The Dos and Don'ts, and Why They Matter
It's fair to say that most people know that managing their credit is an important part of maintaining financial health. Paying your bills on time and properly managing your expenses are best practices that may contribute to a good credit rating.
As the saying goes, however, to err is human. While seemingly harmless, a missed or forgotten payment or two, applying for too many credit cards or opening too many bank accounts are things that may inevitably begin to eat away at your credit score.
Your credit score is a number that is used to predict how likely you are to pay a loan back on time. Many lenders will rely on your credit score to determine how much money you can borrow – also known as how much credit you are eligible for - based on your track record of debt repayment. Lenders use credit scores to evaluate the potential credit risk of lending money to consumers.
Lenders are more likely to lend to a borrower with a higher credit score as compared to an applicant with a lower credit score.
The first step to managing your credit score is to understand how it is calculated. Minneapolis-based company Fair Isaac Corporation (better known as FICO) was the first to turn a person's credit history into a number – the idea being that an individual's creditworthiness, as well as their ability to repay a loan, could be measured using a scale.
The FICO model is used by the vast majority of banks and credit grantors, and is based on consumer credit files of the three national credit bureaus: Experian, Equifax, and TransUnion. The FICO scale ranges from a low of 300 to a high of 850. The higher your credit score, the better.
To be clear, very few if any hit the magic 850-number. While a remarkable achievement, the method each credit bureau company uses to calculate an individual's credit score is still subjective – how old you are, how many credit cards or other loans you have, how often you have paid your minimum monthly credit card payment versus the full balance, and so on.
Indeed, there are very few who have a perfect credit score – a very positive number is typically around the 700-750 mark.
Whether you are starting to build your credit or looking to maintain or repair it, below are a few suggestions to help get you on the right track.
First, it's important to understand how to check your credit score so you have a clearer picture of your current credit status.
There are a few different ways to access your credit score:
- Contact a credit bureau: Obtain a credit report from one of the three national credit bureaus - Experian, Equifax, and TransUnion. Typically, each organization provides one free credit report per year, but do your research to understand the information they are presenting to you - the actual number you see may not be what a lender sees.
- Get an annual credit report for free: Go to AnnualCreditReport.com. Select your state and answer a few quick questions. The service will then provide you with reports from all three national credit bureaus, giving you a snapshot of your overall credit health. Because each credit bureau calculates its scores slightly differently, and sometimes with different information, this is a useful way to receive a compilation of your credit score.
- Use a credit monitoring service: A credit monitoring service helps you to monitor your credit score on an ongoing basis – something that can be helpful if you are looking to repair your credit rating. This is a good option for someone looking to get more regular monthly or quarterly updates on their credit situation.
One caveat to bear in mind is that some types of credit score inquiries can negatively impact your credit rating. In industry terms, there are two types of credit inquiries: "hard" and "soft."
A "hard" inquiry is an inquiry from a lender that pulls a report on you to make an assessment on whether they should lend to you or not. One or many inquiries by multiple lenders can impact your credit score, as it indicates you are looking for different sources of credit.
A "soft" inquiry, on the other hand – is where you yourself are looking to check your credit score, or where another lender or company might be doing a general background check on your credit history. This type of inquiry does not adversely impact your credit score.
Beyond finding out what your credit score is, it is important to ensure that your credit rating is as good as it can be – and that it stays that way. For this, it is critical to understand what to focus on and what to avoid. Some factors that can impact your score include:
- The total number of your accounts – A higher number of open accounts often results in a higher score as they have been approved by more lenders, provided all payments have been made on time to all lenders.
- Your payment history (typically, the higher percentage of payments you have made on time in the past the better).
- Your current credit card balance(s).
- The average age of any open credit lines or credit cards – if you have utilized several credit products over time and you have made the payments on time, your score will likely be higher than if you did not have this credit history.
- Any current or past unpaid loans or bills – this includes any accounts in collections.
- Any connection to a current or past business venture – includes any form of bankruptcy.
- Past or present connection to a spouse/partner with poor credit.
Below are some additional "dos" and "don'ts" that can help you keep your credit score in good standing, and improve it going forward.
What to focus on:
- Understand and know all your options and what you're dealing with – Take an inventory of your credit cards and other loan options to get a proper understanding of what you owe and what you have available to you. Speak to your bank: a personal line of credit, if you have one or are eligible for one, is a great option as it gives you access to the funds you need when you need them up to your available credit limit – usually at a lower rate of interest. Then decide what makes the most sense for you based on your circumstances: how much do you need to borrow? For how long? What other payments do you need to make? From there, you should choose the best and most flexible option for you – and how these options may or may not impact your credit score.
- Compare rates and plans before committing – and read the fine print – Before taking on more credit, find out what you're getting yourself into and what the details are – because applying for and using credit products can affect your credit score. Different financial products from different lenders have varying terms – be it a credit card, loan or line of credit, it's your responsibility to ask questions and understand what's available to you. Some credit cards apply additional charges and retroactive interest on purchases if you are even just one day late in making a payment. Others may charge a late fee, even if you pay the bill on the due date, because their terms require receipt of payment on the actual due date. Take additional time to research available options each time you're using a new financial tool.
- Check your credit score and your monthly statements – Just because you have checked your credit score in the past does not mean it's the same now. Make a point of using the resources available to you to check your credit score often and stay on top of your credit situation. It's also important to check your monthly or periodic bank and credit card statements. Whether you have paper statements or online statements, pick a day each month to go over all of them to ensure all charges and payments are accounted for. Staying organized and informed are key steps in managing your credit score.
- Set up a routine for yourself - Whether you use online tools, add your bills to your calendar or set up automatic payments, routines are a great way to stay on top of your finances. Just like anything else in life, having a proper routine will yield better results. Setting up a system where you pay a certain amount to each bill monthly is a great way to ensure all your bases are covered.
- Try to pay in full whenever possible, and always pay on time – If you spend a fair amount on your credit card, try to pay it off each month. The same goes for loans and/or lines of credits. Use financial products wisely to take advantage of the convenience of having the funds you need when you need them, but be sure to avoid getting behind on your required payments. Remember that different types of loans have different repayment terms: a payday loan is meant to be repaid in full when you receive your next paycheck, whereas an installment loan is meant to be repaid in installments.
What to avoid:
- Thinking of a credit card (or other forms of credit) as free money – It's a common mistake and it can sometimes be tempting to spend when you see that you still have a lot of available credit you can access. This is an extremely common mistake. We all have tons of things we want but do not need, and certainly wouldn't lay out physical cash for. However, when you have a credit card that almost 'magically' allows you to make purchases without having that cash in your wallet, some of those wants suddenly start to seem like needs. What many do not realize until it's too late is that not only are you paying for that item out of your pocket, you'll also be paying interest on it if you spend more than you can afford to repay by the due date.
- Paying your bills late – This is a huge mistake when it comes to your credit. Not making payments on time is likely to damage your credit score. Late payments often result in a direct hit to your score – meaning your credit score may go down and stay down if you do not pay your bills on time. It's very important to try to pay in full when it comes to credit card(s) and your credit line(s). Even if you can't afford to pay in full, you should still ensure you make at least your minimum payment(s). If you are in a situation where you can't pay in full right away, be sure to make a payment above the minimum to pay off the remaining balance as soon as possible. As much as carrying a balance can negatively affect your financial situation, not paying at all is the worst move you can make.
- Letting one bad month ruin your momentum – There may be times when you run into an emergency and are left with few options. Don't panic. Deal with the situation as an isolated incident and don't let it distract you from your long-term goals. If it's a one-time emergency where you need money immediately, consider taking out a payday loan so that you can pay it back with your next paycheck and move on.
- Sharing your credit information – Always make sure that any person, website and/or other entity that you share your credit information with is safe and secure. Fraud is very common and extremely hard to detect. Always read the fine print, ask questions and/or look up reviews and other resources on the party you are interacting with. It can take years to repair damaged credit, so be as vigilant as possible to avoid damage to yours through ID theft.
- Opening several credit card accounts at once – This may seem like a good idea at the time if you need some extra spending room or cash, but it really isn't. Opening several credit card accounts at once is an invitation for future financial trouble. Each financial product is bound to come with some combination of monthly or annual fees, interest rates and/or additional conditions. Having too many active accounts may cause confusion when trying to track your payment dates and may ultimately cost you extra money in interest or fees. If you need quick access to money, consider opting for a payday loan, an installment loan or a line of credit instead. In addition, having too many credit cards can adversely your credit score.
What impact may there be to your credit score if you don't pay on time or if you run into trouble?
If you pay only the minimum balance, pay late, use cash advances from credit cards or a line of credit to fund daily living expenses or often find yourself making balance transfers from one credit card to another, you may be in the credit "danger" zone. Talk to a financial counseling organization to regain control of your finances.
It is important to responsibly pay off all your debts. To do this, you will have to construct a plan. You can choose to consolidate your credit into one monthly payment by taking out a credit line to pay off all your debts and then paying that back monthly, or you can take out a separate installment loan to take care of certain emergency payments and then get that out of the way. Whatever approach you decide to take, be sure to do your research and manage your credit use wisely.
Managing your use of credit and understanding the factors that may impact your credit score are important to your financial health.
Treat management of your credit score as an investment in your future. By using credit wisely, you can increase the likelihood of the availability of financial products such as personal loans or personal lines of credit when you need them. Having more options for funding available to you in the event of an emergency can help reduce the stress of finding solutions to your financial shortfall.
MoneyKey Frequently Asked Questions: https://www.moneykey.com/wordpress/faq
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What is a credit score? https://www.consumerfinance.gov/askcfpb/315/what-is-a-credit-score.html
Credit Reports and Scores (USA.gov): https://www.usa.gov/credit-reports#item-35087
Coping with Debt (FTC): https://www.consumer.ftc.gov/articles/0150-coping-debt