Credit Scores and Building Credit

You’ve likely seen countless advertisements about checking your credit score for free, but what are credit scores and why do they matter? With this article, I hope to explain everything you need to know about credit scores, as well as how to build strong credit.  

What is a credit score?

A credit score is a number assigned to an individual that gives banks and other lenders a quantitative view of how risky it is to offer or extend credit. Credit scores are determined and issued by credit bureaus; of which there are three: TransUnion, Experian, and Equifax. In most cases, lenders collect scores from all three and use the middle score to make their decision. 

What is a good credit score?

Credit scores range from 300-850, with 300 being the worst and 850 being the best. The chart below outlines the different credit score ranges.

Why is my credit score important?

1. Getting Approved for Loans & Credit - Your credit score can impact whether or not you are approved for a mortgage, car loan, credit card, or any other type of loan.

2. Lower Interest Rates: A high credit score will generally yield a lower interest rate on new and refinanced loans. Depending on the type, even student loans can be offered at lower interest rates for those with high scores. Higher scores mean more savings!

3. Lower Premiums – Even insurance companies care about your credit. Home and auto insurers consider credit scores when calculating premiums.

4. Other Approvals – More and more, employers, landlords, and utility providers are requesting credit scores before offer employment or signing contracts and leases.

5. Stewarding Finances - Maintaining a high credit score is one indicator that you are wisely stewarding the finances God has blessed you with. Very few go through life without taking on some kind of debt (see last month’s post titled When is it OK to take on Debt?). Minimizing debt, tracking debt, and having a plan for paying it off are fundamental to stewarding your finances.

How is my credit score calculated?

A common misconception is that everyone simply starts with a perfect credit score, and that they are then “docked” for late payments and so on. The truth is that your credit score needs to be built. In other words, you start with no credit and then build up your score. There are five factors that contribute to building your score:

1. Payment History (35%): Paying credit cards and loans on time will improve your score, skipping payments or paying late will hurt your score.

2. Current Debt (30%): How much of the total credit available to you are you currently using? Maxing out credit communicates that you may soon have trouble paying on time. This hurts your score.

3. Length of Credit History (15%): this includes the age of your oldest account, your newest account, and an average age of all of your accounts. Generally, having a longer history will improve your score.

4. Credit Mix (10%): This section examines what types of credit you have (student loans, credit cards, mortgage, etc.). A more diverse mix of credit will generally improve your score, so long as payments are all being made on time.

5. New Credit (10%): A high number of new credit sources and applications for new credit will negatively impact your score. This issue is further exacerbated for those without a long credit history. Because of this, try to avoid applying for too many types of credit in a short amount of time, or shortly before you intend to take out a new loan. 

How do I build my credit?

From the list above, the largest component of your score is your payment history. Because of this, the best thing to do to build or improve your credit score is to pay all loans on time and in full. Just this alone will go a long way towards a high score. Next, monitor the amount of credit you are using compared to your total amount available. This is called your credit utilization ratio. Issuers of credit like to see this below 30%. Therefore, do everything you can to never carry a credit card balance from month-to-month. If you are expecting to make some big purchases in a given month, plan to make multiple payments shortly after each purchase rather than running up your total bill and paying it all at the end.

Frequently Asked Questions (FAQ)

1. Where can I check my credit score for free?  There are quite a few different places to get a free credit score. Credit Karma is one I recommend because it’s free, quick, and easy to use. Mint.com is another great option.

2. Where can I get my credit reports?  You can check each of your credit reports from each credit bureau once per year for free at annualcreditreport.com.  These reports won’t show your credit score, but you will see a detailed summary of all of the data that is being used to calculate your credit score.  It’s a good practice to check these from time-to-time and confirm their accuracy.

3. I am a student and I have absolutely no credit, what’s the smartest way to start?  The best option for you is most likely a student credit card. You can also look into secured credit cards. Secured credit cards work mostly like normal credit cards do, except that they require you to make a security deposit equal to your spending limit. If you don’t pay the full balance, they take what you owe out of your deposit. When you close the card, you get this deposit back.

4. I am not a student and I have absolutely no credit, what’s the smartest way to start?  Your best (and probably only) option is to start with a secured credit card. It won’t have great rewards, but you have to start somewhere (see FAQ #1 for details on secured credit cards). Once you establish some credit, you’ll soon be able to qualify for better offers.

5. How many credit cards are too many?  There is not a magic maximum number of cards that you should avoid. Paying your credit cards on time and not continually having a low available balance on each card is much more important when it comes to your credit score. 

6. Will student loans affect my score?  Yes, student loans are part of your credit just like any other kind of loan. Therefore, paying your loans on time can be a great way to increase your credit score, while paying late or not at all will hurt it.

7. I’m paying off my balance every month, but my credit report is still saying I have high credit utilization. Why?  This could be because your credit card issuer reports to the credit bureaus just before the end of your billing cycle. So it could look like you continually have a high balance even if you are paying the full balance off days after. A couple tips to fix this are: (1) call your credit card issuer to find out what day of the month they report to the credit bureaus Then try to pay off your full balance prior to that date.(2) Make small payments throughout the month instead of just paying your full bill at the end of the cycle. The ultimate goal is to keep your credit utilization below 30% of the maximum credit available to you.

8. Will applying for a bunch of credit cards in a short amount of time hurt my score?  Yes. Applying for one credit card will only very slightly hurt your score, but applying for many in a short amount of time will hurt your score more, especially if you have little credit history.

9. Will shopping around for mortgage, auto, or student loans hurt my score?  Typically not. This is understood as being a smart option and typically won’t hurt your so long as you find a loan within 30 days.

 

If you have questions about your own credit score or how it might be imporved, please reach out to Wacek Financial Planning for a free initial phone call.

 

About Wacek Financial Planning

Founder, Ben Wacek, is a fee-only, Certified Financial PlannerTM who has a passion to help people of all income levels make wise financial decisions and steward their resources from an eternal perspective, using Biblical principles.  If you’d like to learn more about Wacek Financial Planning, please visit www.wacekfp.com.

 

Photo courtesy of Sasha of StockSnap.io

 

 

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