Is a Low Credit Score a Never-Ending Cycle?

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We’ve been talking a lot about credit scores lately, and for good reason. We all have a credit score – whether we choose to play the credit game or not – and that score dictates our future financial situations in many ways. By acting as a report card for our finances, our credit score serves the purpose of telling lenders what to expect from us as borrowers. And a low score could make it nearly impossible to obtain new credit – or too expensive to reasonably do so.

Now, a report has emerged that says a low credit score isn’t just bad for the present, but can actually lead to a never-ending cycle of poor finances and a future with fewer opportunities. We’ll help you distill down this data to find out why this could be and explain alternative options that can help you build a bright future, low credit score and all.

How Credit Scores Work

As media attention on credit scores grows – thanks in part to the increased options for finding out your score and the news that we all in fact have many scores – it’s becoming more popular to find out what your score is and figure out ways to improve it. But how much do you know about how the credit score works?

Essentially, a credit score is a reflection of your financial history, based on the number of credit accounts you have, the type of credit accounts you have, the amount of debt you owe in comparison to the amount of credit available to you, and the consistency with which you’ve made your monthly payments on time. If you have a diverse mix of accounts, low debt to credit ratio, and a history of making payments on time, then your chances of a good score are high. But if you’ve made late payments or missed payments (or defaulted on a loan) or have credit cards which are maxed out, then your score will be on the lower range.

What does a low credit score really mean?

A low credit score tells lenders that you’re a riskier borrower. They see the score and think that (A) you may not be reliable enough to make payments on time, (B) you may not have the income necessary to cover new credit payments on top of old ones, and (C) you might not pay back your debt at all. Since the lenders think you pose a risk, they’ll either choose not to approve you for a new loan (or line of credit) or approve you at a very high interest rate. The high interest rate is a way for them to mitigate future lost funds from you by charging you more up front in the form of interest.

The Never-Ending Cycle of the Low Credit Score

So what happens if you want to improve your credit score? According to a report by NCLC (National Consumer Law Center), improving a low credit score can be difficult. And a low credit score could even drag you into a never-ending cycle.

Here are a few reasons why, as stated in the report:

  • A low credit score will make it more difficult to borrow, which leaves consumers who are in trouble with only the option of turning to payday lenders. Payday loans often come with an APR of 400% or higher.
  • Lenders aren’t the only ones looking at credit scores. They’re also considered in applications for rental agreements and insurance companies.
  • It’s becoming increasingly common for employers to look at credit scores as well, thus potentially costing people job opportunities – and making it even more difficult to earn an income that will allow them to get on track financially and improve their score.

In other words, a low credit score can be difficult to overcome, not just because of the time and financial changes necessary to do so, but also because it leaves few options for obtaining new credit, for obtaining housing and insurance, and even for obtaining employment. What’s worse is that the score is being treated as a way to judge someone both financially and as a person. According to the NCLC:

“One of the most pernicious aspects of the use of credit reporting is its use as a proxy for ‘character.’ There is a popular conception, not just in the credit industry, but also among employers and the average layperson, that a poor credit score means that the consumer is irresponsible, a deadbeat, lazy, dishonest, or just plain sloppy.”

But is that a fair assessment? Data isn’t needed to show that a person is more than a number and that poor credit could be a result of many things that have nothing to do with personal intent to repay debt. Things like job loss, medical emergencies, and a fluctuating economy can all factor into our lives and throw everything off balance. And if you’re living paycheck to paycheck in the first place, then it’s that much more difficult to recover. So the credit score suffers. It’s easy to think that setbacks won’t happen to us, but consider these statistics, also from the NCLC report:

“The foreclosure crisis and the massive unemployment caused by the Great Recession saddled millions of consumers with poor credit histories. These include the over 8 million workers who lost their jobs, as well as the 4.5 million families whose homes were foreclosed upon…Some of these consumers could be good borrowers after their foreclosure, and would certainly be good workers. They are not bad or irresponsible people, but simply unlucky.”

Not only can this assessment seem unfair, but it’s also inaccurate. NCLC further explains that “… a score of between 500 and 600 is generally considered to be a poor score. Yet at the beginning of the foreclosure crisis in 2007, only about 20% of mortgage borrowers with a credit score in that range were seriously delinquent. Thus, if a score of 600 is used as a cut-off in determining whether to grant a loan, the vast majority of applicants who are denied credit would probably not have become seriously delinquent.”

*Let’s not forget that many of these foreclosed homes were purchased at variable interest rates, marketed by subprime lenders who were known to push consumers into mortgages without closely calculating a borrower’s ability to repay or even to explain the terms of repayment to the borrower. These loans were being sold at insanely low interest rates, which made it hard to imagine how high those rates would eventually climb.

While the credit score as a means to judge consumers is clearly skewed and difficult to overcome, how is someone expected to build a future for themselves?

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Alternative Solutions for Building Your Future

A good start would be to adjust lenders’ beliefs about what the credit score truly indicates so that consumers who got caught in hard times or unexpected circumstances could get a second chance. NCLC points out the positive effect this would have on our economy:

“Helping these consumers rectify the credit reporting harms caused by the foreclosure crisis would enable them to move on economically. Their recovery, in turn, would help with the nation’s economic recovery from the Great Recession.”

But since we can’t all change the system overnight, there are things that you can do if you have a low credit score and you want to break out of the cycle:

Focus on small steps. Owning a home is the American Dream. So it’s no surprise that, even after a harrowing situation like variable interest rate spikes and foreclosure, many still want to own a home again. However, going for that goal right away can be unrealistic and often isn’t the best financial choice.

Instead, think about rebuilding slowly. It will take many years to wipe a foreclosure off of your credit report. But those are years that you can spend rebuilding your credit by using any and all extra money to pay off debt and save for that next home. Then, once your credit score is back in action, you’ll have more money for a down payment and a better chance of scoring low interest rates on your mortgage.

Build proof. If you can’t own a home, then renting is clearly your only other option (unless you have loved ones you can live with temporarily). But if even a rental unit has been difficult to acquire due to your score, you can get around this by showing potential landlords your deposit statements, paycheck stubs, and recommendation letters from previous landlords. If possible, you can also overcome a low credit score by offering to pay a few months of rent upfront.

Play through the pain. If your low credit score is getting in the way of you obtaining new employment, then that could be the moment when you truly want to give up. And for good reason! How could you reasonably make good on past debt or build up your credit for the future if you aren’t even able to work for an income to help you do so?

But this isn’t the moment to give up. Yes, you may have to seek out a different employer (or apply for many jobs at the same time) or even work multiple part time jobs to get back on your feet. But this hard work will pay off in the end. And every day of progress you make, you’re then one day closer to a better score and a chance at the job you really want.

Make a plan and stick to it. Finally, you’ll want to make a plan of action to help you get back on track. Whether it’s paying off debt, saving more money, or rebuilding your credit (or all of the above), outline the steps you’ll need to take to help you get there. Rework your budget, consider looking for extra income, research options for a less expensive living situation, and more. Be creative so you can find solutions you may not have thought of otherwise. Then set your short term and long term goals and check in with them frequently. If you stick to your plan, you can sleep well knowing that your hard work now WILL pay off in the future!

Image Credit: Malkav

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  • Solace

    I’m surprised it’s legal for a potential employer to look up your credit score and use that as a deciding criterion, and even more surprised anyone thinks it’s a good idea. Unless the job directly involves money or something else where the applicant would use the same skills you’d expect them to use when managing their own finances, what the heck does their credit score matter? That feels like discrimination just as much as racial or gender discrimination.