Watch: What is a credit rating and why does it matter?
Borrowing money is a fact of modern life. There are 62.8 million credit cards issued across the UK, according to comparison website Finder — almost one for every person in Britain.
Another form of credit, although not always thought of as credit, is buy-now-pay-later, worth £2.7bn ($3.76bn). It has become a hugely popular method of paying for things in the UK, allowing consumers to get what they want now and spread payments over a period of time or pay the whole cost later on.
Payday loans were rocked with scandal — notably in 2018 when Wonga went into administration and had been charging interest as high as 4000%. They are now better regulated, but not everyone is clear on credit and how it works.
Misunderstanding credit can land you in serious financial difficulty further down the line if you're not careful.
Craig Simmons, head of debt, credit policy and strategy at the Money and Pensions Service pointed out that 11.5 million people have less than £100 to their name, and 9 million often rely on credit to buy food or pay for bills.
Here are some myths and truths about credit that you need to be aware of:
1. Checking your credit rating can hurt your score
Many people worry that even checking their credit score will negatively impact their rating and give lenders the wrong impression. This is not true with a soft credit check, which is essentially made up of your credit score, according to Louise Higham, a chartered financial planner and director at Tilney Smith and Williamson.
You can check your credit score yourself on websites such as Equifax and Experian, and even download the apps as well. This will allow you to keep track of your finances and see how you can boost your score, and this is a soft check.
A hard check, which shows payment history and county court judgements (CCJs), can lower your score. They usually happen when a company is lending money or credit, such as for:
personal loan or credit card applications
car loan applications
apartment rental applications
student loan application
Higham adds that applying for credit is usually a soft check process now, so that if you are declined, it doesn't hurt your score further.
2. I've maxed out my credit cards, but if I pay back in full and on time I'll be fine
Wrong. How you use your credit — or credit utilisation, as it's called — affects your score. Higham says it's best to keep your borrowing below 30% of your limit.
The higher above 30% you go, the more you are showing lenders that you are not managing within your means, which lowers your credit score.
3. Your income affects your credit score
No, it doesn't. If you are applying for a loan, there will be checks to see how affordable it, but this is different to how credit-worthy you are. Income should not affect your score, says Higham.
"You could have a better credit score earning £20,000 than someone earning £100,000, because you are maintaining your credit better," she explains.
4. Payday loans don't affect credit scores
This is another misconception.
"People think they can get a payday loan and it doesn't really affect them," Higham says. "I don't think people understand how much it can affect their credit score and potential lending in the future, like when they come to get a mortgage."
A one-off payday loan won't affect you as much as habitually relying on them. Regular use shows lenders you are not managing on your income.
Dennis Hussey, money adviser at National Debtline, said: "Although high-cost credit options, like payday loans, might seem attractive at first they can come with steep repayment costs that can cause debts to escalate.
“If you are worried about paying your essential bills like rent or council tax, it is important to contact your creditors as soon as possible, to explain your situation and see if they can offer any support or a repayment plan so that you don’t run into arrears."
5. Credit is free money
This is a pervasive misconception some still have. A 2019 survey in the US found 1 in 10 students thought credit was free money, according to personal finance website WalletHub.
The perception of credit as free money often comes about because of the offer of 0% down payments, or similar. From a behavioural-economic standpoint, the consumer is too focused on not having to pay up front, making it seem affordable, and doesn't think seriously about the other fees involved with paying through financing. This can make a product look more affordable than it actually is.
Watch: How to prevent getting into debt
1. It can be harder to get a mortgage with no history of managing credit
Higham says lenders trust someone who has a good credit history over someone with no credit history at all.
"To have no credit cards cards at all, it doesn't demonstrate that you've ever managed credit," she says. "It should look better [not borrowing at all], but actually it can go against you. Even if you have applied for a credit card and you don't use it, it's showing that you're not tempted to use the credit on there."
She also advises not to take out credit cards right before applying for a mortgage, as that would involve a hard credit check, thus bringing down your score.
2. It's good to have a credit card even if you don't need one
You may not use it right now but you may do in the future.
"It can act as a bit of an emergency buffer for you, in case you need something for your car, or something in your house breaks," Higham says.
So who would have a higher score — someone who has a credit card but doesn't use it at all, or someone who uses it but pays it off each month?
"It would probably be the person that uses the credit card and pays it off each month", says Higham. "That would show that they are using credit but managing it well."
3. It is possible to have too many credit cards
Having lots of credit cards can lower your credit score because of the hard checks to get them. Having lots of cards can also increase the risk that you lose track of your spending, incurring fees for late payments on top of the interest.
"In particular, store cards, they seem to be frowned upon by lenders, over credit cards," Higham warns.
"People take them out and spend them on clothes, and they're not essential, whereas with a credit card [maybe] you needed new tyres on your car — that is deemed as an essential."
4. Closing a store card with no balance on it should not affect your score
That is true, because you have paid it off.
What would stay on your credit history is if you defaulted on a payment or had a CCJ. That stays on for six years, says Higham.
5. Buy-now-pay-later schemes affect your credit score
Buy-now-pay later allows consumers to pay the whole cost of something at a later date after receiving what they have bought, or spread the payments out through instalments over time.
Citizen's Advice found that in the last 12 months, 42% of people using BNPL schemes didn't fully understand what they were signing up for.
It is important to ensure you have the money to pay it off when it's time to. If not, that will affect your credit score, because you will have an outstanding balance.
Higham says if you have a BNPL account, your use of BNPL would still be on your credit file. If you pay it off, the balance should show as zero, Higham says. The account would have to be closed to take it off your credit file.
There has been news of people being declined for mortgages after using BNPL, but Higham says there could be other reasons in the background as to why people are being declined, such as affordability of the mortgage rate.
Some stores use BNPL companies like Klarna to manage their checkouts. If you buy anything, it will show the company as your payment method even though you entered debit card details and did not select pay later.
Higham says in that case, you would check your credit report to make sure that a BNPL account has not been opened. If it has, you should shut it down and it would be removed from your credit history.
Unfortunately for many who mismanage credit, it lands them in debt. However, data from the Money and Pensions Service shows 63% of customers with debts are reducing or clearing them within 3-6 months after receiving debt advice.
WATCH: The risks of buying now and paying later