The Paradox of Credit: The Secrets of Good Credit that Defy Logic

by Amy Lillard

(10/12/2012) Credit is not a new invention. In informal agreements, verbal promises, and other methods, credit has been around for as long as there has been people buying and selling products. But today credit has assumed a bigger role than ever, in the economy at large, but also in each individual's life.

It's critical then to understand that there are some fundamental paradoxes of credit in today's society. Possessing a good credit profile means understanding some apparently contradictory things, and engaging in financial activities that may not seem entirely logical. Gaining a grasp on these can help you develop a smart credit philosophy and approach.

IMPORTANCE OF CREDIT

Credit by definition is simple. A customer wants to purchase an item, but he or she does not have the discretionary funds to cover it. The seller agrees to let the customer have the item, with a promise that they will receive the funds by a certain date.

In the past, credit was often extended informally in local communities – the grocer let families in his neighborhood have groceries now, and would get paid when they received their paychecks. Today it is a rigidly formal process, with credit extended as a loan through banks and other lenders and accessed through cards. Also part of today's process is a complicated system of interest that means people can wind up paying much more than they originally borrowed.

Credit is used today in purchases big and small, from mortgages to cars to pharmacy items. Our society has become dependent on and driven by credit. To be considered financial healthy and viable, individuals need to establish and nurture their credit. But the way credit works is often difficult to truly understand and ot navigate.

A CREDIT PARADOX: HISTORY

Credit is important. But the first paradox of credit? You need it in order to get it.

We said that right. Credit is critical to have these days, but it can be hard to get credit without any history. This can be an issue for young people just establishing their finances, adults who have never obtained loans, or people of all ages who have had financial struggles in the past.

Why does this paradox exist? It derives from the method by which people apply for and obtain credit. While credit in the past could be a matter of knowing your neighbors and appreciating their trustworthiness, big banks and lenders use a formal examination process to determine if borrowers will pay their loans back. They look closely at an individual's history of using credit as an indicator for this.

But when a person does not have a credit history, lenders are at a loss. They can't make a good approximation on potential borrowers' responsibility and their likelihood of paying their debts.

This becomes a situation in which many people can feel trapped. How can you fully participate in our credit-driven society if no one will give you credit?

There are methods of getting around this. Lenders may require a co-signer on an account, someone who has an established credit history, to help alleviate the risk. Borrowers can also start establishing credit through using retailer "layaway" and other programs, which spread payments out over time for purchases.

And this introduces the second, and potentially more disturbing, paradox of credit.

A CREDIT PARADOX: UTILIZATION

Saving vs spending. Paying for everything all at once. These are financial choices that seem logical, preventing future problems. But when it comes to credit, what's good for your wallet is not necessarily good for your credit. In fact, keeping debt, and keeping it in multiple places, is necessary for a good financial profile.

Why is it that what seems like less-than-smart financial moves are actually the best to take? It again comes from how credit is evaluated.

Take your credit score. This three digit number is assigned by three different credit bureaus (Experian, Equifax and TransUnion) based on a model developed by the Fair Isaac Corporation (FICO), and is used by lenders, utilities companies, even employers to judge your trustworthiness and financial situation. For years this credit score was shrouded in mystery, but as its importance grew companies became more transparent with their methods, revealing the five factors that go into your credit score: payment history (35%), level of debt/credit utilization (30%), age of credit (15%), mix of credit (10%), and credit inquiries (10%).

Utilization is the key driver behind this paradox credit. The idea here is to determine how much of your total available credit you are currently using. Logically, it would seem credit companies would want a very low utilization, indicating that you receive a loan and pay it back promptly. But in reality, keeping some debt is ideal.

The magic number is 25. To have a good utilization ratio in the eyes of credit bureaus, you need to keep some debt on your credit cards, but no higher than 25 percent of the credit limit. This applies to each individual account (a credit card with a $500 limit should have no more than a $125 balance at any time), and to overall usage (a combined credit limit of 5 cards of $10,000 should have a balance of no more than $2500).

The concept of utilization also means keeping debt in multiple accounts, and keeping credit accounts open. While it may make good financial sense to pay off an account and then close it, removing temptation to spend more and increase debt, keeping an account open helps your utilization. If you have three credit cards with a combined limit of $5000, and total utilization is $1000, this 20 percent is a highly attractive ratio to credit scores. However, if you close one of those accounts, lowering the total limit to $3000, that total balance of $1000 increases to 30 percent, which is less attractive.

CREDIT CONCLUSIONS

So you need to have debt. But not too much debt. You need to have multiple accounts, but watch your spending. And you need to have credit in order to get it. It's all a little strange to comprehend. But understanding these fundamental paradoxes of credit go a long way to helping you maximize your profile, and engage fully in our credit-driven society.