Qualifying for a 30-year mortgage that charges 1% less because you have good instead of average credit could save you $30,000 on a $150,000 loan. The bigger your loan the more potential interest savings is at stake.
But even if you decide to never borrow a penny, your credit rating still affects your finances. For instance, having poor credit means you could be turned down by a prospective employer or have an application to rent an apartment denied.
Poor credit typically causes you to pay more for security deposits on different kinds of utility accounts, such as power, cable, and a cell phone. Your credit is also a big factor in the rates you pay for auto insurance, homeowners insurance, and renters insurance, in most states.
For all these reasons, maintaining good credit is a fundamental part of a healthy financial life. In this post, I’ll answer four questions about how to build credit, correct credit errors, handle past due accounts, and prioritize debts the best way possible.
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4 Questions & Answers About Credit
Here are several questions from Money Girl readers, podcast listeners, and members of Laura's free Dominate Your Dollars Facebook group:
Credit Question #1
Thomas M. says, “I have four credit cards, two of which have apoplexy-inducing balances with high utilization ratios—but I plan to pay them off within about five months. My other two cards are paid off in full every month and have low utilization rates. When will I see the high utilization matter less for my credit scores?”
Answer:
Thomas, thanks for your question and for being a long-time participant in the Money Girl community! If you’re not sure what the heck Thomas is talking about, stay with me. I’ll answer his question and then give you more background on this topic.
Your credit utilization on revolving accounts, such as credit cards and lines of credit, is graded or scored every month as your creditors report new information to your file and the reporting agencies update your balance information.
So, if your available credit limit stays constant while you reduce your outstanding balance each month, your utilization ratio will also decrease each month. That boosts your credit scores right away and they’ll continue to rise each month as you chip away balances and cut your utilization rate.
Now, let me back up and make sure you understand credit utilization. Your credit utilization ratio is a formula that divides your outstanding balance on a revolving account—like a credit card or a line of credit—by your credit limit on the account. For example, if you currently owe $1,000 on a credit card that has a $2,000 credit limit, your ratio is $1,000 divided by $2,000, or 50%.
To build or maintain great credit, the lower your credit utilization ratio the better. A low credit utilization ratio tells potential lenders and merchants that you’re using credit responsibly. A high ratio indicates that you could be under financial strain or be getting close to missing a payment.
A low credit utilization ratio tells potential lenders and merchants that you’re using credit responsibly. A high ratio indicates that you could be under financial strain or be getting close to missing a payment.
Optimal credit utilization is no more than 20% to 25%. That means for a card with a $2,000 credit limit, your ideal balance would never exceed $500. But what if you want more spending power?
If you need to charge more than 25% of a credit card’s limit, it’s time to get an additional credit card so you can spread out the charges. It’s better for your credit to have two cards, each with low utilization rates, than to have one card that you consistently max out.
A common misconception about credit utilization is that you can exceed the recommended 25% limit without hurting your credit, as long as you pay off the balance in full each month. Paying off your entire credit card balance each month is a wise move because you never accrue interest.
Problem is, using too much of your available credit can still be a drag on your credit scores, even when you pay it off each month. The reporting dates used by card companies varies and typically is not the same as your statement due date.
In other words, if your balance is high on the date your card company reports it, you’ll have a high utilization ratio and see your scores go down, even if you pay off the entire balance the next day. So, it’s always better to have low balances on multiple credit cards than to have one card that you max out.
If you don’t want more than one credit card, another strategy is to make multiple payments throughout the month, such as one per week, to reduce the balance as much as possible before it’s reported to the nationwide credit bureaus.
To build credit, you don’t have to pay interest or go into debt. You can use a credit card to make small charges that you pay off in full every month. Again, interest only accrues when you carry over a balance from month to month.
Also note that your utilization ratio is generally considered a comparison of your total credit used compared to your total credit available. However, it’s also calculated on a per-card basis, so don’t let your balance on any one card get too high.
To build credit, you don’t have to pay interest or go into debt. You can use a credit card to make small charges that you pay off in full every month. Interest only accrues when you carry over a balance from month to month.
See also: 5 Lesser-Known Reasons Why Your Credit Score Drops (Podcast #467)
Credit Question #2
Phoebe M.R. says, “I'm in so much credit card debt and am trying to create a plan to pay it off. Should I focus on my card with the highest utilization ratio or the one with the highest balance first?"
Answer:
Thanks for your question, Phoebe. You’re moving in the right direction because having a plan is the first step toward taking control of your finances!
If your credit is good, I recommend that you focus on the highest-interest rate credit card first. For instance, if you have a card that charges 28% APY and one that charges 14% APY, tackle the 28% card balance first.
Getting rid of your most expensive card cuts the most interest, which you can use to pay off the balance even faster. Of course, continue making minimum payments on all your accounts, but funnel extra amounts into the most expensive card.
However, if your credit is in bad shape, it’s also costing you in ways that I previously mentioned. If you have average or poor credit, I recommend paying more on your card with the highest utilization ratio until it’s 25% or less.
See also: How to Build Credit With a Secured Credit Card (Podcast #437)
Credit Question #3
Kristy J. says, “I recently saw on my credit report that an apartment I rented a long time ago is trying to collect over $5,000 from me. I called the complex but they don't even have a record of me living there. When I left the apartment, my lease was up. What can I do to get this off my credit file?”
Answer:
Kristy, I know how frustrating it can be to see incorrect information on your credit report. Errors can be hurting your credit scores without you knowing it. That’s why it’s so important to check your reports at least once a year at free sites like Annualcreditreport.com and Credit Karma.
If you see an error on your credit file, dispute it right away with the credit bureau that issued the report.
If you see an error on your credit file, dispute it right away with the credit bureau that issued the report. You can submit a formal dispute online 24/7 with any of the three credit reporting agencies: Experian, Equifax, and TransUnion. Give a clear and concise explanation of why you believe the data in your file is incorrect.
However, if you suspect that an error is due to fraud—such as a new account on your record that you never opened—there are different procedures to expedite the process that may require speaking to a representative or mailing additional documentation.
Since you did live at the apartment, it sounds like the collection could be a genuine error and isn’t the result of fraud or identity theft. Once you make your dispute known, the credit bureau will open a claim and immediately forward it to the organization that originally provided the information. In general, the entity that submitted the data must verify it within 30 days.
In the meantime, I would also get the name and address of the collection agency and contact them by snail mail to request verification of the debt. I don’t recommend speaking with a collector on the phone because it’s easy to accidentally say something that gives them a leg up or resets the statute of limitations on a debt. So, keep all communication to certified mail so you have hard copies of everything, just in case you end up in litigation.
The bottom line is that a collector must prove that you owe the debt and that they’re authorized to collect it. If they don’t, it should be removed from your credit file.
See also: Facts You Should Know About Old Debt and Zombie Collections (Podcast #487)
Credit Question #4
Shanti M. says, “I have two accounts in collections and four high interest credit cards that are almost maxed out. I just got a low-interest loan to consolidate the debt. I want to boost my credit score quickly so I can be get a home loan. Which accounts should I pay first, the ones in collections or the high-rate credit cards?"
Answer:
Thanks for your question, Shanti. Tackling debt in the right order is important because it helps you reduce the most interest, which can allow you to pay off your balances faster. Plus, there are serious legal consequences to consider when you’re in default and haven’t paid an account as agreed.
Tackling debt in the right order is important because it helps you reduce the most interest, which can allow you to pay off your balances faster.
The credit bureaus can keep accounts in your credit file for a certain amount of time. Those with positive information stick around for 10 years. Any accounts with negative information, such as late payments and accounts in collections, stay on your credit report for up to 7 years (except some types of bankruptcies, which remain for up to 10 years).
A common misconception about accounts in collection is that if you pay them in full or settle for a reduced amount, they instantly disappear from your credit report and boost your credit scores. The truth is that, as I mentioned, every old debt stays on your credit report until 7 years after the date it first became delinquent.
Having old accounts with negative information certainly hurts your credit scores; however, they become less damaging as they age. In addition, if you pay credit accounts on time each month, that new, positive data is a powerful way to repair your credit. But there’s another time limit you should be aware of called the statute of limitations. It sets a deadline for when a creditor can sue you for an unpaid debt. It varies depending on the state where you live, the type of debt, and your agreement with the creditor.
For instance, the statute of limitations on credit card debt in some states is three years, but in others it can go up to 10 years. And some debts, such as income taxes and federal student loans don’t have a statute of limitations because you’re never off the hook for them.
Even if the deadline for a creditor to sue you has passed, that doesn’t guarantee that they will disappear. Creditors can try to collect overdue money from you indefinitely because you still owe the debt. They can contact you and ask you to pay the debt or offer payment terms, but they can’t sue you once the statute of limitations has expired.
What’s important to know is that there are rules that allow the statute of limitations to revive or restart at day one, which is known as re-aging an old debt. For instance, in some states, the statute of limitations clock restarts any time you take an action on an old debt. The action could be something as simple as acknowledging that an old debt is yours, promising to make a payment, agreeing to a payment plan, or making a payment—no matter how small.
Once you re-age an old debt on purpose or by mistake, the creditor can sue you for the full amount owed. That’s a serious legal ramification you shouldn’t overlook.
Nevertheless, you may still decide to pay an old debt. For many, paying debt is a moral obligation that they want to honor, even after struggling through a financial hardship. A benefit to paying a debt in collections that hasn’t already fallen off your credit report, is that it changes the account status from “unpaid” to “paid,” which improves your credit.
Another option to consider is settling your old debt for less than you owe. Most collectors are very willing to settle for a partial payment. For instance, if Shanti owes $10,000 she could offer to pay $5,000 with an agreement to be released from any further obligation.
If you do negotiate a debt settlement, always get it in writing before making a payment. Otherwise it could be considered a partial payment, reviving the statute of limitations in some states, as I mentioned.
If you do negotiate a debt settlement, always get it in writing before making a payment. Otherwise it could be considered a partial payment, reviving the statute of limitations in some states, as I mentioned.
When you settle a debt that’s still on your credit report the status changes to “settled,” for the remainder of its 7-year history. This indicates that the debt was not paid in full, as originally agreed, and will have a negative effect on your credit scores. That’s better for your credit than leaving it unpaid, but is not as good as paying it in full.
So, my advice for Shanti is to get clear about how she feels about her debt in collections. If she wants to pay some amount to make sure that collectors don’t come after her, then I’d consider contacting them to negotiate a settlement. But if she can’t afford a settlement, thinks the debt is an error, or isn’t bothered by getting contacted from creditors then she could use her loan proceeds only for her credit cards.
Shanti, until your credit and financial situation improves, I wouldn’t even consider buying a home. Having two debts in collection and four maxed our credit cards tells me that your financial life isn’t stable enough to handle the added pressure of homeownership right now.
When you have poor credit, you’re either turned down for a mortgage or charged a sky-high interest rate. Paying for a home with an expensive mortgage is an unnecessary drain on your finances that I don’t recommend.
Credit scores don’t increase overnight; it takes time to rebuild credit, especially with serious black marks like accounts in collections on your record. It could take 12 to 24 months before your credit rebounds. Besides credit, home lenders evaluate you on other factors, such as income, employment history, debt-to-income ratio, and the total amount of your debt.
Shanti, instead of thinking about making a big purchase, focus on reducing spending so you can improve your financial foundation. Get back to basics and work on the fundamentals. That includes building an emergency fund, investing a minimum of 15% of income for retirement, and having the right kinds of insurance to keep you safe.
Once you’ve achieved those key financial goals and cut your debt to reasonable levels, you’ll be in a much better position to own a home responsibly.
Related Content:
Best Tips to Improve Your Credit Score
The Law About Debt Collections Harrassment (Podcast #314)
What Is a Mortgage Refinance? 5 Ways to Know If It's a Good Idea Podcast #476)
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