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You understand that credit is important, and you’ve likely picked up some strategies to improve your score. However, there's a critical lesson about credit everyone must learn: boosting your score isn't always in harmony with maintaining financial health. Sometimes, credit practices can contradict healthy money habits.
Whether you like it or not, credit is essential. It’s also a complex subject. In our “Everything You Need to Know About Credit” series, we’re simplifying the core concepts for you.
Consider this: if you avoid using credit entirely and stay away from debt, your financial situation might seem stable. After all, debt is generally harmful, often spiraling into more debt or forcing you to live paycheck to paycheck. So, avoiding debt should be the right move, right? Not necessarily when it comes to credit.
Building a credit history involves using credit.
If you don't open a credit card or take out a loan, it will be difficult to establish credit. Unfortunately, we rely on credit for more than just big purchases like a home or car. For instance, landlords check your credit when you apply for an apartment, and some employers do too. Furthermore, service providers are legally allowed to charge more if your credit is considered “risky.” Without any credit history, you may be deemed a potential risk.
That's why many experts suggest getting a credit card and paying off the balance in full each month (despite the misconception, carrying a balance on your credit card doesn't improve your score). Keep in mind, though: avoiding debt is far more important than having a high credit score. Many “credit building” websites may mislead you into thinking you need a large number of credit cards, but that's not true. There are alternative ways to build your credit without opening a multitude of credit cards:
Consider getting a secured credit card instead
Become an authorized user on someone else's account (just ensure they have good standing)
If you're assisting your college student in building credit, get them a low-limit card.
If you're helping your college-aged child establish credit, you might even want to keep the card in your possession to prevent them from using it impulsively.
Credit Utilization Means You’re Rewarded for Higher Limits
Credit utilization makes up 30% of your FICO score. This refers to the ratio of your available credit to the credit you actually use. The goal is to have a lot of available credit but not use much of it. However, the downside is that you might be tempted to use it!
Thanks to credit utilization, actions like opening several credit cards at once can sometimes actually boost your score. On the other hand, closing old cards can lower your score—not just because of the utilization ratio, but also due to the history tied to that card. So, even if you’ve paid off an old card and don’t want to use it (which is a smart move), your credit score could drop if you decide to close it.
Paying off a loan can occasionally cause your score to decrease as well! As Credit.com explains, this isn’t common, but it does happen. That said, this doesn’t mean you should open countless cards or keep cards open for no reason (especially if you’re paying fees) or avoid paying off a loan. Remember, your score is just a number. While important, what truly matters is your credit report and history. A solid history of timely payments will leave a lasting impression on lenders, landlords, and others.
There are still responsible ways to use credit utilization to your advantage. For example, you could keep an old card open but store it away to avoid the temptation to use it. If you have a card you don’t use, consider asking the issuer for a higher limit. Just make sure to monitor any accounts you keep open.
Settling Old Debts
You might assume that settling a debt would improve your credit. After all, you're agreeing to pay at least a portion of your overwhelming debt, so that should help your score, right? Not always.
When you settle a debt, you're typically working with a third-party company that buys your original debt at a reduced price, and then arranges for you to pay part of it. In the best-case scenario, this company will report your account as 'paid as agreed,' which can have a positive impact on your credit.
However, while this might happen as a courtesy, the company isn’t obligated to do so. Credit expert Todd Ossenfort explains how settling a past debt can sometimes hurt your score even more:
If you settle a debt for less than what you owe, your credit history can take a significant hit... even if your accounts are current at the time. Settling debt makes your credit worse because creditors are only willing to settle for less when they believe it's better to get part of the money than none at all. If you're up to date on your payments, the creditor will have no reason to doubt that they'll be able to collect the full amount and will likely refuse to settle your debt.
However, if your debt is already over 90 days past due, Ossenfort notes that settling probably won’t damage your score much more.
Credit can be tricky because we often view a credit score as a reflection of financial well-being. But it's not. Your credit score measures how well you manage credit, not how you manage debt or savings. That’s why it doesn’t always align with good financial habits.
