Canadian Finance Blog

Why Debt-Free Living Doesn’t Help Your Credit Score

Posted: 15 Feb 2011 02:00 AM PST

You’re responsible with your finances. You don’t use credit cards, preferring to pay with cash. A debt-free lifestyle means that you are in charge of your finances, and your money is working for you — rather than working for someone else. It seems like you should be rewarded for such behaviours when you apply for a mortgage. Unfortunately, that’s not the way it works. If you are living debt-free, then you may find that your credit score isn’t as good as it could be, and it could mean a higher interest rate on loans you are approved for.

You Need to Use Credit to Get a Credit Score

The main thing about a credit score is that it is used to measure your credit worthiness. This means that there needs to be information on how you use credit. If you don’t make use of credit, then there is no data for the score. If you look at the five general factors that determine your credit score, it becomes apparent why debt-free living doesn’t help your score.

Since the most important factor is your payment history, you need to be making payments on something in order to have a good score. The next important factor is your credit utilization — how much of your available credit you are using. If you don’t have any credit accounts at all, your credit utilization will end up being a negative item, dragging down your score.

Other factors include the length of your credit history, the types of credit that you have, as well as new credit applications. It seem unimportant to worry about your credit score, but it could affect more than just the interest rate on a loan that you might get. Landlords, insurance companies and cell phone service providers might all check your credit score, and what they find can have consequences. This is especially true if the insurance company charges you a higher premium because of your credit history (or lack thereof).

So, Do You Have to Go Into Debt for a Good Score?

It may seem backward that you have to get into debt in order to have a good credit score, but the whole system is designed so that you have to use credit. The good news is that there is no reason to live a debt-ridden lifestyle if you want good credit. You do need to use credit to build a good score, but that doesn’t mean that you have to live in a debt cycle.

You can use credit cards to help build a good credit score. If you use your credit carefully, paying off your balance quickly, you can begin to build a history. Additionally, something basic like a car loan can be of use. Try to borrow as little as possible, and pay it back quickly. You will minimize the interest you pay, while establishing a credit history.

Another option is to look for alternative credit scoring models. While the FICO score and other similar models focus on your credit use, there are some models that take into account other behaviours. FICO actually offers an Expansion Score that includes items like paying utility bills on time, and checking account monitoring. There are also alternative agencies like PRBC that offer information on bill paying. However, in order for these scores to matter, you need to convince your bank or utility company to report the information — and there may be a fee to get things set up.

For now, your credit score is a necessary evil. You can take steps to build your credit without getting into debt, but you need to concede to using a credit card (responsibly!) on occasion.

Author Bio: Miranda Marquit is a professional blogger. She specializes in writing about personal finance for a variety of blogs, including the Credit Score Blog.

Why Debt-Free Living Doesn’t Help Your Credit Score originally appeared on Canadian Finance Blog on February 15, 2011.

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