Understanding the Financial System

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Posted by The Savvy Retiree on July 25, 2016 in Money Saving Strategies, Personal Finances

Tom Kerr writing on financial freedom

Understanding how the financial system operates can help you use it for your own gain…even if your intention is to be relatively independent of traditional banking and the credit card habit. It can also help you work out a plan for becoming debt-free.

If you want to enter into a business partnership your credit score may determine whether or not you are invited to participate. Landlords usually check them before approving rental and lease applications, and potential employers may also use your credit score as a determining factor in the hiring process. When it’s time to complete your college education – or to send your kids to school – a high credit score can enhance the potential for you to qualify for financial aid.

So even though you don’t want to depend on a credit score, take a few moments to find out how you can raise yours…with smart “credit utilization.”

How Credit Scores Work

Credit agencies crunch numerous pieces of data related to your credit history, and then come up with a numerical ranking system represented by a single number. Just by glancing at that score, a lender can get a quick snapshot of your credit worthiness or risk. The financial industry has relied on these scores since they were first introduced in the 1960s.

The formulas used to generate credit scores are a closely guarded trade secret, and each credit scoring company uses its own proprietary algorithms. But these companies do reveal general information about the scoring procedure. We know that delinquent payments have a severe adverse impact, for instance, while paying on time strengthens your credit profile.

In recent years a major factor in computing credit scores known as the “credit utilization rate” has also emerged. Although most consumers are unaware of this terminology or what it means, understanding what it is and how to manage it can give you a powerful advantage to help you raise your credit score. Credit scoring companies have acknowledged that approximately 30% of your overall score is influenced by your credit utilization rate, which is a way of computing your debt-to-credit ratio.

Calculating Your Ratio

The credit utilization ratio is the total amount of outstanding credit card or loan balances you currently have, divided by your total available credit – expressed as a percentage.
For example:
• If you have a credit limit of $1,000 on one credit card and $2,500 on another, then your total available credit is $3,500.

• Meanwhile, if you have an outstanding balance on one card of $575 and an outstanding balance due on the other card of $1,700, then your total usage of credit adds up to $2,275.

• $2,275 divided by $3,500 = .65, so your credit utilization rate is approximately 65%. Another way to understand this calculation is that $3,500 X 65% = $2,275.

Dealing With Your Debt

Knowing how much debt you carry compared to how much access to credit you have is helpful not just to lenders, but to anyone trying to reduce debt.

The ratio can quickly show you whether or not your debt load is manageable or has become burdensome and at risk of getting out of hand. Experts recommend that you should limit your credit utilization – or usage of a credit line – to no more than 35%. Pay off your outstanding credit card balances, for example, and then charge no more than 35% of your credit limit before paying down the balance. More conservative guidelines call for a credit utilization of 30% or less, and in today’s tight credit environment the lower you can keep the rate, the better.

If you want to transition away from the banking system and are striving to live debt-free, don’t make the common mistake of canceling your credit card accounts after you pay off those pesky balances. Doing so erases your credit history and can hurt your credit score, because you no longer have access to available credit.

Keeping the account open, and only using it with the minimum frequency required ensures that it stays on “active” status. Check with your credit card company’s policy. But for most cardholders that typically means doing at least one purchase transaction a year, for any amount, that you can immediately pay off so you don’t carry a balance. I have a card, for instance, that I use to pay for a $15 subscription once a year, and that is enough to keep my card membership activated.

Having open accounts with available credit that you basically never use is one of the most reliable and effective ways to improve your credit utilization and, subsequently, elevate your credit score.

To further ensure that your credit files do not contain errors or inaccuracies, you should periodically check them. Everyone in the U.S. is entitled by federal law to view their reports from the three major reporting agencies annually, free of charge. To learn how to do that, visit the government’s Consumer Financial Protection Bureau devoted to annual credit reports.

Image: ©iStock.com/Courtney Keating

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