In this article we'll talk about:
- What's a credit score and why you should care
- The money you can save by having a great credit score
- How your credit score is calculated
- Ways to make your credit score higher
I bet you're thinking, "look at this jerk, who cares about his credit score?" I may be a jerk but if you've ever had a student loan, applied for a credit card, or driven a car, chances are you've had your credit score looked at.
What’s a Credit Score?
A credit score is your financial report card. It tells lenders how good you are at paying your bills on time. If you suck, lenders charge you more interest because you’re seen as a more risky borrower – someone who is more likely not to pay back your loan on time. On the other hand, if you pay all your bills on time and demonstrate that you’re a responsible borrower, lenders will give you a better interest rate.
Why Should I Care?
I’m going to go over three BIG reasons why you should care about your credit score: your mortgage, your car loan, and your insurance premiums. Even if you don’t own a house or a car, I’m assuming that someday in the future you will want to buy one, which is why you’re reading this blog in the first place.
Let’s compare the difference between two people who are both buying a house and car in New York City - one has a great credit score and the other has a crappy credit score.
Mortgage Loans
Let’s assume that both Piggy and Ninjy both buy a house in New York City and have a 30 year fixed rate mortgage loan out for $300,000.
Piggy, with a credit score of 620, will have an interest rate of 6.286%.
Ninjy, with a credit score of 750, will have an interest rate of 4.709%.
I bet at this point, you’re thinking, “so what the hell does that mean in terms of dollars?” Good question.
- Mortgage Loan Amount: $300,000
- Over 30 years, Piggy will pay $106,792.12 more interest than Ninjy because of his higher interest rate
- Piggy will have a monthly mortgage payment that’s $296.64 more than Ninjy. Ouch!
Now if you thought having a bad credit score for a mortgage loan was tough, check out the interest rate that our little friend, Piggy, gets on a $25,000 auto loan: a whopping 14.234% - over eight percentage points higher than Ninjy’s. 
- Auto Loan Amount: $25,000
- Over 3 years, Piggy will pay $3,626.63 more interest than Ninjy because of his higher interest rate
- Piggy will have a monthly car payment that’s $100.74 more than Ninjy. Yowza!
I’m going to tell you now – I have no idea how credit scores directly affect insurance premiums. All I can tell you is that credit scores are part of the equation and that your credit score is becoming more and more important in determining your insurance premium.
Insurance companies have a really difficult time determining how risky you are as a person. Risk is just something that’s difficult to quantify so they try the best they can to use proxies for risk – credit score is one of those proxies. Insurers believe that there is a direct relationship between an insured’s financial dependability and potential insurance losses. For example, someone who’s always late on their credit card payments may be more likely to be irresponsible and crash their car. Therefore, they should pay a higher premium.
What do you mean that doesn't make sense to you? Well, to be honest, it doesn't really make sense to me either. So if anyone could offer some more insight into insurance premiums, drop a comment!
How Can I Raise My Credit Score?
First, it’s important to look at the factors that affect your credit score:
Payment History – 35% of your score
What is it? The most important factor of your credit score is how responsible you were with paying your bills in the past, with a greater emphasis on your most recent payment history.
The good – Pay all of your accounts on time. Don’t be consistently late on payments. A missed payment or two on a small bill won’t affect your score that much.
The bad – Having a delinquent account sent to a collection agency will hurt. Filing for bankruptcy will hurt a lot!
The ugly – If any serious negative information shows up on your credit report, you can expect your score to go down big time and this information may remain on your credit report for 7 to 10 years, sometimes more.
Debt Usage – 30% of your score
What is it? This is a measure credit utilization calculated by taking your total debt divided by your available credit. For example, $800 of credit card debt with a $10,000 credit limit will produce a debt utilization of 8%.
The good – Having a utilization of less than 10% will help you earn the most points for your credit score. To make sure you earn the most points from this category, keep your credit card balances low.
The bad – There’s a common myth that carrying a balance will help your credit score. It doesn’t. Carrying a balance is better than maxing out your credit every month, but not better than keeping a low credit utilization.
The ugly – People who max their credit out are perceived to be the biggest risk. On the other side of the spectrum, people who never use their credit lines have no history at all. The people who get the most points from this category are those who keep their balances low and their credit limits high. However, you shouldn’t open new accounts or request credit limits that require a pull on your credit report; both can negatively affect your credit score. The safest option would be to continue using your existing credit, keep your credit balances low, and accept credit limit increases that don’t require a pull on your credit report.
Credit Age – 15% of your score
What is it? Your credit age is made up of your oldest credit account and the average age of all of your existing accounts.
The good – There isn’t much you can do here except be responsible with your credit for a long (really long) period of time. For example, I have over 5 years of credit age and score really poorly in this category.
The bad – There’s a common myth that you should close old accounts that are in good standing and get them removed from your credit report because they’re closed. This will lower the average age of your credit and can negatively affect your credit score.
The ugly – Closing old accounts can also hurt your credit utilization.
Account Mix – 10% of your score
What is it? Your account mix is the diversity of your credit. No, having an AMEX black, blue and gold does not count.
The good – Having a healthy mix of both revolving credit (credit cards) and installment credit (mortgage loan, auto loan, student loan) will help your credit score. People who have installment credit are considered more stable because installments are just that, stable payments over a long period of time.
The bad – A lot of young people just don’t have any installment loans. Luckily, account mix only makes up 10% of your credit score.
The ugly – Applying for in-store financing offers to save a few bucks on a single purchase is bad. A lot of these cards are targeted towards higher risk consumers and having too many of them will hurt your credit score.
Inquiries – 10% of your score
What is it? This is the number of credit inquiries that you’ve had in the past twelve months
The good – For most credit scores, if you perform all your credit inquiries in a 14 day period, they will only count against your score once.
The bad – Inquiries will hurt your credit score but only for the first twelve months that they’re on your credit report.
The ugly – Plan ahead and shop around in the shortest possible time frame you can when looking for a mortgage loan or an auto loan. This will minimize damage to your credit score.
What Now?
Credit scores are one of those things that no one thinks about until they need to take out a large loan. By then, it’s usually too late to make any significant improvements to your credit score. Establishing and maintaining a good credit score is a big win in the world of personal finance. Think about how many lattes from Starbucks you could buy with the amount of money you save in interest for taking care of your credit score.
Just keep in mind that having a good credit score can save you hundreds of thousands of dollars in your life time. Here are some tips to make sure your credit history is in good standing:
- Check your credit report once a year from all three reporting agencies, Experian, Transunion and Equifax, for free at www.annualcreditreport.com. Your credit report is a detailed history of your credit history and is also what your credit score is based off of. So, you'll want to check it out every once in a while to make sure it's accurate.
- Examine your credit report and correct any inaccuracies that appear – including erroneous accounts, inaccurate delinquencies, an incorrect name or address. This is really important to do. Credit reports can get really messy over time and I find that getting them fixed periodically is a lot more manageable than dealing with it a few months before you need to take out a loan. It's easy; all you have to do is mail a letter to the credit reporting agency notifying them of your error. I had to do this once when they listed addresses on my credit report that weren't mine.
- If you want your exact credit score, you can check out these services from Credit.com. Most of the credit score reports are bundled with some kind of credit monitoring or credit protection. There are a lot services that offer free trials so you can try them out risk-free and cancel after the trial period if you decide that it's not for you.
Seriously. Taking care of your credit score is a gradual process and it doesn't take a lot of time. If you think about the amount of work you put in to take care of your credit history: making sure to pay your bills on time, looking over and correcting any errors on your credit report once a year, or even looking to see how you can improve your credit score and doing something about it(important), it's not a lot of time. And, if you go a little farther and look at the amount of money you'll lose by having a poor credit score, taking the time out to take care of your credit score is probably the most per hour you'll ever make.
What are some of your favorite credit related services? What questions do you have?
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This article was featured in the Carnival of Personal Finance #242 hosted by Cash Money Life. Please check out this carnival for many other great articles about personal finance.
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12 comments:
You're legally entitled to an annual credit report from each of the three major credit bureaus- see www.annualcreditreport.com. I recommend getting one every 4 months or so. I check mine periodically and have never noticed anything strange. If you get on your parent's credit card, their good history (assuming they have good history) will help you. I have credit history going back to 1988, I was born in 1987.
Also, Mike, you made an error in the car loan table, you flipped either the people or the amounts or something, forgive me, this is my thirteenth day in a row working and I'm a bit overtired to figure out what I'm trying to say but if you look at it, I'm sure you'll be able to correct it.
Yep. That's it. Thanks, interesting read as always Mike!
@Joshua
Great points! Thanks for pointing out that error. It's fixed now. Sharp eye! That's an interesting idea about getting on your parent's credit card to increase your credit age. I never thought about it. How does that work?
www.annualcreditreport.com is the site linked in the first bullet point. I guess it wasn't that clear - I'll fix that now.
What do you do, Josh? Are you at a Big Four?
Thanks for making me feel that my credit score is worse than it should be.
@Wilton
All in day's work. No need to thank me!
Not a fan of the credit monitoring services . . . I think they're unnecessary but that's just me.
What I got from this was . . .
If you want to ruin your credit score, ruin it well before you make a big purchase! I think my score was 680-690 when I was a fresh grad but now it's in the upper 700's. Can't seem to break that 800 mark.
@Alvin
I don't think credit monitoring is necessary for most people. For me, there was a security breach during college where all of my personal information was compromised. The school provided us a free year of credit monitoring services and I decided to extend it, just in case.
I like to think that it's just really hard to break the 800 mark at our age considering that our credit age can only be so old and most young kids don't have mortgages. Or we just suck. Haha.
From what I understand though, having a 760 credit score pretty much already qualifies you for the best rates.
It's amazing to me how much our credit score affects our finances. A friend of mine mentioned the other day that brokers will pull your credit history before authorizing you to trade options! Anyway, great article, and I love the site.
Best, DR
@DR
I'm not surprised that brokers pull your credit history too - especially if you're trading on margin.
Thanks for the support!
Mike,
Here is a good link that explains credit based insurance scoring: http://www.insurancescore.com/creditvinsurance.aspx
@Nancy
Thanks for sharing that link with everyone. That was really helpful!
Good info, but sad that a credit score impacts us so much. I underpaid my mortgage one month due to an increase in taxes. Got the lender to remove the late fee, but after 2 months it still appeared. So now my account is way late. Supposedly they fixed the issue, but it will take another 60 days for it to update with the credit bureaus. One simple mistake and my score dropped about 70 points, crazy!
@Kris
Hopefully they'll fix that with no problem.
How long ago was this when you missed your payment? I was listening to NPR's Planet Money where they interviewed people who "strategically defaulted" on their homes when they were underwater on their mortage and those individuals had a drop of around 200-300 points on their credit score.
70 points for missing 1 payment is relatively severe!
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