Credit Scores 101
A great deal of hype follows talk of credit scores – too much hype in my opinion. How important is a good credit rating? What is a good score? What is the advantage of a good credit score?
Your credit score is essentially how reliably you will pay back a loan. A high credit score means the borrower is of lower risk, which translates into lower interest rates and better terms.
A bad credit score on the other hand has fewer desirable terms and may even prevent a loan from being approved. At The Financial Cocktail, we aren’t big on borrowing money, but there are times in life where there aren’t many options.
If a potential lender wants to know your credit score, they request a score from one or more of three credit bureaus: Experian, Equifax, or TransUnion. These credit agencies gather and evaluate your information, delivering the results in one of two scoring models, FICO or VantageScore.
Factors of a FICO credit score per cnbc.com:
Payment history (35%) – reliably pay bills
Amounts owed (30%) – credit utilization
Length of credit history (15%)
New credit (10%) – open new accounts
Credit mix (10%) – having a variety of loans
I have read the true formulas of credit score calculation remain undisclosed. FICO and VantageScore both use similar scoring metrics with payment history being the most heavily weighted.
The credit bureaus spit out a number on one of the following scales:
Credit to yours truly
“Very good” and “excellent” credit are the cutoffs for favorable rates and perks. Mortgage amounts and rates will be most favorable with excellent credit. Many sites report a 1.5% interest rate difference between “good” and “excellent” scores. This could easily translate to a couple hundred bucks per month.
If you find yourself on the “very poor” or “fair” end of the scale, anticipate difficulties being approved for loans. Certainly, low credit limits with high interest rates. A 400-credit score tells the lender that your likelihood of repaying the loan is low.
As they say, history tends to repeat itself. And not reliably paying back borrowed money is how one ends up with a 400 credit score.
Remember, no one is your friend out there, including mortgage brokers and credit lenders. With a low credit score, they are operating under the assumption that you will simply not pay back the loan and must charge high rates to ensure they don’t lose money.
Improving your credit score
Remember the factors at play, payment history, debt utilization, and credit duration. The easiest way to check these boxes is to pay recurring bills via credit card. Think utilities, internet, phone, or mortgage. Ensure the payments are not greater than 30% of the max card limit. Or 30% of your total available credit as this is part of credit utilization.
I have used a Capital One card since high school. I had a $3,000 limit, which was more than enough since I was a big fan of paying with cash at the time. The card exclusively paid for my fuel. This would be a couple hundred bucks per month, usually less.
I paid the card off every month. This showed a great track record of on-time payments and low credit utilization. Keeping the card now for over a decade shows good duration. All things in my favor.
The result -- My wife and I both have credit scores in the low 800s by all three credit bureaus. And my credit limit per request increased to $4,200 this year for those of you wondering. Now that I am primarily a credit user, my debt utilization is a bit high some months.
I should look to increase the limit farther, but I don’t really care. Other factors on my credit supersede my need to increase the limit farther. And I don’t plan on borrowing money anytime soon.
Kids and Credit
If you have kids, consider making them an authorized user. They don’t need to carry a card, but their name goes on it. They begin to build credit via the card. This is the safest way to build their credit provided the card is used responsibly and paid off each month.
At age 18, kids with independent income or a cosigner can officially apply for their own credit card if they wish. Be careful as this opens a new world of easy spending that may be exponentially more detrimental than building some credit.
Credit cards decrease friction during shopping which makes spending easier. Increased spending for credit or rewards points is not worth it.
Maintaining good credit
This is vanilla, but don’t overthink it. Pay your bills on time and in full. Don’t max out your card. Limit new lines of credit. Fortune.com reports the average American having 3.84 cards with a limit just over $30k. That’s plenty. Pick two or three max and go for it.
I remember during our mortgage application; they told us to not open any lines of credit as it will alter your credit score. It must make a difference.
Is closing old cards okay?
Many preach to avoid closing lines of credit to maintain credit longevity and maintain debt utilization ratios. In reality, closing a card will only briefly influence credit score. Credit utilization may be affected, but don’t let this stop you from closing an old card.
Carrying a balance
This is senseless. End of story. Paying 18-26% interest on a balance doesn’t help your credit. If anything, it negatively impacts your credit AND costs you a bunch of money. Don’t carry a balance.
Checking your credit
If you look at a summary of your credit, there is no downside. They consider this a “soft pull.” If you apply for a new line of credit, they consider this a “hard pull.” This will decrease your credit score for a short period. If you don’t open a new card for every department store, you’ll be fine.
What isn’t in your credit score
Information such as marital status, race, religion, age, occupation, and salary are not included. Relating to CRNAs, occupation and salary are not included. This is where underwriting comes in.
Underwriting is when a lender, usually mortgage broker, dives beyond the credit score of a broke recently graduated student. The underwriter may ask for your income or job contract, assets, and debt. This is common for high-opportunity cost professions. This is what they do for all of the “physician loans” I see inquiries about.
Side note about physician loans:
Lenders know you are broke, in debt, and have a much greater than average income. Banks agree to lend you money for an asset (house) via underwriting. They typically don’t require a down payment or mortgage insurance; However, the rates aren’t any better. They still want a credit score of 700.
Be weary of underwriting. You may be approved for a mortgage to buy that first house out of school. Great. Well, maybe. The downside is the lender will see the income and try to grab as much as possible by allowing a large mortgage payment. This leads to someone being “house poor.”
Ahh, the financial pitfalls are underway.
Yet another reason why I don’t blindly accept the amount of house the lender says I can get. They would have cut my wife and I a mortgage for $1.8M. We bought more house than we needed for $255,000.
Do your research as to how much you can or want to spend on housing. Never a bad idea to rent for a few years while you try out the job and area. Don’t be one of the many folks who can’t get away because they can’t afford to walk. Can’t afford to miss a paycheck. Can’t afford a lower income.
What a credit score doesn’t show
A credit score, like all other financial metrics, is not a measure of self worth. It isn’t a measure of net worth either. Someone who is broke and regularly takes out $200 payday loans may have great credit because they regularly pay them back on time, plus the huge interest rates.
Similarly, the Dave Ramseys of the world who filed bankruptcy then never borrowed money again have a terrible credit score. The last thing on his credit report is filing for bankruptcy and he is worth hundreds of millions of dollars.
In closing…
I have one credit card with a $4,200 limit, and I don’t worry about my credit utilization. I pay it off every month. My debt-to-income ratio is amazing compared to the average bear. Don’t sweat the small stuff. Be a responsible borrower and you will be fine.
