Imagine a three-digit code that seemingly defines your financial stability, providing information to creditors about your ability to pay credit obligations as well as provide you financial confidence. This mysterious code, your credit score, seems to dictate your financial future. But should it?

• Is it a good representation of your financial stability? Yes and no. It reflects your payment history, but not your ability to pay in the future or your savings and investments.
• Provides information to creditors about your ability to pay? Maybe.
• Provide financial confidence? It shouldn’t. Your confidence should be in how you manage your money and looking at your net worth.

Yet, this enigmatic number dictates whether you can buy a home, secure a loan, or even land your dream job. But what exactly is a credit score?

 

Your credit score is a three-digit number that is based on your interaction with credit (or debt). Used by the three credit reporting agencies (TransUnion, Equifax and Experian), your credit score is determined by these factors:

1. Payment History (35%): Paying your bills on time is crucial. Late or missed payments can significantly lower your score.
2. Credit Utilization (30%): This is the ratio of your current debt to your credit limit which is based on your annual income. Keeping this low (preferably under 30%) can boost your score.
3. Length of Credit History (15%): The longer your credit history, the better. It shows lenders that you have experience managing credit.
4. Types of Credit (10%): A mix of different types of credit accounts (e.g., credit cards, mortgages, auto loans) can positively impact your score.
5. New Credit (10%): Opening multiple new accounts in a short period can be seen as risky behavior and may lower your score.

 

What it DOES NOT include is your financial habits such as saving for your short and long term future. IF you have no interaction with debt (credit), there is nothing to score you on outside of paying your regular bills on time – which if they are not a debt and paid on time, not reported.*  If you purchasing a home or a car and payments are made on time every single month, you will have a excellent rating for several years.

What happens when you pay off your car or your home? Your score slowly goes down. Why? Because there is no payment evidence to ‘score’ you on.

This is certainly a dilemma. We need a good score for renting and/or purchasing a home, sometimes for the best insurance premiums or sometimes your cell phone costs.

What can you do to improve your credit score?

• Keep your number of debts and amounts in check.  Don’t take out credit cards, personal loans, or car loans unless necessary. I always recommend saving and paying cash. Yet, if not possible don’t take on more than you can afford. If you over your head, pay down your debt – your credit score is increased as your income to debt ratio is decreased.
• Pay on time, every time.

Keep your credit safe.

• Check your credit report (not just the score) a minimum of one time/year to assure all information is correct.  By US law you can receive a free report every year. Make it part of your yearly routine (1st of the year, on your birthday, etc.)
• Freeze your credit. Freezing your credit protects your reports from being accessed by scammers. You can unfreeze your report if needed. Read more here from Nerd Wallet.

Bottom Line. 

• Benefits of a credit score:
  • Maybe lower insurance premiums.
  • Ability to reduce paperwork when applying for a home loan (no credit score requires manual underwriting).
• Cautions:
  • It is not a full representation of your financial health.
  • Credit scores (nor your net worth) are not indicative of your worth.

When/if you choose to live a debt-free life, you will not have a credit score. And that is okay – if you don’t want/need to borrow cash, you don’t need a credit score. If you are concerned about insurance rates or cell phone services, you can use credit to pay your regular bills. IF you make this choice, pay the balance off every month.

The credit score mystery is not a mystery; it is simply a tool that creditors use to determine whether they want to lend you money. There are other indicators of your financial health, credit score is only one indicator. Financial health should be scored on your ability to manage your money, save, and feeling secure in your decisions.

*There is one exception to this. Some states have a separate rent credit score where rental companies may report rental payment history.

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