How important is your credit score to you? Nowadays your score is pulled for an apartment, cell service and even some employment. Like it or not it’s a part of our lives. So regardless of your feelings about it you need to understand what makes up your score, so your ignorance doesn’t cost you money. Using credit is not a bad thing — it’s how you use credit that can be good or bad. Credit is good for building a strong credit history and emergencies. Credit is also convenient and safer than carrying large amounts of money. Credit also can have drawbacks if you use it to “buy things you can’t afford now” without thinking about “paying later”. You need to view credit as a tool. It’s part of the way you conduct your financial life to get the things you need, such as cars, homes, technology, furniture and appliances. And of course, credit can be a necessary cushion in emergencies.
Your credit score
Your credit score is a numerical summary of your credit report. Scores range from 300 – 850 and are made up of five elements: Payment History, Amounts Owed, Length of Credit, New Credit and Types of Credit. Lenders use your credit score to assess the likelihood of them getting their money back if they loan it to you. Your score will also determine how much interest you’ll be charged if they do decide to loan you the money. The lowest interest rates go to those with the highest credit scores.
The tricky part is that the five categories are not created equal and not all lenders use the same credit score. Your payment history is more important than the types of credit, and the types of credit you have is less important than how long you’ve had the credit. A “good score” will depend on the scoring model used to calculate it. The FICO score is the standard, but there is another competing credit scoring system called the VantageScore, which was developed by the three major credit bureaus: TransUnion, Equifax, and Experian. Although the three agencies created the Vantage score your credit score may be slightly different across the three agencies because they all use different methods to calculate it. Both FICO and VantageScore emphasize paying your bills on time and maintaining a favorable credit capacity (the amount of credit you are using in relation to your credit limit), but the two systems give different weights to particular types of credit-related behavior.
Understanding the numbers
The largest percentage of your credit score is based on you paying your bills on time. That’s straight forward. Instead of moaning and complaining about not having the money to pay the bill off completely make sure to at least pay the minimum amount owed. If you’re a few days late; don’t just give up and pay next month. Most companies only report payments that are 30 days late. A common mistake is to miss the payment and, “Say forget it!”, I‘ll just wait and pay double next month. Don’t do that. Work to get the payment in that month and you may avoid the lateness from being recorded on your credit report. 30% of your score is based on the amounts you owe. Maxing out credit cards is bad bad bad. You shouldn‘t be spending any more than 30% of your available credit. If your credit limit is $1,000 you should make sure your balance remains below $300.
15% of your credit score is linked to how long you’ve had credit. This includes the age of your oldest credit account, the age of your newest credit account and the average age of all your accounts. In general, a longer history will increase your score.
10% is based on the type of credit you have. You’ll gain or lose points based on how diverse your debt is. Do you have all credit card debt or do you have installment loans, lines of credit, a mortgage etc. It‘s also important to note that a home loan or mortgage usually is one of the better forms of debt because most homes increase in value over time and the interest paid on the loan may be tax deductible. A student loan is another type of “better” debt because educated workers generally earn higher wages (if the degree leads to a lucrative job). Consumer debts such as balances on credit cards and car loans generally do not increase in value over time, making them less favorable types of debt. The interest paid on consumer debt is likely to be high and not tax deductible. Having a mix of is best! That’s not an invitation to go out and get accounts you don’t need. Just know it matters.
The last 10% is based on new credit and this is why you should NOT be applying to every offer that gives you some type of perk. The freebies and the introductory offers will trap you every time. How frequently you apply for new lines of credit and the diversity of credit all impact the new credit factor. Knowing what makes up your score is the first step to improving your credit. You are entitled to one free credit report from TransUnion, Equifax, and Experian every year; however, your scores will not be listed. To access your scores you will need to pay a fee. Before doing that I suggest speaking to your bank to see if they have a way to see your score for free. Remember you will have three different scores.
Start where you are
Credit is resilient so your credit score today doesn’t mean your score forever. You can put together a plan immediately to strengthen your credit history so you are positioned to secure credit in the future. The following guidelines can help you assess where you are in your debt management:
- Maintain a credit score of 700 or more to show good credit management.
- Know how long it will take to repay debts making monthly payments.
- Know the total amount to be paid over the life of credit obligations (how much you borrowed vs. how much you will pay overall).
- Know the costs associated with making monthly payments, such as fees and interest.
- Maintain a debt-to-income ratio of less than 20 percent.
- Spend under 20% of your net (after-tax) income on debt excluding mortgage, outstanding rent, home insurance and taxes.
Remember that these are just starting points to use as you set your SMART credit goals. Don’t give up hope if you have problems with debt. There are ways to get out of debt and repair your credit. Remain positive and take action. Call your creditors to discuss your options (ideally, call them before you miss a payment). Quite often, you can work out favorable repayment terms with your creditors. Be sure to get any agreement in writing.
You can ask your creditors to:
- Divide payments into smaller amounts
- Forgive some of your debt
- Suspend payments
- Lower payments
- Waive late fees
You can also go to a nonprofit credit counseling service such as the National Foundation for Credit Counseling (NFCC) or Financial Counseling Association of America to put you on a budget and help you negotiate with lenders. Be wary of credit repair companies that offer to fix your credit history for a fee. Only you can repair your bad credit by repaying your debts and paying your current bills on time. Good credit and successful debt management don’t just happen overnight. It takes time and energy to monitor your spending and put together a plan to increase your credit profile.
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