Your credit score can seem like a mythical beast that is too complicated to understand. But, it doesn’t have to be. Emily and I have noticed that many people have either no understanding of credit, or very skewed ideas of how it actually works. Personal financing, budgeting and credit stewardship have all fallen by the wayside in the American Education system. These subjects are no longer taught to people who are about to take out massive student loans.
How can we expect entire generations of Americans to make wise financial decisions if they don’t understand the rules of the game they are playing? Whether they want to play or not, we are all in that game. We wanted to shed some light into what credit is and why it is so important in our daily lives.
Let’s start off with a bang. First, what is credit and how is it best utilized? Credit is defined as a contractual agreement between a lender and a borrower. The borrower receives something of value now and agrees to repay the lender at a later date, usually with interest. For example, a friend gives you two slices of pizza now, with the promise that you’ll give them 3 pieces of pizza next week in return. The utilization ratio is the percentage of the borrowers available credit line that is currently being utilized. In other words, if you have a $5000 credit limit and you are utilizing $1000 of it, your ratio is 20%.
In the United States, there are 3 main credit bureaus. These are Equifax, Experian and Transunion. Each bureau compiles all of your credit information and consolidates this into a report. Not every lender or creditor reports to all 3 bureaus, owing to why each report may differ. After that, the bureaus crunch our reports through the FICO Algorithm (explained later on) and out pops our 3 digit score that represents how responsible we are with credit.
To explain how all of this sprouted forth from the Ether, we need to travel back in time around 100 years. Borrowers would go to their local bank and ask a banker for a loan. The banker would demand something in collateral, like the family mule or maybe Aunt Maude. Almost every loan in the early to mid 1900’s was considered a secured loan due to this collateral. This was how credit came into being. It was on a hyper-local level.
The Birth of Credit Bureaus
As a result, small agencies started popping up to track all of the info surrounding these loans. With the intention of reporting to the local lenders whether said borrower was responsible with the credit given or not. Flash forward in time, and now we have the 3 main agencies listed above. However, these bureaus operate on a much grander scale today.
Types of Credit and Why They Matter
The two types of credit are revolving credit and installment credit. Revolving credit is chiefly credit card accounts. As well as home equity lines of credit (HELOCS), gas cards or retail cards. These are considered revolving because the account will not close when the balance reaches zero. These will not have set monthly payments, although they will have minimum payments. Revolving credit allows the consumer to spend money now, in the hope that they can pay it back when they have the finances to repay it. On the negative side, these type of accounts tend to have a much higher interest rate.
Conversely, installment credit comes with specific payment terms, as well as a repayment schedule.This type of account differs from revolving credit due to a crystal clear end date. When the last payment is made, the account will close. Another interesting facet of installment credit is the behavior of the utilization rate. At the beginning of the line of credit, your utilization rate will be very high. On the contrary, the last few months of payments will show a considerably lower utilization rate due to payments made. Common types of installment credit lines are mortgages, car loans, student loans and personal loans.
Why Your Credit Score Matters
Now that we understand the types of credit, let’s find out why it is so important in today’s world. Every time that we apply for a mortgage, car loan, utilities for our home, a cell phone, (the list goes on and on) our credit is run. Any situation where a business needs to check your reliability with using credit or paying for services rendered, they will check your report. Even buying an insurance policy is effected by your credit history. I wish I would have learned about the importance of credit at a much younger age. Seeing that credit is key in most financial situations, the better your credit is the better terms and conditions will come with a new line of credit.
Types of Borrowers
Credit wouldn’t exist without borrowers, and we all fall into one of two camps. The first camp being the Transactors. This is the ideal position to be in when utilizing your available credit. Transactors will spend only a small portion of their credit line and pay it back every month. I can already hear the retort of “but paying interest helps build my credit!” Nope. Wrong. That’s a myth. The proper utilization ratio is what actually builds your credit. Debt to income ratio is also a factor.
If you pay back your debt each month, you won’t rack up hefty interest fees nor carry a balance from month to month. Being a Transactor almost always guarantees positive credit. Equally important is the sage wisdom of living within your means. Transactors tend to live within their budgets and keep their debt manageable.
Camp 2: Revolvers
On the other hand is camp two, the Revolvers. Here’s an example: you receive a credit card with a limit of $1000. You’ve had your eye on that flat screen the Jones’ have at their house. It’s only $500, so why not? This in itself isn’t the issue. The issue is that when it comes time to pay your credit card bill that month, you only pay in $100. Leaving a $400 revolving balance. This will carry over into the next month and will tack on interest. Wash, rinse, repeat.
Folks in this situation traditionally do not have much wiggle room in their personal budget. The margins keep getting smaller and smaller with each passing month. If spending is consistently more than payments, levels of debt skyrocket out of control like gangbusters. This is how a majority of Americans become overwhelmed and eventually end up swimming in debt.
The FICO Algorithm
As much as credit reports and credit scores seem like the same thing, they aren’t. Your credit report will show your credit history, notes from lenders, closed accounts, public records, etc. The entire ball of wax all in one place. As well as each bureau’s report being slightly different. With this in mind, what is the difference from the report to the score? This is where the FICO algorithm takes it’s turn. The algorithm distills down your credit report into a 3 digit number between 350 and 800.
This allows lenders to quickly look at your credit score and determine your credit-worthiness. With this purpose in mind, the Algorithm’s main goal is to predict the likelihood that a borrower will default on payments within the next 18 months. If a borrower’s score is low, the likelihood to default is considerably higher. Compared to a borrower with a much higher score, say 715, who is much less likely to default. We will discuss the factors that are used to determine your credit score within the algorithm shortly.
What is Considered a Good Credit Score?
On most scales, a score of 720 is a quality benchmark. With a score of at least 700, a borrower has a strong chance of being approved for the best rates for credit cards, mortgages and car loans. Scores in the higher 600s aren’t considered bad, but may not qualify for the prime interest rates someone with a 700+ score may receive. In the mortgage market, each type of loan will have a minimum credit score for all borrowers. At the time of this article, the national minimums are as follows:
- FHA Loan – 580+ (500-579 is possible approval, but not likely)
- VA Loan – 620+ (some lenders require 580)
- USDA Loan – 640+
- FHA 203K Loan – 620+
- Conventional Loan – 620+
In view of this information, we know that a high 600’s score will butter the bread, but you may end up with higher interest rates than one would hope for. So, we can all shoot for a 720+ score and know we are moving and shaking in the right direction. In light of this, let’s look at the factors that make up your credit score.
5 Factors Taken Into Account in Your Credit Score
The first factor that effects your credit is your payment history. Your past payment history accounts for 35% of your credit score. Needless to say, this is the heaviest hitter to contend with. A late payment is not the end of the world, but should be avoided like the plague. Apart from being a late payment, the severity and frequency of late payments are also considered into this 35%. 30 days, 60 days, or 90 days late; all of these are taken into consideration with your credit score.
But, so do collections. If these late payments are turned over to collections, it will dramatically effect this part of your credit score. On the contrary, it’s not all doom and gloom here. If you are working towards fixing your credit, being delinquent in the past doesn’t effect nearly as much as being currently delinquent. Furthermore, all late payments will drop from your credit report within 7 years of the initial delinquency.
How Much You Currently Owe
Next up to bat is the amount you owe. How much money you currently owe constitutes 30% of your credit score. This is that CREDIT UTILIZATION RATIO we talked about earlier. This is much less critical for installment lines of credit. These have fixed payment schedules and strongly depend on the life of the loan. However, this is very critical for revolving lines of credit. A good rule of thumb is to never utilize more than 20-30% of each revolving line of credit.
The best option is to be transactional and pay it all off every month. However, life has a way of throwing us curveballs. So, if you must carry a balance between months, never charge more than the 30% of your credit limit and pay it down before utilizing that line again. On the negative side, many borrowers do not use this rule and inherently finance a lifestyle that they truly cannot afford. The price tag of this lifestyle is a very high debt to income ratio, a high utilization ratio, as well as those unbearably high interest payments. Let’s avoid that pitfall at all costs.
Length of Credit History
Thirdly, the length of your credit history comes in at 15% of your credit score. Remember that FICO Algorithm we talked about earlier? This section is about how long those data points have been around. A borrower applying for their first line of credit will generally have a lower credit score. The algorithm doesn’t have enough data points to show whether said borrower is responsible with credit or not. They need to show more history.
Another key point is the longer you have a line of credit, the better. With this purpose in mind, it is a bad idea to cut up credit cards or close lines of credit. Closing down a line of credit drops your available credit. In the same way, this will raise your utilization ratio which is counter to what we are trying to accomplish. A lengthy borrowing history shows the algorithm and lenders that you tend to be a long time customer with quality repayment history.
New Credit Requests & Credit Mix
Finally, we have new credit requests as well as the types of credit mix in use. These make up 10% of your credit score each. Every time that we apply for a new credit line, the lender will more than likely pull your credit before approving the account. This will be considered a hard credit inquiry. A hard credit inquiry will drop your credit score by a few points on the average. But, this drop will only be temporary. Within 6 months to a year of solid payment history on that account, the drop will be reversed and you’ll be on your way to building your credit score up. Try to limit new credit applications to no more than two every six months.
Sidenote: annually checking your own credit score with any of the bureaus does not effect your credit score. Go to www.annualcreditreport.com to get your free annual report.
As for the credit mix in use, this shows the FICO algorithm how you paid back credit across the board. Not just with credit cards, but with mortgages and car loans as well. This helps the algorithm predict if you are as responsible with installment credit as you are with revolving credit.
Building Positive Credit & Repairing Credit Mistakes
Bootstrapping your credit game and repairing bad credit issues usually need the same actions to be taken. As stated at the beginning of this article, the key to financial security is a strong understanding of personal finance and budgeting. Make sure to pay EVERY SINGLE BILL ON TIME. EVERY TIME. Set an alarm in the calendar on your phone so you know when each bill is due. Don’t brush it off or grow lax towards your financial situation.
The Credit game is a marathon, not a sprint. Small issues can take 3-6 months to cure, and some negative history can stay on your report for up to 7 years. Bankruptcies can haunt your report for 7-10 years. Given these points, you will have to play the long game to come out on top. The first step in this is building a home budget and sticking to it like gospel. Now that we have our household finances in order, let’s go over some of the tricks we can employ to speed up this process.
Tricks to Build Positive Credit
First, let’s go get a secured credit card through your bank. These little babies are the cornerstone to building good credit. A secured credit card is considered “secured” because you pay money to build a credit limit. Let’s say your bank offers you a secured card with a $1000 limit. You give them $1000 in cash and they hand you a card. Then, you use all the wonderful brain mojo we have given you within this article. No more than 20-30% utilization ratio, that’s $200-300 at a time.
Always pay that down before utilizing that card again. Never miss a payment. Pay more than the minimum payment due every month. After a few months, go back into the bank with a fat pile of cash and raise your credit limit even further. Repeat this until it becomes muscle memory. You’ll be absolutely blown away how much this little trick will grow your credit score in the positive direction. After a period of strong payment history, you can ask the bank for your credit limit deposit back and convert this card to a standard credit card. Allowing you to keep your credit limit and your cash money.
Pay More Than the Minimums
Secondly, if you are financially able, pay extra every month towards your mortgage. Click here to see our post on determining how much mortgage you can afford. Make sure your mortgage service provider knows that the extra payment should be posted to your principal amount. This will help pay off your home at a more rapid pace.
Third, pay more than the minimums on any revolving credit account you have. Manage your debt, never let it manage you. If at all possible, pay your credit cards off every month. Find out when your billing cycle is closed and posted to your account. If you pay the balance off before that date, you won’t be carrying an interest payment into the next month’s cycle.
Work towards becoming a Transactor at all times. Being debt free and financially conscious can be more than a “some-day” dream. The last tip I have doesn’t help your credit so much, but is a massive perk to playing the credit card game. Find a credit card that offers air miles or perks. Our favorite is the Chase Sapphire card. Our purchases help us build up air miles for all of our amazing adventures. There is an art form to balancing credit card perks that Emily and I are still novices at, but we plan on offering another “Adulting” class on this soon.
First, for fear that all of this is unforgivingly overwhelming, keep your chin up. With some resolve and tenacity, any credit situation can be repaired and brought over to the light side. Keep notes from this article taped up next to your calendar. Pay those bills before they are due and if you can, pay extra towards your mortgage and credit card bills.
If you’re a parent, pass all of this information on to your children. They will not learn it anywhere else. The power to put yourself in the best possible financial situation lies inside of you. You just need to take the first step and never look back. We have faith in you.