NEW YORK (MainStreet) — It may not surprise you to learn that, when it comes to your credit score, the game is often rigged. The murky rules by which FICO calculates this number impose increasingly harsh penalties the lower your score goes. A bad score leaves you with increasingly bad options, which in turn reduces your score even further.
To make matters worse, the lower your score, the larger the importance of negative events. Late payments that would barely move the needle for someone with great credit can have an outsized impact on someone whose credit is already poor, making every mistake hurt more than the last.
One area where this is particularly relevant during the holidays is in store financing. We all know the snappy ads, often for electronics and furniture, offering no money down and 0% financing for big ticket items. You buy the computer then pay it off $100 a month for the next year. These loans generally don't require good credit since, after all, if you default they can always send the repo man. It seems like a perfectly reasonable way to spread out holiday spending and not go broke by the end of December.
It's also a mistake.
According to Jeff Hindenach, Director of Content with NextAdvisor.com, taking out these in-store lines of credit can seriously hurt your score in the long run.
"In a lot of cases those loans are called loans of last resort," Hindenach said of in-store financing for big ticket items. "And they can have a drag on your credit score. Is that going to always be the case? No, not necessarily. But those loans are definitely looked at by FICO in a less than positive way."
By a loan of last resort, Hindenach means the types of loans available only to people with poor credit. Another example, he said, is payday loans, which are a huge red flag to the scoring industry. Taking out a loan of last resort signals that you can't get money any other way, which they take as a bad sign.
"These are loans that are basically given out to people who might not have the best credit," Hindenach said. "They're loans where people can't afford to pay for whatever it is that they're paying for, so they take out these loans of last resort. That's why its called 'loans of last resort,' because it's the last resort for people who can't afford to pay for [the purchase] themselves."
"FICO looks at it like the person can't afford to purchase the thing on their own," he added. "They have to take out this loan of last resort, so it makes them less desirable to other lenders... they're basically borrowing against debt."
Of course, "people who can't afford to pay for what they're buying" also applies to almost every credit card user on the planet. What FICO has not explained is why that's O.K. for someone who uses plastic, and scandalous for anyone else. Both lines of credit involve going into debt to purchase consumer goods, except one hurts your score regardless of whether or not you make the payments on time.
Have good enough credit to get a credit card and you can build more. Have poor credit so you can only get approved for in-store financing and it will keep getting worse. This is why Hindenach recommends that consumers take advantage of credit card introductory offers as often as possible instead of making payment plans.
"What we're looking at is it's better to just get a credit card with a 0% intro APR," he said. "It's basically the same thing, zero percent interest for a year to a year-and-a-half, but as far as your credit score is concerned it's a better option." This works for multiple reasons he explained. First, you avoid the drag on your credit caused by retail payment plans, which is always good in and of itself especially considering how negative events act as multipliers for each other. Second, it will actually help build good credit. Making timely payments on a card builds good credit, as well as having a lot available. According to Hindenach one of the elements FICO uses in determining your credit score is "credit utilization ratio," basically how much credit you have available relative to how much you're using. Having a lot of credit available but using only a small percentage looks good, for example carrying a low balance on a high limit credit card.
A higher ratio, such as taking out a line of credit worth $800 to make an $800 purchase, looks bad. Paying off that loan might not even get you back to neutral. According to Hindenach, FICO doesn't release the details on how it calculates scores, aside from broad percentages, to keep people from gaming its system. We do know, however, that while making payments on a loan of last resort helps your score, it often doesn't help as much as the original loan actually hurt.
Even taking out the loan and using it responsibly, paying everything off on time, might result in a net negative.
"The best option is a credit card that has 0% intro APR for the longest period of time possible," Hindenach said. "The longest that I've seen is 18 months — that's a year-and-a-half where you're not being charged interest. That's obviously a huge benefit. Also, if you don't want to pay fees and you don't want to pay interest, look for a card that has no annual fee. And definitely look for a card that has annual rewards. That will help you out because you're getting cash back for something that you were going to purchase anyway."
People with good credit who want to avoid denting it should have no trouble finding cards that fit this bill. Hindenach recommended particularly two from Chase Bank, the Slate and Freedom, as good options for their long interest-free introductory periods.
People with credit that's fair, middling or poor will have a tougher time of it.
"Average credit it's harder to get a zero percent intro APR card, because rewards for people with average credit aren't as abundant," Hindenach said. "There might be a couple out there, but for the most part I haven't seen them. So you're going to want to look for a card with the lowest percent APR you can find."
"In that case maybe it's better to go with the store financing," he added. "But it's going to hurt your credit even more. It's kind of a toss up between whether you're worried about paying interest or you're worried about hurting your credit score."
<—p> —Written for MainStreet by Eric Reed, a freelance journalist who writes frequently on the subjects of career and travel. You can read more of his work at his website www.wanderinglawyer.com.