In the banking world, "credit" refers to an arrangement that defers payment for borrowed money or a purchased item until later. Basically, you get money or stuff now, and you agree to pay it back over time. Something many people don't fully consider is the interest that gets added to borrowed money. If we don’t take care of our credit, the interest we pay will most likely be higher and can really add up over time.
Your credit score is like a report card
As I deliver countless education classes on this topic alone, many people say they know that they need to take care of their credit. They just aren’t exactly sure of the proper steps to do so. So, in classes, I break down this topic in a way that most people can relate to, by comparing it to the time we spent in high school.
In school, most of us had both small and large goals. These could have ranged from getting a certain grade on a test, to graduating on time or getting into a desired college. To make any of these things happen, a certain amount of work needed to be done.
Your credit standing is much like a school report card. We get graded on certain things we do in life (paying back money we borrow), and we can check our report card (credit report) to see how we are measuring up for lenders (people we borrow $ from).
In school, our main objective in any class is to get an A. In the world of credit, it’s no different. Credit (FICO) scores are broken down just like our school report card, from A to F. In school, we pretty much know what percentage we need to earn to achieve a desired grade. In the credit world, there is a certain breakdown of what makes up our A through F scale as well. Credit scores range from 300-850. According to Experian (one of the largest credit bureaus), here is a breakdown of the various scores with a corresponding grade:
Factors that go into improving your score
Let’s go back to our school example. If my daughter Ashlyn comes home from her 2nd grade class, very upset because she failed her math test, do I tell her, “Well Ashlyn, life is over, you are never going to make it?” Absolutely NOT! We sit down and have a conversation. I ask her, “What area did you struggle on?” She may say, “Multiplication, Dad. I just don’t get it.” So, we work hard on multiplication to help improve for the next test. The more we practice, the better she should do.
Now let’s fast forward to life as an adult. If someone comes to me and shows me their 579 credit score. Do I say, “Life is over. You are never going to make it.” Absolutely NOT! The big difference is, many people know what changes a school grade, but they don’t know what goes into making a credit score rise. As in school, there are certain factors that weigh more heavily than others. In school, what are some things we need to do in order to hopefully get that desired A score?
- Attendance – Show up each day for class
- Turning in homework on time – Many teachers will lower your grade if you turn in an assignment late (paying credit back works much the same way)
- Exams (weighted heavier)
- Midterms (weighted the most)
Let’s say you are my math teacher (one of my favorite classes growing up by the way). To get a good grade in your class, I need to do those things mentioned above (show up each day, turn in homework, study for tests, etc.), in order to have a better chance of getting an A in your class. I'm going to focus on the areas with the greatest impact (tests and midterms), since they will help raise my grade the quickest, but I still need to do well in those other areas as they impact my overall grade.
In the credit world, earning an A takes a variety of steps, with some items weighing more heavily than others. Here is the breakdown:
- Payment history (35%) - Paying bills on time helps your credit score. That's the single biggest factor! If you have struggled in this area, it needs to be a major focus.
- Credit usage rate (30%) - Experts recommend using no more than 30% of your total credit card borrowing limit to avoid lowering credit scores.
- Length of credit history (15%) - FICO® Scores tend to increase over time. New credit users can't speed that up, but establishing a record of timely payments will help increase your score as you build a credit history. Also, closing out credit cards does not always help the score. Keeping an open card with a zero balance can help you build credit, as long as you have the self control not to use it.
- Total debt and credit (10%) - Credit scores reflect your total outstanding debt and the types of credit you use. The FICO® Score tends to favor a variety of loan types, including both installment credit (loans with fixed monthly payments) and revolving credit (like credit cards, with variable payments and the ability to carry a balance).
- Recent applications (10%) - When you apply for a loan or credit card, it triggers a process known as a hard inquiry, in which the lender requests your credit score for use in their lending decision. Hard inquiries typically lower your credit score by a few points, but as long as you continue to pay your bills on time, scores typically rebound within a few months. (Checking your own credit is a soft inquiry and does not impact your credit score.)
Now, let’s relate the two. Instead of my math teacher, you are my mortgage lender. My goal is to get an A score on how I manage my loan with you. In order to do that, I need to pay you every month, on time. I will do the same with my car lender, credit cards, student loans and other lenders I have financing with. Every time I pay each financed bill on time (every month), they report my individual grade to the principal (Credit Bureau). When the credit bureau receives all my “grades”, they put together an overall GPA (credit score).
Why is a credit score so important?
In school, the higher my GPA, more doors open (scholarships, grants, school of choice, playing athletics, etc.) In the credit world, the higher my GPA (credit score), more doors open in various aspects of life. More places pull credit than ever before, so it’s very important in today’s world that we take great care of our credit. Here are a few places that may pull your credit:
- Employers – To get that dream job, be aware that some employers can choose not to hire based on credit score.
- Renting – Many landlords pull credit. With a higher credit score, you have a greater chance of getting into the apartment you desire.
- Insurance – Who doesn’t want cheaper insurance? The higher the score, the lower your premiums can become.
- Cell phones – Service plans can be less expensive with a high credit score, and you most likely won’t need money down
- Access to capital (money) – When the time comes where you need to borrow money (house, car, etc.), having a great credit score will give you a better chance at being approved, and you will be borrowing that money a lot cheaper than others (lower interest rate).
What it comes down to, is that taking care of our credit means we can get the same services that everyone else gets, at a lower cost. Taking care of your credit is taking care of you. Who doesn’t want to save more money!?
Ten to fifteen years ago, we may not have needed a great credit score to get all these items cheaper, but more and more places are using a credit score to determine your pricing. Credit scores are deemed as a nondiscriminatory way to evaluate risk for the lender or company providing a service to you, because everyone’s credit score is made up the same.
It’s more important than ever to understand what goes into our credit score and to take care of our credit in today’s world.
I hope this school analogy helps you in knowing how to start working towards that desired credit score today!
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