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I’ve written many times before about some of the dangers and traps associated with the use of credit cards. But an article (with some interesting Facebook comments) that Megan sent me about a new credit card program with super-OMG!-amazing sign-up bonus features got me to thinking about the psychological effects of using credit cards and why we find them so hard to get rid of, yet so easy to rationalize.
I hope to make the argument that the rationales for the use of credit cards ultimately rely upon thinking primarily in terms of a best-case scenario and rarely take into account the substantial risk entailed by their use.
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4. USING DEBT TO ENABLE MORE DEBT
One of the oft-cited reasons for using a credit card is that it helps to build your credit score. Sometimes the actual mechanics of the credit score (and its uses) are understood, but sometimes a good credit score is simply held out as a good in and of itself. It is easy to think that it is indicative of financial health or success, since there are no lack of commercials and voices telling us precisely that.
A credit score, however, simply measures one’s use of debt according to a specific formula. It looks at how much debt one has, how much one has available to use (credit), and what the ratio of debt utilized to debt paid back is, along with other time-based metrics.
Seen in this manner, there is nothing about a credit score that actually gives any indication of one’s financial health or success. To be sure, one might assume that a good credit score means one is being successful or financially healthy because debt can be utilized and paid back. However, this doesn’t at all take into account one’s assets, cash position, net worth, etc. One could be living from paycheck to paycheck and yet still have a “great” credit score because the debt utilization and the like falls within the specified ranges for a good credit score.
Thus, while it is certainly possible to have a good credit score and be financially responsible, it also indicates a certain amount of financial risk in that one has to perpetually interact with debt and debt products in order to maintain a “good” credit score. Some advice from CafeCredit on this shows how misguided conventional wisdom can be:
Having different kinds of credit is helpful. Only having credit cards demonstrates a limited ability to manage money. Having a credit card, a car loan, and a mortgage (and paying those debts on time) shows that you know how to balance a variety of demands. (CafeCredit, https://www.cafecredit.com/improve-credit-score/)
Different kinds of “credit,” of course, means “different kinds of debt,” and that pesky d-word even slips in there as a caveat. The amusing thing about a good credit score is that it basically means there will be even more people and institutions extremely willing to offer you debt and debt products. In this sense, a good credit score opens you up for even more potential financial risk and disaster, but that’s not how it’s ever framed:
If your score is labeled “excellent”, you’re golden.
This always means you are in the upper echelon of potential borrowers in the opinion of the credit bureau or lender you received the rating from. It is the best credit score range there is.
You’re pretty-much-guaranteed approval, the lowest possible rates, and best terms. (ibid.)
Of course you are pretty much guaranteed approval! A high credit score (especially one that has been high for a long time) often indicates someone who is perfectly comfortable utilizing debt on an ongoing basis.
This would be analogous to placing a sign outside of your house that asks solicitors to come and sell you something. Or like chopping off a leg in shark-infested waters.
While credit scores ostensibly have other uses, the main reason for a good credit score is so that one is able to use increasing levels of debt, presumably with benefits like better terms. But at the end of the day, a debt product is what lenders are wanting to sell you, and your credit score helps to indicate the nature and quality of your interaction with debt.
Thus, the game is ultimately to use debt to allow one to use even more debt.
Using credit cards can be an especially bad way of building
debt credit, especially if one is continually chasing after rewards with different cards. Putting “everything” on your credit card- even if you pay it off- can actually be detrimental to your credit score, since it can show a high balance and affect your credit utilization ratio. Constantly turning over cards with balance transfers and the like can also negatively affect your score, since it can indicate a lack of stability with your credit utilization. Similarly, only using credit cards can indicate an inability to manage multiple types of credit (naturally larger types!).
All of this, of course, doesn’t even take into account just how bad the terms on credit cards can be, and how much continuous financial risk they can entail. And unless you play the credit game like it’s predetermined to be played, your use of credit cards for the purpose of building a credit score may ultimately be self-defeating.
Of course, there are supposed benefits to building a good credit score (and by extension using credit cards to achieve this). You may find it easier to rent an apartment, get a better deal on car insurance and better terms on a car loan or a mortgage. And while there are of course plenty of exceptions to these (one can get an apartment without a credit score, a good deal on insurance without one and good terms on a manually underwritten mortgage), for the sake of argument let’s take this as a present day reality.
The argument then must be reframed: Given that debt (and especially credit card debt) represents substantial financial risk, are these trade-offs worth potential financial difficulty or disaster?
One website frames the rationalization for credit cards this way:
Without fail we have had a credit score run on each of us when we have rented apartments in Utah, NYC, Boston, and North Carolina. Especially in a location like NYC where a good apartment gets swiped up within hours, a solid credit score put us a notch above other applicants. (OurFreakingBudget.com, http://www.ourfreakingbudget.com/why-we-use-credit-cards-dave-ramsey/)
I wouldn’t dispute that this may actually be the case, but the question really needs to be asked: is the potential benefit (which is by no means a given) or convenience worth taking on this kind of financial risk? After all, you have to have a long track record of interaction with debt to get this kind of good credit score. It is perhaps instructive that the preceding rationale is followed with this:
Better Credit Cards: When we have shown credit card companies that we’re reliable, inevitably better credit cards become available to us… (ibid.)
Oh, hello sharks. Let me just go ahead and dip my bloody leg in the water…
In our own experience, Megan and I have actually had really good credit (unintentionally), even though we have almost never used credit cards. Rather, we both paid off student loans and have made all of our mortgage payments on time.
At the time of closing on the house we had a pretty decent score, and we were able to get a 3.5% rate on our 30 year loan. I’m not sure what the rate would have been had we had a worse score, but within the entirety of the amortization schedule it probably would have represented a substantial amount of money. Let’s try some numbers:
Let’s assume we made every payment for 30 years on a fictitious $175,000 mortgage. At 3.5%, the total payoff would have been $282,000+. However, if we had gotten a worse rate of say 4.5%, it would have been $319,000+, which means having a “good” credit score would have saved us around $37,000 over 30 years (which would be approx. $1000 or so a year, vs. paying an extra $3000 a year in interest…). If it had been 5.5% because of an even worse credit score, it would been $357,000+ and cost us over $75,000 extra.
Now, it might seem like I’m essentially making the case for having a good credit score. However, the truth of how useful good credit is comes to light when one considers the actual terms.
The significant savings or losses that differing credit scores represent assume the completion of the term as it stands, and that is the basis for the rationalization of building a good credit score. But if one considers a faster payoff amount, the savings or losses all but disappear.
In the same example, let’s consider a 15 year term. At 3.5% it would be $225,000, at 4.5% $240,000 and at 5.5% $257,000. The spread between a great interest rate and a worse one goes down to $32,000. And as this calculation narrows the shorter the term is.
Megan and I ended up paying off our mortgage in about 2.5 years. Using that as an example and assuming the same terms:
At 3.5%: around $181,000
At 4.5%: around $183,000
At 5.5%: around $185,000
Thus, the actual spread is only $4,000 due to the interest rate predicated on the credit score. $4,000 is still a considerable amount of money, but it’s not a sufficient reason to place yourself in financial risk.
Of course, this is a pretty extreme example, but the point is that the favorable terms and such due to a credit score only become more favorable the closer one sticks to the original term. However, the irony is that sticking to the term will actually cost one more in the long-run, especially on larger amounts of debt.
There’s nothing wrong with getting favorable terms on one’s mortgage, all things being equal. But the credit score game is meant to keep you in debt as long as possible, and thus favorable terms can actually act like the rewards on credit cards writ large.
Using debt to be able to get more debt isn’t a good long-term strategy.