Save Yourself Thousands by Understanding Your Credit Score
Last week we talked about how beneficial credit cards can be in helping to build your credit. This week I figured we would take a step back and understand what is credit and how does it affect us? This article is a direct transcription from my book Young, Dumb, and NOT Broke?!. Basically, consider it a free chapter. I could’ve re-wrote this information but after reading what I published six months ago I felt like it covered the information about credit, credit scores, and credit reports, very well. These topics aren’t glamorous by any stretch of the imagination (that’s why this will take you 5 minutes to read) but understanding them is. With that, let’s jump right into it.
Credit is something most of us don’t ever think about until we go to make our first big purchase like a car or house and then it’s usually too late to do anything about it. Since the 2008 market crash, your credit has become extremely important to you. Banks have become tighter on loan requirements and now even getting an apartment or renting a house may require a credit check. Knowing your credit history and doing everything you can right now to get your score as high as possible will save you tens of thousands of dollars in the future. When discussing credit, there are two topics that come up; the credit report which is your full financial story and the summary of your financial story, or your credit score.
Your credit report is made up of many different pieces of financial information but according to MyFICO it generally will break down like this:
- Payment history: this having the largest impact on your score should be no surprise to anyone. Whether you pay back your past debts or not is going to be the most important factor a potential lender will want to know. Pay on time and pay the full amount.
- Accounts owed: When a bank or other lender evaluates you for a potential line of credit or a loan, they will look at what you currently owe and how you use your already available credit. For example, if you have a credit card with a $5,000 limit per month and you spend $4,800 you may be viewed as a high risk of defaulting and in turn, could hurt your credit score.
- Length of credit history: Like anything, history tends to repeat itself. If you have a long history of making payments on time and in full, your score will reflect that and be higher.
- Credit mix in use: Just having a basic credit card isn’t enough to build your credit. I’m not saying go out and buy something you don’t need but while having a long credit history will boost your score so will having a wide array of credit sources like a mortgage, auto loan, and credit cards.
- New credit: Trying to open too many lines of credit in a short period of time can be detrimental to your credit score especially if you have a short credit history. By applying for these different lines, your credit institutions may have to do a hard inquiry which again, too many of these will hurt your score.
- Hard vs. Soft Inquiry – A hard inquiry is something done by a bank or other financial institution such as a mortgage company or a car dealership. A soft inquiry is what is done by someone doing a background check for something like an apartment application. A soft inquiry is less accurate but close enough that they can make a judgment on your worthiness to repay and it does not influence your score.
These pieces of information combined are then put through multiple different equations to spit out a number known as your credit score. Your score will range from 300-850 and it tells your creditworthiness or risk of not paying back a loan, credit card, rent, etc. The lower your score, the more likely you are to be at high risk of defaulting on a payment. Along with that, your interest rate or payment will be higher as a lender tries to mitigate their risk of losing the money they have loaned you. Different lenders may have their own standards for credit scores but here is the general rule of thumb:
What many people don’t know is that by law you are able to check your credit score and report for free twice a year. All you must do is go to Credit.com and register. There are no strings attached and you don’t have to pay, it’s your right. Other services like Credit Karma and even some credit cards will give you a quarterly report. The advantages of this are that you can make sure you are building your credit score and make sure there are no errors on your report (this happens more often than it should).
How to Save Thousands
Ok, enough with the boring stuff, you’re here to learn how you can save thousands. This example below outlines how Amanda and Jim went about to buy their first home.
Amanda and Jim both got approved to buy their dream starter homes for $100,000 and get a mortgage for 30 years at a fixed rate. They are, however, extremely different people though. Amanda has been building her credit for over 5 years now and has had a car loan in that time that she fully paid off. She has never missed a payment and she credits this to her scheduling to pay online automatically; her score is 750. Jim, however, got his first credit card 6 months ago, he missed the first payment by a couple days but paid it off in full, he has no other credit history; his score is 610. In an example like this Amanda would have an excellent credit score so she will get a much lower interest rate than Jim. Here is how it will look:
Since Jim didn’t take the right steps and build his credit, he received a 7% interest rate on his mortgage and in turn this costs him almost $68,000 more, and he bought the same exact house as Amanda! This example may seem extreme but it is realistic if not a low estimate of how a bad credit score could negatively affect you.
Do you know what your credit score is?