credit. It is important to not only make prudent financial decisions but also understand how credit works as well as how it is tracked, scored, and measured. To do this, you need to know what a credit score is and what a credit report is, so you can read and manage yours accordingly.
A credit score is a number that depicts your creditworthiness and it is based on metrics derived from your consumer credit history. The exact calculation remains somewhat of a mystery, but factors include your total amount of debt, types of debt, number of open credit accounts, age of your open accounts, your record of repayment, and credit utilization, which is the percentage of available credit you’re currently using.
Most financial institutions use a credit score model known as FICO (originally short for Fair Isaac Corporation). The number ranges from 300 to 850, and it is used by lenders to evaluate the probability that you will pay back the money lent as promised and that they can expect your payments on time.
Excellent: 800 to 850
Very Good: 740 to 799
Good: 670 to 739
Fair: 580 to 669
Poor: 300 to 579
Again, the exact calculation is not expressly known, but we are privy to how activity is weighted. Your payment history, or the number of payments made on time, accounts for 35% of your credit score. The length of your credit history factors at 15%, with shorter credit histories considered riskier. The total amount you owe and the percentage of available credit you are using — also known as credit utilization, accounts for 30%. The mix of types of credit you use — mortgages, car loans, credit cards, etc. — counts for 10%. How recently you’ve opened accounts and how many new credit inquiries have been made, makes up the final 10%.
A credit report consists of the raw data that serves as a basis for your credit score. It is a historical record of how you manage your finances, like a report card. Your credit report lists specific information, such as open accounts, balances, payment history, and negative marks, such as late payments, collections, judgments, foreclosures, liens, repossessions, and bankruptcy.
The report provides context and information that is supplemental to your score. It tells your story — good or bad, the highs and the lows. It’s used by financial institutions when they are making decisions about granting credit and can also be used to verify your identity and screen your background.
Components of the credit report include your personal information, such as your name, address, and employer, a list of all open and recently closed accounts, information on companies that pulled your credit report for an application, and public records associated with your credit history such as civil judgments.
Financial institutions, companies you do business with, collection agencies, and local and state governments furnish your consumer credit information to credit reporting agencies, such as TransUnion, Experian, and Equifax; and these three bureaus are responsible for maintaining credit reports for consumers nationwide.
A good credit management practice is to keep tabs on your credit report often and review your credit report carefully every few months and prior to making any significant financial decisions or attempting to qualify for major loans such as a mortgage.
What steps can I take to manage my credit?
At its most basic level, good credit management simply means keeping debt to a minimum, paying off debts you’ve already accrued, making your payments on time, and reviewing your credit report regularly for errors. But to improve your credit score and maximize your creditworthiness, you will want to follow some best practices for credit management.
Make Payments On Time
Remember, your payment history is the most heavily weighted factor in your credit score. Paying all of your bills on time every month is the best thing you can do to manage your credit wisely. Any payment that is over 30 days late can damage your score dramatically and immediately — as much as 100 points in one hit. At the very least, make your minimum payment due to avoid such penalties. Set up auto-payments or payment reminders to ensure you never miss a payment if you can avoid it.
Use Less of Your Available Credit
Just because the credit has been extended to you doesn’t mean you should be using it. You should strive to utilize less than 30% or ideally less than 10% of your available credit on each card, keeping in mind that this is the second-biggest metric in determining your credit score. So if you have a credit card with a $10,000 line of credit, limit the balance you carry to no more than $3,000, preferably less than $1,000, and ideally paid in full each month. And if you need to make a big purchase, it may help to spread it out over several cards to keep the utilization percentage lower on each card. Another tip is to make payments prior to the due date to keep the reported utilization low.
Manage Your Credit Limits
One way to avoid excessive debt is to limit your credit lines. When it comes to revolving accounts such as credit cards, a general rule of thumb is to limit your total available credit line to no more than 20% of your total household income. So if you make $100,000 per year, your total credit lines should be no more than $20k. This guideline assumes that paying back more than this amount would be difficult and having access to more would tempt you to use it.
Use Credit Wisely
Many people have trouble staying disciplined with credit, especially credit card usage. But if you learn to manage your credit more wisely, you will begin to see how it can be used to your advantage. Avoid traps like store credit cards that lure you in with a small but tempting discount and tend to carry high interest rates. Opt instead for cards that have advantages such as rewards programs and cashback.
Think of credit cards as a tool that can help you build your financial future, rather than something to run up and cause harm. Using a credit card to cover emergency car repairs when you don’t have the cash is wise; using a credit card to buy new designer shoes because you don’t have the cash is probably unwise.
Credit management doesn’t have to be difficult; in fact, it’s fairly simple. If you are saddled with mountains of debt or a low credit score, the burden of credit management can seem insurmountable. If you have no credit history or limited credit history, it can seem like a tough climb. However, small steps will carry you forward, and little by little, you can make great strides.
If you don’t have a lot of debt and already have a good credit score, you’re on the right track. Keep going, keep your eye on your credit report, and take every precaution possible to avoid the pitfalls and credit traps that so many find themselves struggling against.
John J. Diak, CFP® is the Principal & Client Wealth Manager at Oatley & Diak, LLC in Parker, Colorado. He assists clients through many difficult lifestyle changes such as business downturns, retirement planning, divorce, the death of a spouse, and family estate issues among others. Oatley & Diak, LLC is a family-run registered investment advisory (RIA) firm that provides clients with investment management and financial planning services in a hands-on, intimate environment. Learn more about them at oatleydiak.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This material was prepared by Crystal Marketing Solutions, LLC, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate and is intended merely for educational purposes, not as advice.