It is only the poor who pay cash, and that not from virtue, but because they are refused credit.- Anatole France
Many of us don’t know that credit, when used responsibly, can actually improve our financial status substantially. Believe it or not, there is such a thing as “good” debt out there. Yes – we did just go through a credit crisis where many people foreclosed on their homes, and yes – many people declared personal bankruptcy. But using credit to purchase appreciable assets (i.e. income producing assets such as property, stocks, bonds, mutual funds, art work, etc.), can secure your financial future and help grow your nest egg exponentially.
Since credit is so important, it baffles me that most people don’t know what their credit score is. Think of your credit score as your resume, and the future mortgage you wish to secure down the road as your ideal job. Wouldn’t you want to build a stronger resume before applying for that job? The truth is, not only will an improved credit score allow you to qualify for that mortgage, personal loan or premium credit card, but a higher score means better interest rates which can save you a fortune in the long run.
Let’s put things into perspective by quantifying the potential impact an improved credit score can have on interest savings. Consider a couple looking to buy their first home and seeking a twenty-five year mortgage loan. With an exceptional credit score they can potentially qualify for a mortgage with a low 4.29% interest rate. However, with a weak to average credit score they probably would pay 7.29% or more – that’s at least 3 full percentage points more in interest. On a $300,000 mortgage loan, that 3 point difference will cost them $6,350 a year, adding up to $158,750 more over the loan’s twenty-five year lifetime. On a $600,000 mortgage, the additional interest doubles to approximately $317,500. In short, your credit score does matter.
Most people are aware of the basics when it comes to credit scores; for instance not paying your bills on time is a bad thing, or maxing out your credit cards will negatively impact your score. However, these basics are not enough to change your score from average to excellent. Before I suggest simple ways you can improve your score, I think it’s important for everyone to understand the makeup of your credit score.
- Past payment history – 35%
- How much you owe (credit utilization rate) – 30%
- Length of credit history – 15%
- Types of credit used – 10%
- Recent application for new credit – 10%
Credit scores range from 300-850 in the U.S., and 300-900 in Canada. The higher the number the better your score, so you always want to see that number increasing. A general guideline to follow when evaluating your score is:
- 650 and lower is poor
- 650 to 680 is fair
- 680 to 720 is good (most people fall in this range)
- 720 to 750 is very good
- 750 and up is excellent
Keep in mind that each lending company has its own guidance on credit score ranges and they may differ from the general range provided above.
6 Ways to Improve Your Credit Score
1. Request and review your credit report annually at the very least.
2. Make your monthly payments in full and on time.
3. Have five different credit card accounts.
4. Rotate your credit card use.
5. Limit your applications for credit within a short period of time.
6. Protect your identity from fraud and theft.
1. Request and review your credit report annually at the very least. It is important to be aware of your credit profile, so that you’re not caught off-guard when you’re at the bank applying for that ever important loan. You can obtain your credit report from the major credit agencies for free by requesting it through the mail or for as low as $23.95 online.
More often than not, people are under the impression that their credit score is in better shape than it actually is. By reviewing it annually or semi-annually, not only will you be aware of the room left for improvement, but you may also find errors on your report. It is very common to find errors which could negatively impact your credit score. Even though errors can easily be disputed online through the major credit agencies mentioned above, it can take some time to rectify these; therefore it is important to identify them sooner than later.
2. Make your monthly payments in full and on time. This point is fairly obvious but it has to be mentioned nevertheless to emphasize it’s magnitude on your credit score. As mentioned earlier, past payment history makes up 35% of your credit score alone. When you can’t make your monthly payments in full for one reason or another, the worst thing you can do is let the bill go unpaid. The creditor will then report the late payment to the credit agencies which will hurt your credit score. If you can not make your payments in full, ensure that you at least make the minimum payments on time.
3. Have five different credit card accounts. There is no universal number when it comes to credit cards, but having too few or too many can harm your credit score. A good average is between three and eight depending on your credit profile. Having multiple credit cards will improve your credit score by increasing your overall credit limit. Don’t forget that your credit utilization rate (total credit used / total credit limit) makes up 30% of your credit score. Therefore, for good credit scoring you never want to use more than 30% of your available credit limit. By increasing your overall credit limit with multiple credit card accounts, you will in turn be reducing your credit utilization rate.
4. Rotate your credit card use. Now that you have five different credit cards, to improve your credit score further start using one for a few months, then using another. Most people who carry multiple credit cards tend to use their preferred one on a regular basis, and keep the others as back-ups. Having an open credit card that you never use can negatively affect your credit score since, if you don’t use it occasionally, the credit card company might cease reporting your activity to the credit agencies. By rotating your credit cards, your credit card company can report a zero balance every few months to the credit agencies, which indicates that not only do you pay on time but that you pay in full. Therefore, if you have credit cards in the bottom of your drawers that have been inactive, it’s time to dust them off and put them to good use.
5. Limit your credit applications within a short period of time. If you plan on applying for a mortgage, car loan or any significant form of credit within the next 12 months, you should avoid any other credit applications within that period. Recent application for new credit makes up 10% of your credit score, so you should avoid any unnecessary inquiries into your credit report. Any time you authorize a creditor to check your credit, an inquiry is added to your report which lowers your score. If you have a large amount of inquiries in a short amount of time, creditors may infer that you are either applying for too much credit because of financial difficulties or taking on more debt than you can handle. It’s important to note that regardless of whether you’re credit application is approved or not, the credit inquiry will still be recorded on your report. Therefore, do not apply for credit that you know is beyond your means. It is also important to note that requesting your own credit report does not count as an inquiry into your credit profile, so feel free to request it as often as you want.
6. Protect yourself from identity theft and fraud. Unfortunately, identity theft and fraud is very common in today’s world, and the negative impact it can have on your credit score can take a considerable amount of time to erase. The best advice I can offer is to take preventative measures to reduce the risk of this happening to you. The first thing you can do is already covered in my first point, in monitoring and reviewing your credit report on a regular basis. The major credit agencies also offer a paid service, which alerts you within 24 hours of any changes made to your credit report. As a simpler solution, I would recommend that everyone invests $50 in a personal home document shredder. It’s an inexpensive, easy way to ensure that all private documents are disposed of safely. Finally, I would also advise that people are mindful when releasing their Social Security numbers. Never give a person or company your Social Security number unless they have a legitimate reason for knowing it. If a company doesn’t need to check your credit, they most likely don’t need your Social Security number. If a company asks for your Social Security number, ask them why they need it, what they will do to protect it, and what will happen if you refuse to give them your number. Unless you are applying for credit or opening an account that requires a credit check, many companies will move forward without your Social Security number.
It is apparent, with the advent of the recent credit crisis, that we are in times of excessive leverage and overspending, and coupled with predatory lending practices, we do have to exercise some caution when applying for more credit. The more reputable creditors however, now have more stringent lending requirements, and in these markets are placing even more importance on credit scores. That is why an excellent credit score is essential to secure your financial well being. It is fundamental to recognize that building an excellent credit score takes time and patience, and it’s not something that will happen overnight. However, it’s never too late to start and the payoff in the long run is well worth it.
Our credit scores can be vital to our financial health, and people should be aware of the simple ways in which they can improve their score.
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