Financial advice and credit advice are not always the same. Financially, it might make sense to transfer a high interest credit card balance to a 0% APR credit card, but this may not make credit sense.
Before becoming a financial planner, I knew little about credit other than you needed it to get credit cards and rent an apartment. Rarely is anything ever taught about credit, and credit is somewhat counter intuitive. Have you ever heard someone say that you do not have enough credit to qualify for a loan. You mean you have to have debt to get more debt?
Establishing your own credit and having a credit score enables you to qualify for a mortgage, car loan, credit card and even some jobs. The information below will help explain your credit score and provide valuable tips for improving your credit and avoiding pitfalls.
What is a credit score? A credit score is a measurement for lenders to determine how much risk they take on when they lend you money. Your credit score is generated from a statistical analysis that assesses “creditworthiness” and FICO is the standard used. FICO looks at a mix of secured and unsecured credit, your payment history, and bases the score on a scale of 300 to 850. This credit score does not care about income or size of debt payments, but it does care about the percentage of debt in use and timeliness of payments.
Credit scores also have no memory. Your credit score is pulled as of a point in time based on all the information available from the three credit bureaus. The score can be different every time it is pulled, so if you had a great score five years ago, it will most likely not be the exact same number today. Credit scores are more heavily weighted on recent items.
You can get a gauge of your credit score for free once every year at annualcreditreport.com, but this is not your true FICO score. It is sometimes called a “fake-o score”. To get your FICO score, you have to pay a fee (royalties to Fair Isaac). Self-pulled scores are considered soft inquiries and will not hurt your credit score. Hard inquiries, those made by others who are trying to approve you for credit, can impact your score if too many happen within a 12-month period. The good news is that multiple mortgage and auto loan inquires are rolled together and will not hurt your score if they are all done within 30 days of the initial inquiry for that loan. If the inquiries are spread out over more than 30 days, the hard inquiries can reduce your credit score up to 50 points, which can mean real money.
What to avoid?
- Joint credit cards. The biggest mistake couples make is to have all credit cards (revolving credit) and unsecured credit jointly named. There is no reason to have both of your names on your credit cards. If something bad happens to one of you, both of your credit scores are negatively impacted.
- Closing old credit cards. Debt ratios and account seasoning (the age of a given account) are important components of your credit score: approximately 45%. When you close old credit card accounts, your debt usage ratios go up and you shorten the average age of your credit file, which will negatively impact your score.
What should you do?
- Keep separate credit cards. You can pay them off from a joint account.
- Rotate your credit cards. Keep your cards active by rotating your use of cards. The amount you charge does not matter; charge a coffee at Starbucks. In a bad economy, lending standards tighten and credit lines are reduced or closed if not active. Even if they are not closed, credit card companies may eventually stop reporting inactive accounts to the credit bureaus. Again, this loss of payment history will reduce the average age of your available credit and hurt your credit score.
- Pay off your credit card each month and on time. Your debt ratio is Dollars in Use/Credit Available. You want to keep your debt ratio as low as possible. Below 50% is good, but usage under 20% will keep your credit score as high as possible.
How can you improve your credit score before a big purchase? Before looking into a mortgage or other secured loan, here are some tips to ensure that your credit score is as high as possible so that you get the best rate available.
- Take care of the past. This includes getting a copy of your credit report and addressing any errors regarding your payment history or lines of credit available.
- Have four “active” trade lines: 1 line that is at least 24 months old, and 3 that have at least 12 months of seasoning.
- Pay down any unsecured debt. This will decrease your debt ratio, and thus improve your credit score.
Depending upon where you fall on the FICO scale, squeaking out an additional 40-50 points can translate into meaningful savings. You need to have at least a 680 for a home mortgage or you will take a steep price hit. At 720- 740 you get the best pricing, and above 760 you will likely get an additional break either through lower rates or lower costs in processing the loan. For example, the pricing on a $600,000 mortgage (assuming 80% Loan-to-Value) will increase by 0.25% with a 720 FICO score and 1.5% with a 680 FICO score when compared to the rates available to someone with a 740 FICO score. These price adjustments equate to $1,500-9,000 upfront and out of your pocket!
Even if you do not have a big purchase on the horizon, understanding your credit score and how to make sure it is accurate makes both financial and credit sense. If you want professional help, you can meet with a counselor at the Consumer Credit Counseling Service of San Francisco (www.cccssf.org) or work with a private credit restoration expert who will develop strategies and action plans to improve your credit score.