Most of our lives we have heard our parents, relatives, and friends talk about the perils of debt, the issues with credit and the disasters financially it creates. But, credit is an important part of our lives. We are judged by our credit score quite often. Not only for car loans and home mortgages, but increasingly for employment and renting applications. Luckily, there is also easier and easier ways to stay on top of your credit score and ensure that those who look at you, see your good side.
Since credit can matter so much in our lives, it is important that we always keep it in mind and start early building a good credit history. The difference that a hundred points on your credit score can make on the total amount of interest you pay over your lifetime could determine whether you are able to retire on time or not. On a $100,000 30 year fixed rate loan, one percentage point of difference could save you roughly $21,000 of interest over the life of the loan! For many people, that’s equal to close to half their yearly salary saved just by being smart about credit!
Luckily, it can be pretty easy to build a good credit score (granted the more secure your financial situation, the easier it becomes). According to MyFICO, your credit score is derived from the following categories:
Payment History- 35%
Amounts owed- 30%
Length of credit history- 15%
New credit- 10%
Types of credit- 10%
First off, always pay your bills on time! Your payment history is a big part of who you are as a borrower and consumer, as it accounts for 35% of your score! For some bills, such as your phone or other utilities, try to automate your payments so that every month they are automatically withdrawn from your checking account. Just make sure to keep your checkbook balanced and that there is enough money to cover the bills, otherwise you will get hit by your bank with overdraft fees! As for other monthly obligations, such as your credit card, mortgage or auto loan, make sure to keep track of when each bill is due and be prepared to at least pay the minimum every month by the due date.
Secondly, the amount of debt that you have is important to monitor. Carrying more than 30% of your credit limit is often seen as a liability. As for a home loan, a good rule of thumb is to not exceed purchasing a home valued at over 2.5 times your annual salary.
When it comes to length of credit history, this is normally a category that many young adults will struggle in. No matter what this deck will be stacked against you. While you might have a perfect payment history and keep a low balance, your credit score will still suffer since your credit and payment histories are short and thus you are seen as risky. While I have perfect scores in all other categories, my length of credit history drags me down. However, a good way to get going on this is to get a credit card at a young age and be smart with its use. If you use a credit card to your advantage, you can not only reap rewards but also bolster your financial future. By using your credit card ritually each month for only one small purchase and then immediately paying it off in full, you are avoiding interest, perhaps getting credit card rewards, starting your credit history and maintaining a responsible credit account. As you age and begin getting other cards and credit accounts, make sure not to close that first account, even if it has the worst interest rate. This is because as your longest running account, it has the most history in it and by keeping it open you are able to show how long you have been a loyal and responsible client.
Ten percent of your FICO score is derived from how often new credit lines are sought out. If you have applied for many credit cards, auto loans or mortgages in a short period of time, this will pop up as a red flag showing that you may be desperate or underwater on your expenses and bills. By spreading out your requests for new credit lines, you will appear as being more stable and responsible, then if you tried to open up many lines at once.
Last but not least is the different types of credit that have open. This mainly pertains to open and closed accounts. Open accounts involve the ability to continually borrow more up to your credit limit. This types of accounts are mainly credit cards, which can be paid off and then borrowed against again. Closed accounts are things such as auto loans or mortgages, that have a specific start and end of the payment schedule, with a set monetary amount, and a fairly standard monthly payment. These can also be referred to as installment loans. By having different types of credit open, it shows the ability to responsibly manage all major types of credit.
All in all, it is important to just remember to be responsible. Pay off your credit cards each month in full, always pay on time, don’t seek out too many credit lines at once, and keep your oldest credit cards open. I will talk more about credit in other posts, but since it is my birthday and I just got a bunch more personal finance books to read, so I am going to retire to my studies!