8 Credit Mistakes to Avoid
We live in an emerging economy where access to credit has been made easy with schemes such as buy now, pay later and point of sales financing. The term credit has a strong connotation in the financial industry of India.
In the past, credit was not associated with good financial health, however, now it is becoming increasingly unavoidable to avail credit. The capacity to borrow for any borrower is determined by their credit score. With such ease in availing credit, the borrower needs to be cautious in order to avoid any negative impacts on their credit score.
How is your credit score determined?
Credit rating agencies such as CRISIL, CRIF or Experian study the borrowers behavior, rank them based on their pre-defined parameters and use algorithms to determine any individuals’ credit score. The parameters used to define the scores are numerous and include the number of dues-past date, credit inquiries, number of credit lines, repayment consequent to the credit lines etc. When a loan application is made, the scores are sent by these rating agencies to the lenders, based on which the lenders make the decision of credit approval. Typically, credit scores range between 300 and 900, 300 being the lowest and 900 being the highest. Higher the credit score, the easier it is to access credit. Generally, scores above 750 are considered good enough by banks and NBFCs.
Importance of a Good Credit Score
Having a good credit score and maintaining the score is of utmost importance because a bad score can be detrimental when a lending decision is made. A good credit score means lower interest rates, easier qualification for loan, higher purchasing and negotiating power, preparedness for future, etc. Good credit scores can make riskier and expensive products such as unsecured loans more affordable.
Even small mistakes such as forgetting to pay credit card balance, has an impact on your credit score. In contrast a bad credit score can cause numerous financial complications for any individual. Bad scores mean higher interest rates, meaning costlier debt and higher insurance costs. These days, even employers are looking at the credit scores of prospective candidates for certain jobs to check the trustworthiness with finances of the candidate.
There is a myth that credit scores consider the number of dependents on an individual and other factors such as whether a person is married or not, however in reality, these parameters are not taken into account. Other factors such as salary, place of residence, race and religion are also not taken into consideration.
With the availability of point of sales financing, buy now pay later schemes, no-cost EMI, credit card points and rewards, leveraging has become a part of day to day life. When use of credit becomes a part of daily life one must practice caution and discipline in order to maintain their creditworthiness for easier access in times of urgency in future.
Let's look at some basic myths and mistakes when using credit and see how we can avoid the same.
- Payment of only the minimum amount due on credit cards - Credit cards have brought ease and convenience in our lives in numerous ways, from travel to online shopping credit cards have become ubiquitous. Credit cards provide the feature of paying only the minimum amount on the due date. While this may seem like an attractive option it comes with major drawbacks. Not paying the entire amount, and just a percentage of the total amount means, interest charge levied on the outstanding amount. This outstanding balance gets carried forward to the next cycle of billing hence, continuously enlarging the outstanding balance. Since the outstanding amount due keeps increasing, it may lead to a debt-trap.
The other negative of outstanding balances on credit cards is that when the amount hasn’t been paid in full, the interest-free period of 45 days gets forfeited, consequently, levying interest on every new purchase. This means higher credit utilization as compared to lower credibility. Hence, one must not be under the assumption that paying only the minimum balance due will not have an impact on the credit score, because it not only does impact the credit score, but also makes outstanding payments much more expensive. The wisest thing to do is to utilize only the amount that can be paid back.
- Missing Payments - When an EMI payment it not only negatively impacts the credit score, but it also gets noted in the credit report. Other consequences of it include default or late penalties which are sometimes charged on a per day basis and constant follow-ups and visits by recovery agents in some extreme default cases. Every default can be classified either as a major default or a minor default, which is then marked with the same terminology on the credit report.
When the EMI amount is due past more than 90 days it is termed as major and in contrast when it is less than 90 days it is termed as minor. A major default can largely impact your future credit requirements. Missing EMIs can impact your credit score negatively by many points. In some cases the reason for missing EMIs is forgetfulness rather than a crunch of funds. It is beneficial to set up auto debit payments in order to avoid such blunders. However, if a borrower doesn’t want to go for auto debit, the borrower needs to be proactive in paying EMIs and set up personal reminders so that EMIs are duly paid.
- Irregular viewing of credit statements : Credit statements should be viewed regularly in order to keep a constant check on spending as well as any irregular activities or spending occurring which could be fraudulent. Proper maintenance of credit statements can be beneficial for the credit holder in order to be able to tackle any unexpected issues which might arise in the future. Moreover, some credit cards provide some perks such as extended warranties and return protection on eligible purchases. If the credit card holder is negligent, he might miss out on such perks.
- Negligence towards credit utilization ratio : Credit utilization ratio is a measure of an individual’s revolving credit and can be defined as the ratio between the credit limit and the amount utilized. The lower the ratio, the healthier it is for your credit score. According to Experian, one of the top credit rating bureau, this ratio should be around 30%. Meaning if you have an eligibility of Rs 1,00,000 on your credit card, you should ideally only be using up to Rs 30,000.
- Multiple loan applications and inquiries - Making multiple loan applications with different financial institutions can make a borrower look desperate and a high risk individual. Multiple inquiries impact the credit score negatively and hence lenders practice utmost caution, causing difficulty in sanctioning a loan because of the increased riskiness. Inquiries can be classified as soft and hard inquiries.
As the terms suggest, hard inquiries have a higher impact on the credit scores. Soft inquiries are when you get certain credit offers or when you check your own credit scores. These don’t require the concerned individual’s consent and are mostly done by lenders to send marketing offers. These don’t have any effect on the credit scores. On the other hand, hard inquiries occur when a loan application is made and detailed credit reports and credit scores are fetched by lenders from credit bureaus. Doing this requires the concerned individual’s consent and can impact the credit scores. While they don’t have a huge impact on the credit score, multiple hard inquiries by various lenders can lead to marking the applicant as high risk. This can be easily avoided by researching the right credit product before applying for any sort of credit.
- Cash advances through credit cards : Taking cash advances using a credit card is similar to taking a short term loan. While it may not impact your score immediately it may have consequences that might hurt you in the future. Given the ease of availing short-term instant credit, lenders charge very high interest rates. If the borrower is unable to pay the high interest rates, it can affect the credit score. Another indirect impact of using cash advance using credit cards is that it might increase your credit utilization ratio. Finance fees are further assessed starting on the day of withdrawal and continuing until the due date. As a result, save this choice for last and only utilize it in life-or-death situations.
- Charge-off on credit card : A charge-off on credit card is like cancer to your credit score. Charge-off means that the borrower has been delinquent for 180 days. Following this, the debt can be sold to a third party collection agency and they can consequently try to recover this amount from the borrower. A charge-off can persist on your credit report for long periods of time, which can also exceed 5 years. This significantly impacts credit score and the ability to borrow at decent rates in the future.
- Closing a credit card : One of the factors when your credit score is calculated is the tenure for which you hold your credit card. Longer the credit card is held, the better the impact on the credit score. Keeping multiple credit cards is also fine as long as you can maintain them for lengthy periods of time. If a credit card is closed, especially if the oldest credit card is closed, the average holding of credit card changes, hence decreasing the credit history and increasing the credit utilization ratio. Furthermore, this has a domino effect on your credit score.
In conclusion, borrowing money in terms of loans or using credit cards is not always negative. However, it does rely on how well you handle your credit while keeping in mind that every financial institution will record and refer to them in the future. Discipline in paying EMIs and good credit utilization behavior may go a long way toward keeping your credit ratings and finances in good standing. You will be able to profit from the advantages of having credit and credit cards by avoiding these widespread myths and errors.