We talk so much about credit scores when it comes to seeking loans from banks and fintech organisations. Credit score relies on the extent to which we use credit — credit cards and other kinds of debt — to pay our daily expenses.
No doubt, having one or two credit cards helps, especially, to pay for emergencies. However, a lot matters on how much you use your credit cards or the extent of credit utilised. Too much dependence on credit or using your cards to pay for everything can backfire if you are unable to repay the debt on time. Rolling over consequent debt along with high-interest penalties will force you to pay more, thus, affecting your creditworthiness in the long run.
Using credit cards only when required or using only a portion of the credit allowed from your overall limit indicates responsible use. Banks and fintech companies use the term credit utilization ratio (CUR) to find out how much credit one has used or exhausted of the available credit limit. This has a direct bearing on one’s credit score as frequent use of these cards or their rampant use implies poor financial habits.
A higher credit card limit can lower your CUR, which is why having multiple credit cards can help. For example, if you have three credit cards with each card allowing you a limit of up to ₹2 lakh each. Assuming that you have spent only ₹20,000 in total using these cards, the CUR would be somewhere around 3.33 percent.
Considering how the CUR value may impact your credit score, it makes sense not to cross your spending limit. A CUR not exceeding 30 percent underscores healthy credit management. However, a CUR of more than 30 percent can be concerning as lending organisations consider this as an essential parameter of their borrowers’ creditworthiness. Borrowers with a higher CUR may find it difficult to get loans or may have to settle down for high-interest loans.
Unravelling the paradox of credit score
Less use or zero use of credit cards affects one’s credit score too. Isn’t this a paradox considering how a low credit utilisation ratio implies less dependence on credit?
Preeti Zende, Founder, Apana Dhan Financial Services, says, “Credit score known as CIBIL score is the parameter used for accessing your creditworthiness. If your score is high it indicates you have good credit history by paying back the debt on time. But for availing loans such as home loans, vehicle loans or personal, a CIBIL score is required. And for that, you have to have a history of loan repayment. The easy way to get a credit history is to have a credit card. But a credit card is like a double-edged sword so one has to be very careful while using it. The more carefully you use the card, the more benefits you can get through it. While using a credit card, make sure you are not using this easy credit facility for your unnecessary instant gratification and have enough cash flow to pay back the bills next month. Well-planned use of a credit card can help you to have a high credit score which is ultimately useful for you to get bigger loans at a bargained interest rate.”
Extending on the same, Vivek Iyer, Partner, Grant Thornton Bharat. Financial Services - Risk Advisory, added, “Credit score of a person is dependent on the repayment experience of the individual. The absence of credit tells nothing about the repayment experience and hence impacts the credit score. Absence of credit does not have good repayment experience and hence the paradox.”
Credit cards are like other financial instruments that beget a lot of care and responsibility in using them. Knowing when to use them and not succumbing to instant gratification not only helps to stay within the necessary credit card limit but also makes the best use of one’s credit score.