Through these many experiences, it has come to my attention that many people have little knowledge about their credit and how to use it in a way that benefits them. I don’t see this as being their fault. On the contrary, I find it the failed responsibility of the credit industry that makes it so easily available as being the primary culprit.
I have identified what I feel to be the seven most common misunderstandings regarding credit card usage and how it REALLY affects the consumer.
Myth #1 – I pay cash for everything, so I should be able to borrow money since I don’t have any credit cards.
I can’t tell you the number of mortgage borrowers that have come to me who were shocked beyond belief that they couldn’t get a mortgage since they didn’t have any debt. It’s an ironic fact that the lack of credit history actually makes borrowing money quite difficult, not impossible, but difficult.
Since credit scores are generated from the use of credit, it’s not necessarily a good thing to have no credit history if you want to buy a home. In fact, it’s nearly mandatory to get some credit experience.
Now, there are ways to build a credit history in order to buy a home. I have done this very thing using insurance payments, utility bills and cancelled rent checks. I present these to the mortgage underwriter for consideration as an credit history.
There are a few drawbacks using this method. You generally can’t get the lowest rates and you typically need a larger down payment. If you use some of the creative financing strategies I have developed over the years, this can also be addressed, but it requires more work.
If you are someone who is planning on buying or building a home in the next 12-24 months, now is a good time to build a credit history. In fact, many lenders will want to see the accounts, meaning you will need a history about this long.
It’s quite easy to build a credit record. One method I have recommended is to start a savings account at your local bank. Once the balance gets to be a few hundred dollars, ask them to give you a loan for that amount using your savings as collateral.
Make regular payments on the account using the money you borrowed for a few months, then pay it off (one thing that greatly impacts credit scores is a paid in full loan).
Then, do it again.
It’s also possible to obtain credit cards in this manner. Banks will issue you a credit card using your savings as collateral. By using your card in a responsible manner over 12 months, you will quickly gain the experience mortgage companies are looking for.
I often advise my clients to use the card to pay for groceries, then pay the bill using the check you would have written the grocery store. IMPORTANT: If you aren’t a person of discipline, DON’T USE THIS APPROACH!!
Even though it’s possible to get a mortgage without a credit history, it’s much easier to do so with one.
Myth #2 I must have good credit since I keep getting credit card offers in the mail. If I had a nickel for every time I had a client tell me this one, I could retire. This is perhaps one of the most damaging misunderstandings I come across. Let me state one thing, right here and now, that should be understood by every consumer in America.
CREDIT CARD COMPANIES DON’T MAKE MONEY FROM & GOOD CREDIT RISKS & THEY MAKE MONEY FROM PEOPLE WHO BORROW MORE THAN THEY CAN PAY BACK!!
Think about it. How much money does the credit card company make on the user that pays their balance off each month to ZERO!!
However, if they can get someone to max out their credit cards, they make a fortune in interest when the borrower is stuck making the minimum payment every month. Even low rate credit cards can provide the credit card company with obscene returns on their money.
Let me make this clear, you get credit card offers in the mail for one reason:
TO MAKE MONEY FOR THE CREDIT CARD COMPANY!!
Let me share a story with you. There was a time in my life when things weren’t going so well financially. My wife had gone through several years of serious health issues that drained us dry of all our resources.
We were often very late on making payments on our accounts. Some of them were even closed out by the lender. On top of that, we had thousands of dollars in medical collections and a home we had purchased was foreclosed on.
Things were bleak!!
Yet, during this time, we continued to receive credit card offers in the mail.
Was this because of our GREAT CREDIT? Of course it wasn’t. It had to do with the fact that the credit card company saw someone who struggled in the past to make their payments; they knew that if they could get me signed up, the odds were in their favor that I would always carry a balance on the card, thus making them a ton of money.
So, there you have it! Getting credit card offers in the mail have little to do with your great credit and have everything to do with the credit card company wanting you to borrow more than you can pay back.
Myth #3 My credit must be good because my credit card company keeps increasing my credit limit.
This practice by credit card companies is based on a similar philosophy as Myth #2. In other words, the credit card company wants to get you to the point that you borrow more than you can pay back in one month.
Most of the time, the offer to increase your credit limit comes from having a history of paying on time for a few months and carrying a small or no balance.
Again, you have to think about the rational behind the credit card companies. They don’t want to have a bunch of users who can pay the balance in full each month. They don’t make any money that way. Instead, they want to get their customers to the point where they borrow more than they can pay back in a month.
If you doubt the logic of my argument, try this sometime.
After carrying a balance on your card for a period of time, call the credit card company and ask for a limit increase. Chances are, if you have been near your maximum limit, they will decline you. They will do this even if you have never been late with a payment. The reason they will say no is you have already demonstrated that you are the type of borrower who will make them money. There’s no need for them to take the additional risk of increasing your limit when they already know you can’t pay what you owe.
Myth #4 I will be ok with my debt ratios when I apply for a mortgage because I pay my balances in full each month.
This problem with credit cards is a mixed blessing. It is a great practice to pay your balance in full each month. It’s a practice I highly recommend to my mortgage clients. Basically, if you are paying your balance in full each month, you aren’t borrowing more than you are making. Many small businesses operate in this fashion to help with cash flow.
However, you should know that reports to credit bureaus run 30-45 days behind what’s really going on with your accounts on the day you apply for a mortgage. In fact, when a mortgage broker runs your credit report, chances are you will see a balance on each of the credit cards you are paying in full each month.
When a mortgage broker calculates your debt-to-income ratios (this is the amount of money you pay to creditors vs. the amount of money you make) he will be required to use the information on the credit report.
Hopefully, this is a small number, but it can be something that affects how much home you want to buy.
If you want to have those accounts not count against your debt-to-income ratios, you need to have a zero balance carried on those accounts for about 60 days prior to having your credit report run by a mortgage broker.
Since this is probably not too practical for most people, you just need to know that your report will probably show a balance, even if you pay it in full each month and the mortgage broker will have to count it when calculating debt ratios.
Myth #5 When I get a new credit card offer with an introductory interest rate of ZERO percent, I transfer the balances from my other cards to save money and improve my credit.
While it may be true that this will save you some money (which only happens if you apply the combined payment amounts on the new card that you were paying the other cards separately). Otherwise, you may be confusing improved cash flow with saving money.
The part of this philosophy that is incorrect is that it will improve your credit. Nothing could be further from the truth. When you accept the credit card offer, you are authorizing the credit card company to do a verification of your credit. They already have some credit information on you, but now they need to check it again to make sure there haven’t been any changes.
This activity alone will reduce your credit scores due to an inquiry being done. Let me explain. When a credit report is run on you, the credit bureau assumes it means you are shopping for credit. This is seen negatively by the scoring system that is used to create your mortgage credit score (also known as a FICO score).
When you have multiple inquiries, which is what happens with these offers, it drops your score by 3-5 points per inquiry. If you are someone who uses these credit card offers on a regular basis, the impact can be dramatic.
In addition, chances are you have used most of the credit limit being offered to you by the new credit card company. This also affects your scores in a negative fashion.
Another scoring criterion is how much of your available credit is in use when the report is requested. In other words, if you have a $5000 limit on your new card and you transferred $4500 from other credit cards; you are close to maximum on your available credit. This will drop your score because the bureau sees this as someone who uses too much credit.
So, you may have improved your score by paying off a loan balance from your previous credit cards, but you lose the benefit because you are close to being maxed-out on your new card.
Besides the negative impact to your credit scores, borrowers who tend to use this practice are only delaying the inevitable, postponing the payoff of these debts until the next offer comes in the mail, and carrying it for years and years.
Let me repeat something I mentioned earlier. The only reason these offers are made available by credit card companies is that they know there is a high probability you will use the new card to pay off other cards.
THEY WANT YOU TO DO THAT WHY??
Because you become the type of credit card borrower they want (i.e. someone who will carry a balance). Statistically, they know you are likely to keep some or all of the credit cards you pay off and use them again. Once you do, you are likely to be a card user who can’t pay your balances in full each month.
Do you know what that was? It was the sound the credit card company made when they sent you that ZERO interest offer.
Myth #6 I may have a lot of credit card debt, but I’ve never been late on a payment, so my credit should be great!!
It is a common misconception that making your credit card payments on time every month will ALWAYS improve your credit rating. This is only partially true.
The person who pays there balance in full every month will benefit from this approach, but the credit card user who is close to being maxed-out will not only fail to see improvement, they will likely see a lower score.
As I mentioned earlier, some of the credit grading criteria are: available credit used and available credit unused. If you are a credit card user who has used most of your available credit, and you are making only minimum monthly payments, you will have a severely negative result with your credit score.
The main reason this is the case is the minimum monthly payment goes mostly to interest on the credit card debt. So, while you get points for making your payments on time, you lose those points because your balances don’t change much as a result of staying near your maximum credit limit.
I once had a mortgage applicant who had nearly $50,000 in credit card debt. There were several reasons for this that I won’t discuss here. She made her payments on time every month, but because her debt was close to the amount she had available on those cards (about $55,000), her credit score was very low.
She had never been late on any of her accounts, but her score was lower than the borrower I worked with who had two late payments in the past 12 months.
It’s because the scoring system used by the credit bureaus see her as someone who not only has too much credit available, but also too much of it in use.
Myth #7 I have lots of credit available to me, but I don’t use it, so my credit should be ok.
This final misunderstanding about credit card use may sound like a contradiction after what we discussed in Myth #6, but it isn’t.
While it’s true that you want to have little of your available credit in use when you apply for a mortgage, that’s not a guarantee that you won’t have a problem getting a mortgage. Let me explain:
Lets say that you make $4000 per month. Your ideal debt ratio would be 28% over 40%. This means that you would ideally have a mortgage payment of $1120 per month and a total of $1600 when you add the other monthly bills (credit cards and car payment).
Now, lets say you have $25,000 in unused credit available to you in the form of credit cards. While your debt ratios are ok if you don’t use the $25,000, they would be shot if you did. Since your total debt ratio would be 55% (based on a $625 per month payment on the $25,000), you could be rejected for the mortgage.
As you can see, in this example, it’s the availability; of credit that can hinder your chance at getting a mortgage.
My recommendation to my clients who get offers of credit line increases is to reject them. It’s not something that is needed in most cases and it can definitely mess things up when it comes time to get a mortgage.
I hope you have seen how some of the most common misunderstandings about credit card usage can keep you from getting a mortgage. While there remain a myriad of creative financing strategies available to the right mortgage broker, the clients who deal with credit cards in the proper manner can go a long way in making the journey to home ownership a smooth one.
I wish you the best of success as you pursue your dream of home ownership.