I was taught to take care of two things, my reputation and credit score, because once either is damaged, it takes a long time to repair. Your credit score changes and matures with you, but it also has a memory, so be careful!
Why Does My Credit Score Matter?
Your credit history is reviewed by a lender to determine the likelihood of whether a loan extended to you will be repaid. If the history reveals payments paid on time, and adequate credit depth without a large volume of unsecured debt, the credit score will likely be good. If a credit file shows late pays, collections, bankruptcy and credit cards charged to the limit, the credit score will probably be low, and the lender may not consider the borrower good credit risk.
A good credit score (FICO) is like money in the bank because a good credit file will qualify for a better interest rate. A lender might consider an applicant satisfactory in spite of a few credit dings, but because the credit score is low, the rate on the loan may be several percentage points higher than higher scoring applicants.
To put this in perspective, a principal and interest payment on a $200,000 thirty-year home mortgage at 5% would be $1,073. At 6%, this payment would be $1,199, an additional $45,000 over the thirty-year term! A four year car loan for $15,000 at 5% would be a $345.00 monthly payment, compared to $366.00 at 8%, an additional $1,008! The total monthly outlay for a borrower with good credit would be $1418, compared to $1,565 for the borrower with a low score. This is an increase in monthly payments of $147.00, $1764.00 annually. Numbers don’t lie; it pays to have good credit.
What Goes Into My Credit File?
The three credit reporting agencies, Equifax, Experian, and TransUnion compile credit file information on monthly intervals. They use the data they receive from three sources:
- credit account information
- public records
- lender inquiries
Most loan lenders report payment history once a month to the three major credit reporting companies. The reporting agencies apply their formula to the compiled data to arrive at their credit score. The scores of each reporting agency should be similar to one another, but many lenders use a “tri-merge” score from the three reports. In addition, the lender will apply additional internal measurement criteria to determine creditworthiness.
What Affects My Credit Score and Why?
Various factors can affect your credit score. Public records such as liens, judgments or a bankruptcy filing will negatively affect your score, and mortgage lenders may even require certain items be paid before the loan closes, especially if you are obtaining a government-insured mortgage (FHA or VA). The reasoning is that existing liens or judgments may take precedence over the lender’s lien filing if allowed to remain unsettled. Your lender will advise you of their policy regarding this situation.
The primary credit account factors considered are 1) payment history 2) type of debt 3) total debt load, and 4) age of accounts. Obviously, late payments are a negative factor, especially if the loan is recent. One 30 days late on a loan that is two years old in a file that is otherwise clean, will have less effect than a thirty-day late on a loan that is only sixty days old.
Unsecured debt, such as credit cards and no credit check payday loans (if taken from reputable companies) usually do not have any negative effect. Only if there is a large amount of unsecured debt and the lines of credit are nearly maxed out then there can be a problem. Secured debt, such as a mortgage or a car loan, doesn’t negatively affect the score unless the payments are being paid late. A lender views secured debt differently since secured debt is harder for the borrower to walk away from.
If your file shows an excessive amount of debt, or minimal credit history your score will be negatively affected. Lenders are looking for a history of reliable payment and responsible handling of credit. A file that shows a bunch of newly opened credit cards already charged to the limit will be a red flag. A file that has only one credit account, even though paid on time, does not give a lender enough to judge from, therefore, the file may be considered inadequate.
Lender inquiries can bring down your score too, because they may indicate new credit lines are being opened that will affect the overall ability to repay. An unfortunate mistake some new home buyers make is buying new furniture, window coverings, lawnmowers, refrigerators, etc., opening new credit accounts at different retailers. When the lender pulls the final credit report before closing, the homebuyer’s credit score has dropped due to the new accounts and they no longer qualify. Keep lender inquiries to a minimum.
Credit Report Action Items
Each credit reporting agency’s website provides guidance on how to understand your score and gives advice on how to improve your number. Negative records stay on your credit report for 7-10 years, the older they are the less they affect the credit score. Here are things to do to keep your credit clean and improve your score:
- Since credit scores are based on the borrower’s credit history, improving that score can not be done overnight. Most credit reports reflect data thirty days old, so even if debts are paid off, it may take 60 days for that to be reflected. It might take an additional 90 days to have an effect on the score, sometimes longer. Check your credit every 6-12 months, and clean up any issues promptly.
- When paying off credit cards, don’t close out credit lines unless advised by a lender. Don’t consolidate multiple credit card debt onto one card and then close out the other cards. Why? Because you want to keep your ratio of debt-to-credit-availability low, preferably no more than 35%. That doesn’t mean you can’t close some unused accounts, but you are better off to have two accounts with a total credit limit of $20,000 and balances of $10,000, than a $10,000 balance on a card with a $10,000 limit.
- If late payments are an issue in spite of sufficient income, set up automatic payments so that payments won’t get forgotten due to a busy lifestyle.
- If there is something reflected on your report inaccurately, contact the lender first to have it corrected. If you can not resolve it through the lender, file a dispute with any one of the three credit reporting agencies.
- If you have an old collection item for something you insist is paid, get it removed or bite the bullet and pay it. That $30 collection will cost you at least double in interest paid on a higher interest rate loan.
Credit is essential to have available for buying a home, a vehicle, a student loan and for emergencies. By responsibly handling the credit a lender grants you, you will pay less for the money borrowed, and maintain the ability to borrow again when needed. Disregard for these credit basics will cost a negligent borrower thousands of dollars over a lifetime and sometimes even their dreams.