Credit Scores
What is the best way to measure someone’s financial success? Many people want to look at the credit score, but that doesn’t tell the full story. The credit score has become the standard for judging each other’s financial well-being because it is used to determine loans, rent qualifications, and interest rates. When your credit score is high enough, you can also qualify for one of those fancy metal credit cards that impress people as you increase your debt. Credit scores range from 350-900 depending on the credit company. Where did that range come from? Who knows? But that’s the way it is. I haven’t found a financial advisor that uses your credit score to determine when you can retire.
Unfortunately, the credit score is important in our society because companies need to know if you can pay them back. Buying a house, a car, renting an apartment, utility companies, business loans, and many other activities will run your credit score during the process. They will also make you pay higher interest rates when you have a bad credit score. You may be at the point now, or someday in the future, where you can pay cash for everything and don’t care about your credit score. Most people should know about how the credit score is computed, where you can track it, and steps you can take to make it higher.
So here you go!
Bankruptcy – Have you declared bankruptcy? This will destroy your credit. It generally takes seven or ten years for a bankruptcy to clear your records so hopefully you can avoid this unless you are completely out of options.
Delinquent Accounts – Do you have any accounts that have been sent to collections for unpaid balances? This is another thing that will wreck your credit score. You can probably solve these by settling with the debt collector. They will often clear the debt if you can pay them a portion. Just make sure to get it in writing and don’t ever let them have access to your checking account. Get these cleared up as quickly as possible.
Those two factors are the worst things that can happen to your credit. Most people don’t have them and should focus on the following items to increase their credit score.
Late Payments – Always make sure to pay your bills on time. This includes your utilities. Late payments will have a negative impact on your credit score.
Credit Card Balances – One big factor of your credit score is your credit card utilization rate. The ideal rate is between 0-20%. The calculation is done by taking the amount of credit card debt you have and dividing it by the available credit. For instance, your utilization rate would be 10% if you have $1,000 balance on your credit card and have a total credit card limit of $10,000. The best way to keep this rate low is to keep balances low. You can also increase your credit limit, but don’t allow yourself to spend more if you have a higher limit.
Hard Inquiries – These generally occur when you apply for a credit card or a loan of some sort. The bank will submit your information to the credit bureaus to receive your credit score. The goal is to have as few hard inquiries as possible. There are ways you can check your score without triggering a hard inquiry. I will touch on that later.
Number of Accounts – How many accounts do you have in your name? These can be open or closed. More accounts equal a higher credit score.
Length of Accounts – How long have your accounts been opened? Remember that “emergency” credit card your parents gave you when you were in high school? Keep it open! The average account length has an impact on your credit score. The longer that your accounts have been opened, the higher your credit score will be.
Now do you understand why I get frustrated about judging financial wellness using a credit score? Credit scores are a way for banks to understand the likelihood that you will pay them back on time. You may earn $100,000 per year, but never owned a credit card so it will be hard to qualify for a mortgage when you buy a house. Conversely, you could have 20 credit cards from stores at the mall and make minimum payments each month and have a terrific credit score.
The important takeaway from this post is that your credit score is extremely important. Regardless of how you feel about debt, you should care about your credit score. Do everything you can to keep it high. Keep your accounts open. Charge your gas on a credit card and pay it off every month if there is nothing else you want to use it for. That can make a significant difference if you apply for a mortgage and want to qualify for a lower interest rate.
Most credit cards provide credit score reporting for free. There are also some credit monitoring companies that you can sign up to check and monitor it as well. This is a good way to understand more things that you can do to increase your score. It will also allow you to catch identity theft earlier if someone tries to open accounts using your social security number. Hopefully this helps you understand how credit scores are computed and you are able to make some minor changes that will save you some money in the future.
Mike Zeiter, CPA/PFS
