The way that lenders want us to borrow is fundamentally flawed. The upshot is that lenders won’t want us to clear debts.
Credit reference agencies use a measure called credit utilization when they calculate your credit score. They look at the total amount of credit you have borrowed and compare it to the total credit that has been offered to you. For example, if you have five credit cards that have a combined credit limit of £10,000 and you’ve spent £8,000 on them, you’ll have a credit utilization of 80%. The more you’ve spent, the higher your utilization.
It’s only one measure of many that they use, but it is one that influences a lender’s decision to provide credit, and how much.
At first glance, this seems a sensible thing to use. But there are two big problems with it that can cause difficulty for some borrowers.
Experian says that a credit utilization should be no higher than 30%. So, to apply for more credit, you’ll need to leave 70% of your current credit unspent. This is something that neither lenders nor credit reference agencies make clear to borrowers.
The problem here is that if you strive to clear your credit card debts then you may well want to close some or all of those accounts. This removes temptation and the possibility of returning to debt. But, for each account that is closed, your credit utilization changes for the worse. Say, in our example of your five credit cards, you pay off one maxed-out card of £1,500, reducing your total debt to £6,500. If you close this account then your total available credit goes down from £10,000 to £8,500, so your utilization is now 76%. If you leave it open then your credit utilization goes down to 65%. So, despite doing what is perceived to be the right thing, you will harm your credit score.
There are many arguments that can be made about this, but in the real world the temptation is there for many people, and if you just cut up your card to try to remove that temptation then it’s a lot easier to order a new one instead of applying for a new card altogether, and this isn’t fair for borrowers.
Many of us have borrowed using credit cards for whatever reason, and clocked up some debt there, so that our credit utilization becomes fairly high. These accounts tick over from month to month, the payments are made, but there isn’t too much progress in clearing the debts.
If our cards have substantial interest rates then it would be useful to look to a loan to consolidate and clear these debts. This is the second problem that credit utilization creates.
Ideally, we’d ask a loan lender to swap the credit card debt for the loan debt, on the understanding that all of those credit card accounts are closed and that no new credit cards will be taken. The loan, with a cheaper interest rate, is then paid off.
But, if you have a higher credit utilization, there’s no way to do this.
There’s no way to make this arrangement with the lender. There’s no way to tell the lender that you want to take the loan on the firm understanding that it will be used to clear the credit cards. So the lender starts your loan application with, among other things, your high credit utilization and then declines, because there is no concept of swapping.
This is because a lender will rely on your credit report, which in turn is informed by your credit utilization, even though this is the thing you want the loan to address. Here is the Catch 22.
A new product
So what’s needed here is a new way for lenders to look at this.
There are already debt relief orders, debt management plans, individual voluntary arrangements and more. But these products usually hit your credit rating for six (years). So, looking at all of the customers that do make their card repayments as usual, we want to avoid these.
Instead, we should be able to ask a loan lender to swap our credit card debt for a loan. I call it a swap loan.
But it would be a special kind of loan with conditions attached:
- that you identify all of the credit card accounts that are to be paid off using the loan;
- that, when the loan is added to your credit report, it tells credit card lenders not to approve any new applications from you while the loan is being repaid;
- that the loan lender does not consider your credit utilization when you apply for the loan;
- that the loan does not adversely affect your credit rating when it has been repaid.
This is as much a psychologically useful product as anything. Many borrowers want to make a clean break of their credit card debt, and a swap loan would let them focus on doing that.
It would give a borrower a firm end date to clear the debt, as light at the end of the tunnel. And it really should offer a lower interest rate than those of the credit cards. The obvious caveat here is that it’s not worth using a swap loan for low-rate cards, especially 0%.
So, will a lender step up and create swap loans for those who need them?