What is a Credit Score – Like it or not credit scores are an important part of our modern life. The purpose of a credit score is to give anyone lending you money or entering some kind of ongoing contract with you an idea of how likely you are as a person to pay your bills. Are credit scores perfect, do they always represent the true trust worthiness of a person… of course not. BUT they do correlate well with what they are supposed to predict and if you are dealing with lots of potential customers, using the score is way better than just going off your gut instinct. So like it or not it is important and you should spend some time thinking about yours and trying to improve it. You will be rewarded long term with lower cost loan options and doors being open that might be shut to others (did you know some employers run credit checks!). There are three credit agencies, Equifax, Transunion, and Experian, each of them has a little bit different info on you and calculate things a little different. So scores from each of them vary a little, but overall you should aim for a score above 780. You can think about it like this, spending just a little bit of time on your credit score can save you $100’s of dollars a month on lower interest payments and fees. Where else are you going to easily earn $100 an hour for your time?
How its Calculated
Payment History – So how is a credit score calculated, well its complicated and if I said I knew exactly how they were calculated I’d be lying. But I do know some principles about them that I can share. First paying things on time, matters. That portion of the score is trying to measure how responsible you are, do you think ahead and plan when and how to pay your bills? If not you are probably going to run into trouble later and so your score will be lower. For this I would suggest automatic payments! First off they save you time, and second you don’t have to worry about being late. Of course you need to make sure you have your budget in place (the base of financial planning) other wise you may end up running out of money which would of course be a bad thing and defeat the purpose of doing automatic payments to begin with. Another thing to think about when setting up an automatic payment is where the money is coming from. If you charge it to a credit card, remember that as soon as that card expires you are going to need to make a bunch of changes, and that might be worth it to you if you are getting points or other rewards from your credit card and feel like your responsible enough to keep track of that. I do most of my bills through a credit card, and I have to admit something always falls through the cracks in that transition. If you auto pay out of your checking account that isn’t an issue, though you have the possibility of running out of money if your running on a thin budget. Also on an annual basis it would be a good idea to pull your credit report (for free) and just check out what is being reported and make sure there aren’t any mistakes. They’ll have a list of all of your accounts and which payments have been made on time or late, you can then dispute anything that doesn’t seem correct.
Credit Balances – Another important aspect of what goes into your credit score is your credit available and credit balances. So for example if you have 3 credit cards all with $5,000 limits, you have credit available to you of $15,000. Now if you have $4900 on each of those cards your net available is $300. For a credit score that is a bad situation, and if you think about it it makes sense. On average a person who had nearly all of their credit lines utilized means they are close to a financial break down, if some emergency comes along and they don’t have any credit available (and if they have that much credit card debt they most likely don’t have their emergency savings in place) then they are in serious trouble. So the credit score takes that into account, that’s why if possible you don’t want to carry balances on your cards, never mind the interest charges. Now if that same person has zero on their cards, it looks way better, that person must be doing fairly well, and if they are looking for a loan they are probably a safer bet. Yes it is ironic that those who need the money get punished and those who don’t are rewarded, but when you think about it from a risk perspective it makes sense. This is also why some say you shouldn’t close down credit cards, in general that’s true but if you have 10 credit cards your not using it might be better just from an administrative point of view to close a few of them and just ask for larger credit lines on the remaining accounts, that would get you to the same place.
Building Credit
A question that comes up sometimes is how do you even get a credit score if no one will give you a loan unless you have a credit history!! It does seem like a catch 22. Well there are two easy ways to start your credit history. One of them happens almost automatically if you go to college… student loans. If you get a student loan while in college, those prove your identity and as soon as you start paying on them you begin establishing an on-time credit history. Another quick way to establish your credit is to get a secured credit card. This is a credit card that has a small limit, and has some savings account or other account that guarantees your balances. So for example you can get a secure credit card that has a $500 limit, for buying gas and what not, you’ll need to have $500 in an account as back up for the bank. This means the bank has no risk of you not paying, so they don’t care that you have no credit history. As long as you use the card and pay it off monthly you start to establish your credit history.
Below is a link to a description of how a credit score is calculated with much more detail…
http://www.myfico.com/Downloads/Files/myFICO_UYFS_Booklet.pdf