Being vague is my favorite pastime. You don’t want to go to an event? Be vague. Let them know you have to work late on some things that you’ve been planning on. You don’t know what someone is talking about? Be vague. Give a non-committal, roundabout answer that never really arrives at any conclusion or purpose other than to extend the perception that the more you aimlessly ramble the more you know on a subject. Someone asks about how a credit score works? Be vague…or at least that’s how credit agencies designed this seemingly all-powerful rating that impacts some of the most significant decisions of your life. The mission of Adulting in this article is to provide you the background, variables, and small tips/tricks that impact your credit score.
For a Few Dollars More
As a young adult, a credit score is not something you consider all that often. It’s more of a term shouted at you during ads or in discussions between the comic relief who never matured and the narcissistic trust-fund baby. So a credit score, what is it?
A credit score is a lender-utilized rating of an individual’s financial responsibility and likelihood to pay off future debts. This rating impacts that individual’s future interest rates and ability to receive loans. Generally, a high credit score is good and allows for lower interest rates, while a low credit score is bad and forces someone to pay more in interest on a loan. The below terminology should be helpful to decipher what is being said:
Debt – money that is owed to another party
Loan – a borrowed amount of money that is made up of the principal and interest
Principal – the base amount of a loan – i.e. if you take out a $25,000 loan for a car, the principal would be $25,000
Interest – a recurring charge as a percentage of the principal that if not paid will build (aka compound) over time. Say the interest of your $25,000 loan is 3% annually. In the first year you would only owe $750 in interest if you did not pay off any of the loan. Second year would be (3% x $25,750 = $26,522) or a $772 increase. If you did not pay any of the loan for 10 years, that interest amount would increase to ~$8,600 total on top of the original $25,000.
Lender – the party that is ‘lending’ you money which is typically a bank or credit union. Banks: Chase, US Bank, or Wells Fargo. Credit unions: SchoolsFirst or Navy Federal.
Installment Credit: A loan for a car, home, college, jet-ski, or car-lot waving tube
Revolving Credit: A recurring line of credit or credit card
Credit Inquiry: Someone looking up your credit score. A hard inquiry is made by an institution trying to determine your credit worthiness. A soft inquiry is an agent or yourself looking up your credit score.
The Imitation Game
You read the above paragraph and didn’t skim through, so you know that a credit score is a rating of your ability to pay off future loans. Like snowflakes, there are many different credit scores and ratings agencies. Most commonly, the FICO credit score created by the Fair Isaac Corporation in the 1950s is used as a benchmark. This score considers five different attributes of one’s credit worthiness: Payment History, Current Debt, Length of Credit History, Types of Credit, and New Credit. This information is pulled from your Social Security Number by one of three main credit bureaus: Experian, Equifax, or TransUnion. The formula as to how these factors directly impact your credit score is not disclosed by Fair Isaac or any other institution. “But…Adulting. You’re a smart anonymous clique of individuals. Can’t you figure it out for us?” The answer is maybe, if someone can crack the Enigma code then I am sure this could be deciphered. Wildly altering a singular credit factor at a time and documenting the incremental change at the risk of irreversibly damaging our credit score is possible…but at what cost…at what cost. Regardless, the mystery behind the credit score is one of the core factors that cause younger people to ignore building their credit until they realize they need it to buy a car, house, or insurance.
The Usual Suspects
One input that is released by Fair Issac is the weighting of each factor towards determining your final score.
Payment History (35%): Record of delinquent or on-time payments you have made using your credit card or other forms of debt over the course of your credit history. Ore on time payments equates a higher score.
Current Debt (30%): Measures the amount of credit utilization – the proportion of credit limit to credit usage. If you max out your credit card consistently like Katy Perry does every Friday night, that is a high utilization rate which lowers your credit score. You want to stick around 10-30% of your credit limit at a given time.
Length of Credit History (15%): The length of time after opening a credit card or taking on a loan, not after opening a bank account.
Types of Credit (10%): Mix between installment and revolving credit. Higher amounts of installment credit mixed with high amounts of current debt can drive your credit score to the ground.
New Credit (10%): Amount of new accounts, new cards, new loans, and hard credit inquiries over a period of time. Hard credit inquires CAN lower your credit score, but only by a few points.
The Good, the Bad, and the Ugly
Credit scores can range from impressive to downright concerning. Here is the rough breakout of what your credit score says about you:
Excellent: 800 to 850 – You are god-like; mortals cower before you.
Very Good: 740 to 799 – Someone taught you about credit early on you sly dawg.
Good: 670 to 739 – You are a normal young adult trying to make it in this world. You can get approved for loans at standard rates.
Fair: 580 to 669 – You have had issues with your credit or are trying to build credit. You are entering the Danger Zone. You may still be approved for loans but with higher interest rates which ironically make it more difficult to pay off.
Poor: 300 to 579 – You are probably the type of person that roundhouses Everclear on a Wednesday. People are scared of you, but you kind of like that. You live life on the edge and try not to fall off. You will not be approved for a loan.
A lower credit score results in higher interest rates on loans, lower credit limits, and lower likelihood to be approved for that dog washing truck you needed to start your business. If you do not have a credit score, odds are you have not had sufficient credit history – you typically need 3-6 months with an active credit card or other credit allowance. Your score won’t start at 850, but more so around the 500-700 range depending on the amount of credit allowed by your bank.
Shawshank Redemption
Now for the reason why you clicked on this article – tips to boost your credit score and common misconceptions.
Start early: Seeing as Length of Credit History is a factor, it is important to open a credit card account as soon as possible. You don’t need to blow through $1000’s but having the account open when you turn 16-18 is helpful in the long term.
Grab the Bill: A small way to build your credit score is to cover charges that you will be compensated for in-part at a later date, such as going out to lunch with friends. Your credit score will benefit by recording a transaction larger than what you would have paid individually, followed by you paying off a majority of the credit charge on time. Venmo was a fantastic creation by Andrew Kortina and Iqram Magdon-Ismail. Use it to your advantage.
Be on Time: Being delinquent on payments is the fastest way to lower your score. To be on time, try to budget out your monthly expenses and do not take on debts you can’t pay back.
Student Loans: Pay off your student loans. These loans often have specific stipulations built in to make sure you pay them when you start your career and can make a decent income. The most common mistake of our generation is to take on student loans with the idea that you will pay them off when you become a rich [insert exciting life goal here]. When it comes time to pay off your debts you are 25-27 and looking at buying a car, so you take out an auto loan. Then you want to impress the significant other and pitch in for a house. The car and home loans are deemed more essential as they are material items being actively used, so you pay those off first. In the background, your student loans accrue interest and are now tens to hundreds of thousands of dollars. Don’t get caught in this trap. Live simply if you need to, but manage your debt to income ratio like a hawk.
Ask for a Credit Limit Increase: Credit utilization, as you learned, is the percentage of credit allowed and used. A good percentage would be 10-30% according to FICO. If you buy $200 of groceries and other recurring expenses each week, but only have a $500 limit, that is a high credit utilization (40%). If your credit limit increase to $5000, that charge only becomes 4% of your overall usage.
Don’t Cancel Credit Cards You Don’t Use: Credit history is based off of the date you open a credit account or credit card. If you were to close this card, the credit history tied to the card would be removed as well. Keep cards as long as there are no excessive recurring payments tied to their activation.
Check Your Credit Score to Report Incorrect Information: Credit agencies do not monitor the accuracy of credit reports. If someone entered in incorrect information, that will be pulled in your credit report unless actively monitored. Check for loans not in your name or an incorrect # of credit cards.
Experian Boost and Other Credit Boosts: These boosters do work. They operate by reviewing your credit report and adding any on-time bill payments that are not typically recorded – utility or cell. Listen to Destiny’s Child and you’ll understand.
Income Is Irrelevant: Okay, it’s not irrelevant, but income is not a direct factor in your credit score. If your income is being saved or used in areas other than paying off debt, that is fine and appropriate, but will not have an impact. Along that line of thinking, someone making $45k per year could have a better credit score than someone making $1M per year, if they are managing their credit correctly.
Catch Me If You Can
None of the information on this website should be viewed as financial advice or recommendations. If you are lacking confidence in your ability to build your credit, I suggest you speak with a credit advisor to help you determine what your investment goals may be and how to reach them.
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