Blog post #412
Your credit score is very important for your financial future, if you want to get a mortgage, lease an apartment, refinance an existing mortgage, get a credit card, a vehicle loan or almost any other kind of debt. In some states, your credit score can even impact your homeowners insurance rates.
This post can be helpful to you, regardless of your age, marital status or income. It may also be valuable to others you know, such as family members, and we encourage you to forward it and share it with others.
Everyone should have at least a few credit cards in their own name. Even if you are married, each spouse should have credit cards in their own name, so you can each establish and have your own credit history. This does not mean that you have a joint credit card account with American Express and each have a card with your name on it. This means each person in a marriage should have a few credit cards that each person has applied for in their own name. This is vital in case of divorce or death of one of the spouses. We highly recommend this as we repeatedly see spouses, particularly women, who have not established credit history in their own names.
Credit score basics: Credit scores are calculated and maintained by a few major organizations, based on data accumulated by a number of national organizations. FICO score is the most commonly used credit score, based on a company called Fair Isaac.
FICO scores are reported on various scales, with some that top at 850, and others that have 900 as a maximum score. The higher the score the better for you, in terms of likelihood of approval, lower interest rates and other fees.
Per experian.com, these are the 4 major FICO scores and their ranges:
- FICO score 8: 300-850
- FICO mortgage score: 300-850, and there are different models for each rating company, Experian, Equifax and TransUnion.
- FICO Auto score: 250-900, used in auto financing
- FICO Bankcard score: 250-900, used by credit card issuers
Per experian.com, the following scores and grade ranges, based on a grade scale of 300-850:
800-850 exceptional, 20%
740-799 very good, 25%
670-739 good, 21%
580-669 fair, 18%
300-579 risky or very poor, 16%
On an 850 point scale, the average American has 701 FICO score, per experian.com, on 9/17/19.
Obtaining your credit score: Many card companies and banks now provide free FICO or comparable credit scores to their banking and credit card customers, with your monthly statements or online. American Express, Capital One, Citi, Discover, Chase and many others provide this data for free. If you can get your credit score for free in this manner, which is usually updated monthly, there is no need to pay another company to obtain your credit score.
How is your credit score determined?
Credit scores are determined based on a calculation with the following weightings and factors.
35% payment history
30% amount you owe
15% length of credit history
10% new credit open
10% types of credit you have
Although these factors are well known, and more are details below, there is no clear information as to how an exact credit score is calculated. For example, there is no specific formula available to consumers that tell us how each specific score is calculated.
To try to understand how you can improve and then maintain your credit score, let’s review the factors and what impacts them.
35% payment history: If you have late payments, this factor is going to be negatively affected. This is the most important factor in determining your FICO score.
It is vital that you make your payments on time to have a good or excellent credit score.This includes all kinds of obligations, including credit cards, vehicle loans, student loans, mortgage, and medical bills. Any company that you owe money to could report a payment late to a national credit bureau, which can have a negative impact for years (reduce your credit score).
The best way to have a good payment history is to make all your payments on time. Even if you can only afford to make a minimum payment on a credit card, if you make them on time every month, you will get a good score in this category. The best way to make sure you make your payments on time every month is to set up automatic payments. If you are having financial issues and can only afford to be making a minimum payment, you should seek assistance regarding this situation, which is beyond the scope of this blog post.
30% amount you owe: It is not just what you owe, but how you owe it. What does that mean?
Credit bureaus and credit card companies evaluate how much outstanding debt you have. They look at your total debt, which is your outstanding credit limits and loan obligations. It is good to have some debt, but too much will be a negative.
It is recommended that you keep your overall credit card utilization rate, for all credit cards, at below 30%. This means that your outstanding usage should be less than 30% of the total of your credit limits. If you have charged or have a balance outstanding of $5,000 and the total credit limit of your credit cards is $10,000, you have a 50% utilization rate, which is not good. If you have the same $5,000 balance outstanding, and your credit cards limits total $40,000, your utilization rate is 12.5%, which is excellent. Remember, the data may be reported to credit reporting bureaus at a different time than your billing cycle, so this could be impacted even if you pay off your balance every month.
But the factor that many people are not aware of is what is called your card utilization rate. Credit scores are also impacted by the outstanding balance of each individual credit card, as a percentage of the total credit limit of the respective credit card. You should limit the charges per month or outstanding balance of any individual credit card to 30% or less of that card’s credit limit. For example, if you have a $3,000 outstanding balance on a credit card with a $4,000 credit limit, that is a 75% utilization rate. This is viewed as a major negative. The credit card companies report this information to the credit bureaus at any time during a month, so even if you pay off your balance in full every month, this is still negative.
You should strive to keep your usage of each individual credit card below 30% at any point in a month. Thus, if your credit limit on a card is $4,000, you should try not to charge more than $1,000 on that card in a month. If you have a credit card with a $10,000 credit limit, you should not charge more than $2-3,000 on it in any month. This is why it is important to have a reasonable number of credit cards and at times, you may need to spread your spending across multiple cards.
If you only have two or three credit cards, rarely use one and then charge most of your spending on one card, you are likely using up a lot of your credit limit, thus causing your utilization rate to be very high. This will cause your credit score to go down, but can be improved over time, by a better use of your credit cards (use more of them, but not charging more than 30% of each card’s credit limit).
If you close a credit card, you are reducing your overall credit limit, which could be a negative for your overall utilization rate, as well as impact your credit length history, which is another factor.
This is why over time, you should obtain a reasonable number of credit cards, keep them open for a long time and not close them unless there is a specific reason to do so, and have a appropriate amount of credit limits on both a per card basis, as well as on an overall basis, so you can be below the 30% utilization rate both on a per card and overall standpoint.
15% length of credit history: Your credit history is built up over time. This is why it is important to establish credit when you are young, develop good habits, and keep credit cards open for a long time, even if you rarely use them. It is best to use a number of credit cards at least once or twice a year, even if you only use a few the majority of the time. If you set up a utility or automatic bill to be paid, and then set that credit to be paid automatically, you will improve this score over time. In general, if you don’t have an exceptional credit score, don’t close a credit card, even if you rarely or hardly ever use the credit card.
10% new credit open: Applying for a loan or credit card triggers a process known as a hard inquiry, in which the lender requests your credit score for use in its lending decision. Hard inquiries typically lower your credit score by a few points, but as long as you continue to pay your bills on time, scores typically rebound within a few months.
10% types of credit you have: Credit scores reflect your total outstanding debt and the types of credit you use. The FICO® Score tends to favor a variety of loan types, including both installment credit (loans with fixed monthly payments) and revolving credit (like credit cards, with variable payments and the ability to carry a balance). Credit mix can influence up to 10% of your FICO® Score.
Changes in your score: It is not uncommon for your credit score to vary every month, due to changes in your outstanding balances, as well as if you applied for a new loan or credit card. However, your credit score should not move dramatically from month to month, unless something caused it to change significantly, such as a missed payment or payments, or multiple credit requests.
Strategies for those in their 20s: For younger people, particularly those in their 20s, establishing credit and a good credit score is even more important. Since 2010, you cannot get a credit card on your own if you don’t have an income until age 21.
Parents can, and should, have their children become authorized users of one or two credit cards that are actually in the parents’ name, if they feel their children are financially responsible. This could be done for high schoolers, and especially college age students, who could then pay the balances each month. The parents, as the account holders, remain legally responsible for all charges, but the children benefit from being authorized users and begin to build credit history. This will be valuable after they turn 21 and can apply for credit on their own.
Chase is now offering credit cards to college age students, with very low credit limits, which can further help students to establish a credit history, and hopefully good habits. This program is only available to Chase customers. However, it has an interest rate of 16.99%, so we don’t recommend this credit card unless you are sure it will be paid off every month. If college aged students choose to apply for this credit card, you could earn a credit limit increase after making 5 monthly payments on time within 10 months from account opening when meeting the credit criteria. You will not have to pay an annual fee and you will have access to Credit JourneySM. With Credit Journey SM you will have unlimited access to your credit score.
Once someone turns 21, they should develop a strategy of gradually applying for credit cards over a period of years, such as a new card every 6 months. If they are able to pay the balance off each month, they should focus on getting a card that provides a good cash back for most purchases (like 1.5%) from a major financial institution, such as Chase, Capital One, Bank of America or Discover. They should be strategic and selective, as discussed above, as applying for too many cards in a short period of time will result in a reduced credit score and possible rejections.
The illogic of credit scores: Your income, assets, length of employment have nothing to do with your credit score. Even though they would appear to be key to one’s ability to pay off debt, which is the purpose and supposed predictive value of a credit score, they are not any part of the calculation. To us, this seems illogical, but it is reality.
- For example, a 30 year old earning $60,000, with minimal savings or investments, with 5-7 credit cards that are all 3-6 years old, each with low utilization rates and no late payments, and a car loan, may have an excellent credit score.
- Someone who is 60, who earns $200,000 a year, but has only two credit cards, one which they never use and the other is used a lot, a mortgage but no car loan and substantial investments, may have a much lower credit score than the 30 year old above, due to how credit scores are determined.
- This 60 year old may not have as high of a credit score, but the credit score could be raised if the suggestions above were followed.
There are also other applications available to you to view your credit scores. One of those options is Credit Karma. Through Credit Karma you will be able to view your credit score and reports. Credit Karma does not provide you with a FICO credit score. However, it uses Transunion and Equifax to pull your credit scores, but you will need create an account first through creditkarma.com before accessing your credit score. Credit Karma also monitors your credit reports and will send you an alert via the email on file when there is a change on your reports. You could get additional useful information such as thoughts on how you can improve and what affects your scores. Your credit report and credit score should always be readily accessible through logging into creditkarma.com or available through the Credit Karma app.
As your overall investment strategy is important to your current lifestyle or future retirement plans, your credit score is also an important part of your financial well-being. If you work to improve your credit score this should help you to qualify for loans when you need them. Most importantly, using your credit in a responsible, consistent manner and earning good credit scores could help build wealth and allow you to do business with companies. If you don’t know how credit works, this could get you in trouble.
If you have any questions, need direction with your credit, or would like to discuss this further, please contact our office.