Credit Scores and Personal Finance

With all the ink that has been spilled on the effect of investment fees and returns in the realm of personal finance and financial planning, it’s remarkable that financial planners don’t spend much, if any, time discussing a client’s credit score and how to improve it.

It’s common knowledge that better credit leads to lower rates and savings on loans, but the specifics of how to attain a strong score are relatively mysterious to many people. Common sense does indeed go a long way. “Pay on time” is the most important part of the credit score formula, as we’ll see below. With some of the other factors, however, common sense doesn’t work quite as well. Closing unused cards and other common practices can work against you, for example.

Before we learn about how to improve our score, let’s discuss why this is important, to begin with.

Interest Costs Add Up Quickly

Using, I’m looking up a mortgage quote for a person with a credit score of 740+, which is considered very good. Assuming they borrow $320,000 for a $400,000 house with a thirty-year mortgage, they might receive a rate of 3.99% at the time I’m writing this. The monthly payment would be $1,526. A person with a credit score from 720-739 might receive a rate of 4.25%. This would bring the payment to $1,574. This isn’t much of a difference from month to month, right?

The big difference comes in when you compare the interest paid over the life of the loan. The borrower with the 3.99% rate pays $229,613 in interest over thirty years, while the borrower with the slightly lower score will pay $246,791, an increase of $17,178 or 7.5%!

What’s worse is the person who falls just short of excellent credit might have been in the first person’s situation if they just knew a little bit more about managing credit scores. Let’s get into it.

The Recipe for Excellent Credit

A Strong Payment History – 35%

The most important factor is paying on time, just as common sense would suggest. Recent payment history is weighted more than the distant past. If you’re worried about late payments in your past and how they might cause lenders to look at you, the first step is to pull your own credit. Pay on time for several months and check your score again. If you have many late payments, be patient. You can make meaningful improvement over time.

A Low Utilization Ratio – 30%

If you have a credit card balance of $4,000 and your credit limit is $5,000, this isn’t going to be good for your score. However, if you have a balance of $4,000 and your limit is $20,000, you are a much healthier borrower as far as your credit score is concerned. Lenders want to see you aren’t overextending yourself with the credit you have. Keeping your credit use under 35% is recommended. The lower the percentage, the better. If you are in debt and trying to pay off an old credit card balance, do not do what I’m about to suggest, as you might get yourself into trouble.

However, if you pay off your bills each month and are on top of your spending, you might consider calling your bank to ask for a credit line increase. With an increase in your credit line and spending habits unchanged, your utilization ratio will improve along with your credit score.

Also, keep in mind how cancelling a card you no longer use will impact your utilization ratio. A card with a $10,000 credit limit with a balance of zero is helping you. If you are being charged an annual fee for this card, you should ask your bank to change the card to a no annual fee card to avoid unnecessary cost. Simply cancelling it could drop your score.

A Long Credit History – 15%

Lenders like to see you’ve managed credit for a long time. If you’re just getting started, don’t worry too much. Focus on the two factors above which carry more weight. However, this is another instance where it makes sense not to cancel an old card. If you have a no fee card you’ve had for ten years, hold onto it! Make sure you use it at least once and pay it off each year. Sometimes the bank will close inactive accounts.

A Good Mix of Credit – 10%

You are generally better off if you have a mix of installment (think auto, mortgage, or student loans), and revolving loans (credit cards). Don’t stress too much on this one, and don’t take a loan you don’t need just to boost your score in this area.

A Low Amount of New Credit – 10%

If you are about to make a large purchase and plan to borrow money, avoid applying for additional credit for a while. Borrowers want to see only a few pulls on your credit, and they don’t want them very close together in the recent past. If other parts of your credit profile are strong, this won’t affect you as much. Still, to help ensure the best rates, wait until after you get your mortgage before opening a new credit card. The long-term savings are too great to jeopardize.

An Important Part of Your Plan

It’s easy to overlook actively managing your credit score, but it’s also relatively easy to grasp once you know what makes up your score. The financial rewards of low rates on loans and some insurance are well worth the little bit of work it takes to stay on top of your credit.