In the fallout of the coronavirus, banks have begun tightening their lending standards to the point where even the Federal Reserve had to report on the potential impact to lower-credit individuals. Thus, it’s more important than ever to be informed on how to improve your credit score. The good news is that this topic is not as complex as it seems.
To help gain some insight into whether it’s a good idea to lend someone money, let’s consider an imaginary story about two friends from my 3rd grade class, Andrea and Adam, both of whom would occasionally ask me for money to buy snacks during lunch from time to time.
Andrea always paid her money back the very next day. She had a long reputation (the whole school year!) in the class, regardless of whether the person was a friend or not. She didn’t ask for money all the time, and she didn’t have a reputation of owning every single person in the class money.
Adam, well, was a different story. He’d just recently starting borrowing money from the classmates, and took week to pay them back, if ever. It felt like he owed a lot of money to everyone, and he asked for money every single day. The was well known for targeting only certain people for money that he felt he could take advantage of, and when one person said “no,” he went to another person. In no time, he had a well-known reputation of the person you avoid during lunchtime.
Oh yeah, definitely “imaginary,” right Adam!?
This story is not too far off from real life, just with banks and loans rather than classmates and milk money.
Credit Scores receive a lot of coverage in the media, with many outlets implying that the score is a measure of one’s financial acumen. Sadly, when news stories cover personal finance they often rely (heavily!) on sensationalist headlines and anecdotal stories.
Hey, isn’t that why we have bloggers?!?!?!
Anyway, just what is your credit score and why does it matter?
In the United States, a credit score is a number based on an analysis of a person’s payment history and credit usage that (in theory) statistically predicts how likely a person is to pay their bills and financial obligations on time. The U.S. relies on three private companies, Experian, TransUnion, and Equifax, to collect this data and produce a score. Originally, banks and other lenders used this credit score to help them determine whether to lend you money. Nowadays, your landlord, insurance company, cable/phone provider, and employer are usually allowed to use some aspects of your credit score in their decisions of whether to do business with you. Furthermore, even certain overdue non-loans like parking tickets, traffic fines, medical bills, child support payments can affect your score negatively. Both good (on time payments) and bad (late or non-payments) marks could stay in your credit history for up to seven years. It’s easy to see that your credit score has an impact on your financial life, whether you borrow money or not!
Other countries have slightly different regulations surrounding what affects your score and how it may be used, but in general, this concept of a score is accepted worldwide.
Interestingly, your income and employment history are not factors that directly affect your credit score. It is very possible for an unemployed person living on $20,000 per year to have a better score than the executive living on $100,000. However, there may be an indirectly relationship between your income and your credit score, since higher earners should have the ability to pay their debts on time.
In the U.S., most of the credit bureaus use a variation of the FICO method to create and adjust your score overtime, though there are some more modern approaches being tested. Each bureau is a little different, but your score can range from 300 – 850, with 850 being outstanding and 300 being extremely poor. According to fool.com, the average score is 700 with 20% of people having a score over 800, 20% under 550, and the rest in the 550-799 range.
Individuals with higher (better) credit scores can qualify for better types of loans, such as those with lower interest rates and higher amounts of dollars lent. For example, people with scores below 620 usually can’t obtain a home mortgage at all. Those with barely acceptable scores might pay an interest rates up to 5.00% APR in today’s market, those with 660 might pay 4.00%, and those with 740+ might pay as little as 3.00%. Over a 30-year mortgage, this adds up to tens of thousands of dollars in interest alone!
The reason for this disparity is that the lender sees those with a lower score as more likely to default on the loan and cost the lender money. The lower the risk, the lower the interest rate the lender can offer.
So what affects your credit score? There are five main factors:
1) Payment History (35% of your total score)
How often you pay your bills on time, including credit cards, student loans, mortgages, and car loans.
Being 30 or more days late on a loan payment can cause a negative mark on your payment history. Making at least the minimum payment is essential to keep this part of your score strong, though try to pay off all your loans as quickly as you can. Being 60+ days late or affects your score even more, and being 180+ days late is usually a “write-off” where the lender sends your loan to a collection agency and a major blemish appears on your report for years. Payment history is the most important part of your credit score, so do your best to pay your existing bills on time. If you can’t, contact your lender immediately to work something out and avoid being considered late. Many banks and companies are willing to be flexible given the circumstances of COVID, but you’ve got to call first.
2) Debt Utilization (30% of total)
How much debt you have outstanding compared to how much credit you have available.
Most experts agree it’s best to use 10- 20% of any lines of credit that you have available. Lenders want to make sure that you’re not maxed out or otherwise in over your head. For example, if you have a $5,000 line of credit on your credit card, it’s good to use the card a little bit each month to prove you can make payments, but try not to use more than $1,000.
3) Length of Your Credit History (15%)
How many years you have had your credit products or accounts.
Creditors want to see a long history of your ability to manage your debts. Someone who has never had credit products before, such as a loan or credit card, is higher risk than someone who is experienced with them. There are two factors that matter here, (1) the age of your oldest account and (2) the average age of all your accounts collectively. If you open a low-limit credit card when you’re very young (18 years old in many parts of the world) and keep it open for a long time, the first portion of this category will be good. If you keep all your oldest accounts open for a long time, the second portion will be good, even if you only use the old ones occasionally (don’t let the banks close them). Just make sure don’t fall into the credit card trap while you’re young!
4) Types of Credit (10%)
How many types of credit products or accounts you’ve used successfully.
There are two main types of credit accounts that go into that mix. The first type is revolving debt, such as credit cards, where the amount you owe “revolves” or varies each month. The second type is installment debt, such as car loans or mortgages, where you borrow a fixed amount and repay it in even “installments” each month. Again, you should not go into debt for the sake of trying to boost this part of your score, but your credit score will be a bit stronger when there is a good mix of both revolving credit and installment debt.
5) Number of Recent Inquiries to The Credit Bureaus (10%)
How many times in the recent past you have had your credit report pulled for a loan.
Lenders assume that desperate borrows are more likely to default, and they measure this by how many times you’ve applies for loans in the last two years, with heavier wait being put on the most recent six months. Keep in mind there is a difference between a “soft pull” (when you pull your own credit or an employer does so for verification purposes) and a “hard pull” (when a lender pulls credit to make a decision on a loan). Luckily, only hard pulls count towards this part of your score. Try not to apply for more than one credit product per year.
What can we conclude from all this?
Having a good credit score is important for qualifying for credit with good lenders on good terms when you need it. Understanding your credit score and managing your debts accordingly is the key to improving it over time.
Let’s looks back at our friend Adam again. He’d just recently starting borrowing money from the classmates (#3: Length of Credit History), and took week to pay them back, if ever (#1: Payment History). It felt like he owed a lot of money to everyone (#2: High Debt Utilization), and he asked for money every single day (#5: Numerous Inquiries). The was well known for targeting only certain people for money that he felt he could take advantage of (#4: Types Of Credit), and when one person said “no,” he went to another person. In no time, he had a well-known reputation of the person you avoid during lunchtime (Poor Credit Score).
One parting thought: I want to emphasize that your credit score does not define who you are, nor how good you are with money, nor how successful you will be in life. Rather, it is just a statistic; a number assigned to you by someone you don’t know that tries to predict whether to risk lending money to you. While you should learn to manage your finances wisely, you should not obsess over your score continuously. Learn from the past, appreciate the present, and prepare for the future. You are more than your score!
