Are you financially risky?
I’m not talking about gambling or investing in the hottest stock, although those certainly carry their own financial risks.
I’m talking about the everyday, regular way we handle our money. Specifically, are you the type of person that lenders look at and say to themselves, “How can I help you?” Or are you the type that can’t even get a lender to talk to you?
It’s rare that a person goes through life without needing to borrow some money. We don’t live in a society where it’s easy to cash flow everything. A few examples that you may have already experienced: student loans, mortgages, car loans, and business loans.
In order to qualify for these loans, your credit score will be front and center. If you’re dead set on getting that loan, then you’d better get really cozy and comfortable with understanding your credit score.
Before explaining the score, let’s first dive into WHY you should even care about your score.
WHY IS THIS IMPORTANT?
Let’s say you have a $250,000 mortgage with a 30 year fixed term. The interest rate offered to you will depend on your credit score. The higher your credit score, the lower your interest rate. Here’s an example:
$250,000 mortgage, FICO score 800, 4% interest rate= $1,193.54 monthly payment.
$250,000 mortgage, FICO score 600, 5.5% interest rate: $1,419.47 monthly payment.
That’s a difference of $225.93 per month, or $81,336.33 over the life of the loan. All because of a 1.5% difference in your interest rate, which was heavily influenced by your credit score. As you can see, small numbers can make a huge difference.
And it’s not just loans and interest rates. You will also have insurance companies, employers, and landlords checking your credit score as well. It will be a bit like baring your (financial) soul to the world.
A higher score= better rates and terms= lower payments for you= less headache and stress.
Does saving money and time sound good to you? I hope that’s enough of a reason why you would want to pay more attention to your credit score, because this number will follow you around the rest of your life.
YOUR CREDIT SCORE: FICO AND VANTAGESCORE
The FICO (Fair Isaac Corporation) score is the most widely used and well known credit scoring system. According to Experian, 20% of the population scores above 800 (on a scale of 300-850), which is considered “very exceptional.” Where do you fall?
There is another, newer scoring system called VantageScore. This was created by the three credit bureaus (Experian, Equifax, Transunion- see below), and it also uses the same scoring scale of 300-850.
What are the differences between the two scoring systems? One big difference is that VantageScore requires a minimum of one month of credit history, versus a minimum of 6 months of credit history for FICO. There are also differences in how the scores are calculated, although the basic premise is the same. Pay your bills on time, don’t have a high balance relative to the amount of credit you have, and don’t go crazy with opening and closing your accounts haphazardly.
FICO SCORES: THE BREAKDOWN
I’ll focus on FICO scores in this post since these scores are used by 90% of lenders out there. Here is a breakdown of what goes into the score:
Payment History (35%): Have you been good about making your payments on time? This is the single biggest factor in determining your score.
Pay your bills on time. Either have them auto-deducted from your checking account, autopay through your credit card (make sure you’re paying your credit card on time!), set up a calendar (either paper or digital), and/or set up reminders (again, paper or digital). Mix and match these options so that you find a system that works for you.
Amounts Owed (30%): How much do you owe in relation to the amount of credit available to you? This component has almost equal weighting to your payment history. This is referred to as the credit utilization rate. It takes into account your revolving credit, which are credit lines where you can borrow and pay back with no set end date. Credit cards are the most common example of revolving credit.
If you have a $5,000 credit limit on your credit card, and you have a $4,000 balance, your credit utilization ratio is $4,000/$5,000= 0.8, or 80%. A good credit utilization ratio is 30% or lower.
Typically, it’s best to spread your balances over multiple cards, versus getting close to your credit limit on one card.
You can increase your score by paying down your debt. Also, in order to lower your credit utilization rate, you can request a higher credit limit on your cards. Do not close accounts, as this will negatively affect your total available credit.
Length of credit history (15%): From the time you opened up your first credit card or took out your first student loan, you unwittingly started a track record of how good you are with credit. Having a longer history gives lenders a better view of how you’ve handled credit over the years.
As a general rule, the older your credit account, the more you’ll want to keep it around as evidence that you’ve held this account for years without any issues.
Credit mix (10%): What type of credit do you have? Examples include credit cards, student loans, auto loans, and mortgages. Having a mix of credit gives you the opportunity to showcase your ability to handle the mix.
Don’t go around opening up different lines of credit for the sole purpose of adding to your credit mix if you can’t handle the extra responsibility. But just be aware that it may be difficult to qualify for certain loans if you don’t have much credit to your name.
For those that have difficulty getting a credit card (bad credit score, short credit history), a secured credit card is one option. You would open up a card with your own money as a deposit. You can then start using the card like a regular credit card. Once you show your ability to pay on time, this will eventually be reflected in your credit history and payment history. The next step would be to apply for an unsecured (regular) credit card.
Another option is to be added as an authorized user on someone else’s card.
New credit (10%): Have you recently opened an account? This is where inquiries get factored into your score.
Avoiding multiple inquiries and credit checks is your best bet if you want to keep your score high. But even if you elicit a few inquiries and take a small hit to your credit score, you just need some time to pass for that score to go back up, as long as you’re still responsible with your credit.
It’s important to note two different types of inquiries. A hard inquiry (or hard pull) is when a lender is checking your credit to see if you make a good candidate as a borrower.
Examples: when you apply for a mortgage, apply to refinance your student loans, or when a landlord is considering you as a tenant. A hard inquiry may temporarily decrease your score by a few points.
What if you’re shopping around for mortgage rates? If you have a number of credit checks that are bunched together, such as in this situation, then this will be considered as one hard inquiry, rather than multiple inquiries.
A soft inquiry (soft pull) is often done without your knowledge. For example, this can be during a background check or credit card pre-approvals. These inquiries do NOT affect your credit score.
Be judicious and intentional with when you want to apply for credit.
YOUR CREDIT REPORT
In addition to your credit score, it is critical that you also check your credit report!
Your credit score is a three digit number, whereas your credit report gives you the story behind that number. Checking your credit report is kind of like going through an old photo album. Likely without all the warm, fuzzy feelings attached.
It is in your report that you will see your credit history. That first credit card you opened in college. Your student loans. Other random credit cards that you applied for because you were going to get some great deals. Your first car. Your mortgage.
If you’ve had a tough time financially, you will also see evidence of collections, foreclosures, and bankruptcies. Definitely no warm, fuzzy feelings here.
There are three different credit bureaus that produce these credit reports: Equifax, Experian, and Transunion. Because each of these bureaus include different data in their credit report, you will have slightly different credit scores depending on the bureau.
For those looking to improve their scores, combing through your credit reports is the first step to ensure that there aren’t any mistakes that are dragging your scores down. Even if you have an exceptional score, you still need to stay vigilant and make sure that the information is accurate. Identity theft and fraud are becoming much too common, and you can spot evidence of this in a credit report.
One suggestion is to check one credit report every 4 months, versus applying to get all three credit reports at the same time. This will allow you to monitor your credit reports for free throughout the year if you go through the site www.annualcreditreport.com.
A NOTE ABOUT STUDENT LOANS
As with any other type of credit, you must pay your student loans on time in order to keep your credit score nice and high. If you enter forbearance or deferment, as long as you go through the proper paperwork, your credit score should not be negatively affected.
However, if you are 90 days past due, then this is reported to the 3 credit bureaus as delinquent. At this point, your credit score will take a hit.
If you extend this out to 270 days, then your account will be considered in default. This is a huge no-no, as your entire balance will be considered immediately due. You will be unable to enter deferment or forbearance. You will also lose the ability to enter another repayment plan. Needless to say, this will be a huge mark on your credit report, affecting the rest of your finances for a very long time.
These rules apply to federal loans. If you have private student loans, you will need to check their terms and rules separately.
If you cannot pay your loans, please call your loan servicer ASAP, and they will walk you through your options. You do NOT want to find yourself in delinquency or default.
Lastly, remember that if you’re looking to refinance your loans, you will want a great credit score to get the lowest interest rates.
Healthy financial habits will benefit you in so many ways, and this includes maintaining a good credit score. If you have a great credit score now, make sure you keep it that way by checking your credit reports regularly and continuing those good habits.
If you’re looking at your score and it’s not where you want it to be, then it’s time to take some action! Life happens, and it’s never too late to work on increasing your score. Time and patience will be key as you work towards your financial goals.
Do you have a story about how your credit score has impacted you? Comment below!