The 'Catch 22' of consumer credit
Why you may be damaging your credit scores by not using credit cards.
Renting an apartment, securing a home mortgage, seeking employment, buying a car, even turning on utilities – each of these life experiences will demand a review of your credit history. Nearly 1 in 3 purchases in the United States is made with plastic, or $40 out of every $100, adding to nearly $1 trillion of credit-card debt as of August, according to the Federal Reserve.
Faced with an extended economic recession and a tumultuous global credit meltdown, Americans are finally recognizing the negative consequences of leverage (the number of dollars borrowed for each dollar of wealth). Many people are making a concerted effort to de-leverage by reducing their use of credit cards and adopting a "pay as yougo" philosophy. Abstinence from credit cards has become chic among some younger consumers who have formed Web-based networks to support their pledges of credit-card withdrawal.
Some older borrowers are placing themselves on cash-restricted budgets to reduce their urge to buy. A poll of 1,000 Americans released last week by Consumer Action reported that 69 percent of consumers intend to pay with cash and do not expect to take on additional debt in the next 12 months. Only 1 in 4 had opened new credit-card accounts in the past year.
But Americans' commitment to curb credit-card use has ironically become a Catch-22 scenario: By weaning themselves from credit cards, they actually harm their credit reputation.
Whenever consumers lock up or gleefully cut up their plastic, their credit scores drop as they have increased their credit-utilization ratio. This ratio is determined by dividing a person's total of outstanding debt by their total available credit. As borrowers' credit lines are closed, either by themselves or by creditors, their utilization ratio increases and their credit score decreases, hence the Catch-22.