Your credit score. Do you know what it is? I don’t even just mean, do you know what your own current “score” is, but do you know what a credit score is in general? And the large impact it can have on your personal finances? And how it works?
When I set out to write this article I have to admit that I had only about half an answer to most of these questions. So I thought I’d educate myself. It also helps that someone from LendEdu reached out to me and asked to collaborate. As a result, ant links in this article will reference them, as they are super useful in explaining what is actually going on. So let’s get started!
What is a credit score?
A credit score is a number that reflects your financial history. The scale most often used for this is the FICO score (the credit scores created by Fair Isaac Corporation.) The FICO credit scores span from 300 to 850. Good credit scores typically range from 670 – 739, with higher scores being considered either “very good” (740 – 799) or “excellent” (800+). Typically, any score under 650 is considered bad.
How is a credit score calculated?
Now under 650 might be bad, but so far to me it’s also meaningless. This is how FICO scores are calculated, so we can actually put some meaning to the numbers. It’s based on the following factors:
Credit Payment History: A potential lender wants to know how (or whether) you’ve met your repayment responsibilities in the past (did you pay them back? And on time?). A good history reassures creditors, but past indiscretions, such as collections, defaults, bankruptcies, etc., will drop your score by dozens or hundreds of points. Over time, negative items lose their impact but can linger on your credit report for up to 10 years. This determines 35% of your score. So quite important!
Amounts Owed: This factor determines another 30% of your score. Creditors also look at your utilization ratio: the amount of credit you’re using divided by the credit available to you. Ratios above 30 to 40 percent are considered high and will hurt your score. So don’t owe too much.
Length of Credit History: Creditors can get a better handle on your creditworthiness if you have a long history. This accounts for 15% of your score. I find this one very counterintuitive. Because they need you to have had a history with credit (card, debt, loans etc.) before, rather than never having the need for one. If you’ve never even had a credit card, you are an unknown. And no one likes that type of ambiguity.
New Credit: Another 10% of your FICO goes to new credit. Creditors look at how often you apply for new credit and the number of credit inquiries you’ve recently had. I’d recommend you don’t apply for 10 different credit cards in the upcoming month…
Credit Mix: The last 10% goes to how you balance all your financial products. You can achieve a higher score if you have a mix of revolving and non-revolving accounts. This is again a way for creditors to see your behaviour over a variety of scenarios, so you become a lower risk to them.
If you want to know more about the score rankings, check out this article explaining it in further detail. And this article, on which factors actually mess with your credit score, and which really don’t have that much of an impact.
What impact can your credit score have?
Now you might wonder what you need to have a good credit score, or any score, for. And that is a good question. As I said before, the having of any credit score is a signal to lenders that you are (or are not) a good risk to take when it comes to lending money. And lending money can come in various shapes:
Access to Credit: if you’re score is bad, no one will want to lend you money. Consumers with good credit scores can qualify for the best rewards credit cards with considerable spending limits, the best mortgages and even the best auto loans.
Lower Interest Rates: Not only can you access more credit, but you’ll also be able to get better interest rates on your credit cards and loans. The reason for this is simple: you’re less of a risk, so they can charge you less, because they are surer (but never 100% sure), that you’ll pay your debt back (plus interest).
Competition: Good score means good business! Strengthening your position when bargaining for the conditions under which you’re borrowing money: you might be able to work a better deal – lower interest rate, higher credit limit – by pointing out how desirable your business is.
Rentals: similarly, if you are in the market to rent a place to live, most landlords check out your credit history before offering you anything. They want to know whether you’ll actually pay the rent!
Employment: the same story applies to employment. Employers prefer to hire a candidate with good credit rather than poor. If you have foreclosures or bankruptcies in your past, you might find potential employers less than enthusiastic about your resume, or at least very inquisitive.
Better Treatment in General: you might qualify for lower car insurance rates because insurers have found that folks with bad credit file more claims. You also might be able to open utility accounts or secure cell phone contracts without putting up a security deposit.
How to improve your credit card score?
Now it might seem quite intuitive from what we’ve already been through, but let’s make this as clear as glass: what can you do to improve your credit score, and secure yourself that better treatment?
Fix Mistakes in Your Credit Reports: In 2012, the Federal Trade Commission found that approximately one in every five people caught at least one mistake on their credit report. Five percent of them had errors so serious that they had been denied credit or had to pay higher interest rates than they should have. So this is quite important. If you find an error, first contact the credit bureaus, they can however be slow and sloppy when fixing errors, and bringing in the government (no joke) can help speed that process along. You can also contact the original creditor as well; errors in their records will translate to errors in reporting.
Lower Your Credit Utilization Ratio: If you tend to reach for your credit card first when making purchases, stop. Credit utilization – or how much of your available credit you’re using – is a huge part of your credit score because it tells a story about how you use credit. Ways of fixing this is to only dip into your credit card for emergencies, pay off your balance every month and not carry high balances on multiple cards. Obviously, repaying the balance with large payment also helps. Do not just make the minimum payment…
Avoid Late Payments: Use your personal financial software or electronic calendar to set payment reminders for your credit accounts. Paying on time, and paying more than the minimum, are good things and will improve your score – it shows that you have control over your financial situation. If you’ve already fallen behind on payments, get current and stay current.
Engage a Legitimate Credit Counselor: Feel like you’re in way over your head? Get help. Credentialed counselors can give you individualized advice about how to raise your credit score. A counselor can go over your situation and point out several ways to improve your score. Use a reputable credit counselor, but be on the lookout for credit repair scams. These are fraudulent companies that charge up-front fees for services that you can accomplish yourself for free.
DO NOT Participate in a Credit Repair Scam: see above.
Many more can be found on improving your credit score in this article, which also gives you a timeline for score improvement, and more details on the insidious business of credit card repair scams.
How to tank your credit card score?
Now on top of knowing things you really SHOULD be doing as listed above, people always seem to go the extra mile and work like hell to avoid the things they SHOULD NOT be doing. So I also made you a quick list of things you shouldn’t be doing:
Bankruptcies, Foreclosures, & Defaults: as mentioned before, none of these are good. All of these cause multi-year damage to your score. Try to avoid this as best as you can, by exploring alternatives. One such an alternative is working with your bank to avoid foreclosure by arranging for a short sale of your home. Think of other large assets as well. Just try to negotiate terms with a creditor that will allow you to avoid collection on past due debt.
Too Much Debt: don’t take out more debt than you can comfortably handle. A credit utilization ratio above 30% – 40% is not good. The inability to repay on time or repaying only the minimum amounts month after month is also judged as being in too much debt.
Too Many Inquiries: every time you apply for credit, you generate a “hard pull,” or inquiry, on your credit report. If you are frequently applying for credit, your inquiries will mount and reduce your credit score as it just looks as if you’re refinancing an old debt with a new one. Which leads to:
Moving Debt Around: constantly moving debt from one account to another in order to gain some time before repaying looks shady. And credit bureaus have become aware of this type of abuse and penalize your scores accordingly.
Identity Theft: not really that finance related, but this can really kill your score until you fix it. Some credit card issuers alert you to unusual activity, but in any event, you should carefully review your monthly statement and report unrecognized charges right away. If something sus is going on, freeze the accounts, and get fraudulent charges removed!
For more information, check out this article on negative factors impacting your credit score, and this article on credit card utilization, one of the more difficult concepts in this business.
Factors that matters less than you think. Now when it comes to the credit card score, there are a couple of factors that really don’t matter nearly as much as people would expect them to. To avoid confusion, I thought I’d outline those as well:
Having debt: I know, this surprised me too. But being in debt doesn’t necessarily tank your credit score. In fact, carrying different kinds of loans and paying them back on time can help boost your score since it shows credit reporting bureaus that you’re good at consistently making monthly payments.
Your bank balances: it doesn’t matter if you have a hefty sum invested in the bank or if you have a bank account that hovers just above 0. This isn’t a factor in your credit score.
Carrying a balance: there is no benefit to carrying a balance on your credit cards, even though some people think they need to carry a balance to get a good credit score. In fact, if you carry too high of a balance, it could hurt your score by adversely affecting your credit utilization ratio. You can still earn a perfectly good credit score even if you pay off your credit cards in full every month, provided that your payment history is reported to the credit reporting agencies.
Income: income has no direct impact on your credit score either. As long as you keep paying your debts on time, it doesn’t seem to matter much. Indirectly, having a stable income makes repayments a lot easier, and that’s the relationship most people bank on.
Now, I know it’s weird to think that having debt isn’t necessarily a bad thing. I know my audience, and most of my audience will have an awful looking amount of student debt. So I thought I’d link this article explicitly, showing that having a student loan need not be a detriment to your score, if you handle it wisely. Similarly, personal loans needn’t be either.
As I said before, writing out this massive post was quite a learning experience for myself as well. If you want more info, do check out LendEdu, specifically their credit score section. You will not be disappointed! Happy learning 😊
