The 3 digit number that controls your financial life more than any other is that of the credit score. The score started seeing widespread use in 1990 by Minnesota Based company FICO and has become the most popular scoring model for credit worthiness today. The FICO score ranges from 300-850 with 723 being the median score in the United States http://en.wikipedia.org/wiki/Credit_score. Between these numbers are 2 numbers we want to be very familiar with: 600 and below and 650 and above. If your score is 600 or below, you’re considered to be a high risk borrower and your application for credit has a big probability of being denied, having a high interest rate, and a low limit on the credit allowed to you. 650 and above is where the individual is considered a safe risk to lend to and it allows you to take advantage of things such as a lower interest rate, a big line of credit and a higher acceptance rate.
Later on I’ll identify why it’s important to you to have a good score and what to do / not do to achieve that score. First, however, I’d like to explain to you why I don’t like the scoring system (and no it’s not because I’ve been on the wrong side of a 600 before). Your credit score is derived from your credit history and there are many factors that may affect it. The basis for this is simple and it’s a good general way to determine if you’re a risk since it’s typically correct about your behavior with credit. The major flaw I find with the score is that the system fails to take into consideration the age of the person (and therefore overall maturity and general smarts). The typical person needs to make mistakes before they are able to learn from them (at least that’s why I keep telling myself). What good is it to change the way you act if you don’t know the pitfalls of such actions? Your parents will tell you to be smart with money and you’ll listen… to a degree. However, most people when they start establishing credit are very young and they haven’t made the mistakes that most people do when it concerns maintaining your credit.
Take two different people, we’ll name them Person A and Person B. The Credit Report for both A is identical to person B which will result in the same exact score. The difference between A and B is that Person A is 20 and Person B is 30. The score SHOULD be reflected to show that (based on typical human behavior) Person B is the safer risk to lend to (when factoring in age, what they’ve learned, and general maturity level). You may say “but your credit history is taken into account when determining the score and someone with more history would typically be the older person!”
This is true, however there are flaws with this being the “Answer” to age. A typical credit history can be bad at determining how old someone is for the simple fact that anyone can just decide to not establish credit until much later on, this in turn would lead to an older person having a less established history because of lack of usage. Also, it’s not nearly as influential on your score as being late on a payment. Your maturity level and age should play a huge role in determining your score, after all people get smarter about their credit as they see how their behavior has affected it.
The Do’s and Don’ts:
- The single most influential action you can do to affect your score is by missing a payment or being late on said payment. It’s upsetting that the most influential thing you can do is a negative action that will adversely affect your score.
If you want to build a good score that will save you thousands of dollars in interest later on I highly suggest that you get those minimum payments (at the very least) to your major credit cards ON TIME. (I’ll cover the pitfalls of just paying the minimum and a plan to get your cards paid off fast in a future post).
- Your debt to income ratio is the second most influential action on a credit score. (This can positively or negatively affect your score). Simply put, the better your ratio of income to debt, the better your score can be.
This is incredibly important as it is one of the things that you can do to positively affect your score. There’s 2 kinds of debt to income ratio that’s important to note here (this is geared towards a mortgage but the rule of thumb covers credit cards and student loans as well). The first ratio relates directly to your housing costs (Rent, Mortgage, Taxes, Insurance, etc) and it’s desired ratio is 28% (Monthly Gross Income times 28% needs to be more than what you pay for the expenses). The other type is revolving lines of credit (Credit Cards, Student Loans, Car Loans, etc) and the desired ratio here is 36% (Monthly Gross Income times 36% needs to be more than what you pay). To keep it safe you need to make sure that your ratio doesn’t go more than 10% above either number (remember these will accumulate since it’s a snapshot of your expenses and 100% is living paycheck to paycheck). Keep this in mind, your debts should be lower or equal to 70% of your income, if it’s any higher you need to do some work to lower that percentage.
- Your available credit to balance ratio is another aspect that can be looked at as negative or positive.
Basically that $200 balance on your $5000 chase account is good for your credit and the $1900 balance on that $2000 limit American Express card is bad for your credit.
Random Thought: Have you ever found it strange that companies consider people with bad credit as high risk candidates when it’s likely these same people will pay a lot in late/over-the-limit fees and interest fees? You’d figure they’d want that more often than the people that always pay off their balances before the interest is assessed. Anyway, this leads to my next point (depending on the terms of your cards) never close accounts unless you have multiple (5+) accounts. Remember, you need to keep a watchful eye on the terms of the account. Some companies will close the account on you if have a zero balance with no activity for a predetermined period of time.
- Multiple credit inquiries adversely affect your credit score.
I’m not 100% sure why this is viewed as negative, in fact I think it’s only there because “statistically” people that do this have turned out to be credit risks. It’s further explained that people that apply for multiple accounts when shopping for rates for big purchases (Student Loans, Car Loans, Mortgages etc.) don’t get penalized for a 30 day period as it’s normal to shop for loans with low rates for big purchases such as these. And finally:
- Compare your credit reports frequently and note any inconsistencies. Make a claim on reports that aren’t consistent with your credit history.
Experian, TransUnion, and Equifax are the major bureaus to get reports from (you’re allowed to get one report per year for free; go to freecreditreport.com and request yours today).
To sum up, make sure you pay all your bills on time, even if it’s just the minimum payment. Keep your debt to income ratio and available balance ratio as low as possible, apply for credit only when it’s absolutely necessary, and always make sure the information on your credit reports are accurate and there are no discrepancies. One final note, most items on your report are accurate, but there are instances when the report will be wrong for one reason or another. When you dispute a charge on your report, be sure to include any documentation (copies, not originals) to help support your cause. Also, most charges fall off your report after 7 years of the original negative charge’s first appearance. In some instances these charges will still be on the report even though 7 years have passed. Be sure to dispute or ask that the agency removes any charges like this as well.