WHAT IS A CREDIT SCORE – AND WHY SHOULD I CARE?

If you are an adult, I am sure you have heard about credit scores. You know you need a “good” one to get a home, a car, a loan. If you are a young person or an adult still at home, you may not have thought much about your credit score, and if you are out on your own, chances are, unless you have been taught about finances, you may have a pretty weak credit score.

What is a credit score? It is a number based on several financial factors assigned to you that represents your ability to pay debts. Companies use this score to decide if you are someone who will use their credit cards or loans responsibly. This helps companies, in that they won’t have to use their resources to go after you for the money you owe them, which can be a lengthy and expensive process. High credit scores help you, too, by offering you lower interest rates, longer repayment lengths, and better offers.

Here are the things you need to know about credit scores and how they work. Most credit scores are based on the FICO score (Fair Isaac Corporation…not important, but I never knew that is what it stood for!) which is scaled between 300 and 850. If you have no credit, your history is listed as none. The scale is:

Excellent: 800-850

Very Good: 740-799

Good: 670-739

Fair: 580-669

Poor: 300-579

Anything below 640 is usually considered subprime, which will mean higher interest rates, shorter repayment times, and you may possibly need a cosigner. Above 700 is a good place to be for lower interest rates.

You might be surprised to learn that your credit history is also an important factor used by landlords, employers, and utility companies. Landlords and utility companies want to make sure you have a history of paying your bills on time and employers might be checking that your credit score isn’t so low that you might be a poor employee.

FACTORS THAT IMPACT CREDIT SCORES

Okay, so now you know what a credit score is, let’s dig into what creates your credit score. There are 5 factors that are reported to the 3 major credit reporting agencies (Transunion, Experian, Equifax):

  1. Payment history. This is worth 35% of your credit score. Payment history includes if you are paying the minimum amount and on time.
  2. Total amount owed. Worth 30% of your score, this is the percentage of debt that you have used compared to how much you have available to you.
  3. Length of credit history. At 15% of your score, this is the part that takes the longest to help create a good credit score. The longer you have a credit history, the better your score.
  4. Type of credit. This is worth 10% of your score. It is good to have a mix of credit cards, personal loans, auto loans, etc. If you have too many of one type, it could be a red flag to companies.
  5. New credit inquiries. Did you know that every time you apply for credit, even when a car dealership runs your credit at several banks, it negatively affects your credit score. This doesn’t last on your credit score for a long time and is only worth 10% of the total score.

HOW TO BUILD A CREDIT SCORE

“I never had a credit card or a loan, so how do I build my credit score, when I can’t get credit?” There is no easy way to get a good credit score, it takes a lot of time and persistence. However, you can start on the right path with a few simple options.

The number one step is making sure you can afford credit. One of the biggest mistakes is not figuring out your budget and making sure you can commit to whatever the minimum payment is going to be. Whether it is a car payment or a credit card payment, money isn’t going to magically appear for you, so write down what you earn and what you owe. You MUST have a steady income to make sure you can pay your bills. You can check out my basic budgeting skills here.

Okay, so you know you have money left over at the end of each month and are ready for a credit card. One option you have is to ask a family member to become a cardholder on an existing account. If you have built a relationship of trust with your parents, this might be an easy thing to do. You can have your name on your own card and not even use it. Or just use it for gas and promise to pay them the amount every month. The big thing with this is trust and maturity. Your parents may not want to do this in fear of tarnishing their own credit score, so don’t be surprised and don’t take it as an insult. You probably do not know what their score is like.

Another option is to get a secured credit card. Most of the major credit cards offer secured credit cards for first time credit card holders, or those with bad credit. This is a very good way to increase credit score in a way that guarantees the companies won’t lose money. After you choose a card, you have to pay a security deposit on the card. Let’s say I give them $100, I then have a $100 credit limit. You can use this money and make your payments as you would a normal credit card. If you can’t make your payments, you lose your deposit. If you make timely payments, your credit score will start to rise and you will eventually qualify for a non-secured credit card. This is like a trial run for you, to make sure you can make payments, and for the credit card company, to create an ideal customer from the beginning.

For larger purchases such as a car, or personal loan, you may be asked to use a cosigner. A cosigner is someone with a better credit history than you putting their name on the loan and risking their credit score on you. If you don’t make your payments, it negatively affects the cosigner’s, as well as your, credit score. Just like with the above option, you need to have a history of trust with someone if you want to ask them to cosign for you. Many people will not do it, because it is very risky for their own financial health. As a matter of fact, if a friend asks you to cosign something for them, I would discourage that because they are probably in a place where they won’t be able to make their payments, and you will be stuck with ruining the credit score you are trying to build up. I would only encourage you to ever cosign once you have a solid credit history and for someone, like your child, who you can trust or at least have a little more control over the outcome. Don’t be surprised if someone won’t cosign, again it isn’t always personal. However, if someone does, please remember that this should become your most important expense and first on your budget.

Stores often offer credit cards to anyone, whether they have a good credit score or not, but I would be careful with these until you know what kind of a shopper and spender you are. Stores will lure you in with 15% off your entire purchase if you sign up for their card, but then it can take you years to finally pay off the balance. Trust me, this happened to me when I was younger. So, unless you plan on paying off your balances quickly or getting the discount and then never using the card again, the company is actually making a lot more money on you than you ever save from them. There is nothing wrong with having store credit cards, but they are limited to those stores, and for a first credit card, you may want something more universal.

IMPROVING AN ALREADY LOW CREDIT SCORE

Great information, that I could have used YESTERDAY!

Maybe you are thinking this to yourself as you realize that you didn’t know any of this information before you already made several mistakes to your credit score. You might even think it doesn’t matter anymore, you have bad credit and you will have bad credit forever. Well, this isn’t true, but it does take hard work and determination. Just like everything else in your financial life, you have to take action to get to where you want to be. Maybe you had a job when you first started applying for credit cards and loan, but then you weren’t working anymore and had to miss payments or make late payments. Maybe you had to have your car repossessed because you didn’t make your payments and now you can’t get another car, even though you have a job now. Maybe every penny that you DO earn is going to paying off all the debt you have, making minimum payments with your balances never going down. This is all disheartening, and I have been through many of these things, myself. So, how can you improve your credit score?

The biggest step is to make sure you can pay the minimum payment on time every month. Did you know a late or missed payment can stay on your credit score for 7 years?? A lot can happen in 7 years, and yet you will still have that mistake haunting your ability to get better credit. What if you can no longer afford your monthly payment. Call your credit card company. It’s hard, yes, but you have to be proactive here. Make a call and explain your situation and ask them if there is anything they can do to help lower your payment. If you are temporarily laid off or have a medical emergency, some companies may even allow you time to catch up. Whatever changes you make with your lender is contractual and you are obligated to hold up your end of the deal you come up with. Maybe your lender will not budge, and that is their right. There are other options.

A consolidation loan might sound counterintuitive. Why get another loan when you cannot pay the ones you have? If the majority of your expenses are credit cards, for example, you can try to get a consolidation loan to pay them all off. Add up the amount you need to pay them all off for good (sometimes you need to call to get a payoff amount that is accurate) and then get a loan with a lower interest rate. This way you will only have one payment to make a month, which should be lower than the total of all the expenses combined, and it won’t take you as long to pay it off.

If your credit score isn’t terrible, but you want to improve it anyway, ask for a higher limit. If you have been a good customer, companies are often excited to raise your limit in the hopes you continue business with them. The trick is, however, to NOT spend the amount you were raised. This will lower your debt to income ratio, or the total amount owed, which, remember, is 30% of your credit score.

However, if your credit score is so bad that none of these tips will apply, you might have to look for a credit repair agency to help you. There are many free companies out there who will help you lower your payments or make deals with the lenders for you. You may be eating ramen noodles the next 6 months to make ends meet, but fixing your credit score will be worth it later when you need to make larger purchases.

I hope you learned how important a credit score is and how to build and improve what you already have. These financial decisions can impact so many things down the road, including your ability to get the job you want, your credibility as a renter, and if you will ever own your own home. Negative effects on your credit score can last 7-10 years, in which time you could just keep sinking under if you don’t take control and take action. Please don’t let this happen to you.

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