It’s relatively straightforward to maintain a checking account balance: you never spend more than what you have. Spend too much and you have a deficit; spend less than you thought, and you have a surplus. From a budgeting point of view this is easy to maintain. It gets more complicated with larger budgets and investments, of course, but at its course the idea is maintainable and widely understood.
So what’s the deal with credit?
We’ve all seen countless ads for credit report websites or heard talk about credit scores and the like. Many of us know that if you want a loan or to buy a house, or if you want to rent an apartment or take out certain accounts, then you need an acceptable credit score. Lower scores are closer to 400, higher are closer to 800, which high degrees of variance between those numbers for most people.
Here’s a breakdown of some important benefits of good credit:
- Easier buying or renting a house or apartment
- Better auto loan rates
- Credit checks for employment (many employers check reports rather than scores)
- Better business loan terms
- Better terms anytime you want to borrow money
For the record, you probably have dozens of credit scores. That's because a credit score is calculated using a mathematical algorithm of the information in one of your three credit reports. There isn’t a single unified algorithm used by all lenders or other financial companies to compute the scores. The FICO Score is one of the most common.
The best way to maintain good credit is to pay off your bills on time. And not just your credit card bills—utilities, phone bills, and the like are also important considerations. A credit score tends to reflect credit payments over time, on time. Whether it’s student loans or home loans, loans for cars or simply a small credit card used for groceries or gas, paying on time and paying consistently can boost your score and keep you from being frozen out of important life events. Credit utilization ratios are also hugely important for figuring a critical credit score model. A credit utilization ratio is calculated by adding all your credit card balances at any given time and dividing that amount by your total credit limit.
A huge boost to your credit score comes from paying off debt. The less debt you have compared to how much you have available, the better your score will be for the credit utilization ratio. Keeping debts low after paying off cards is also important. And whatever you do, don’t apply for frivolous or random cards. Many people make the mistake of thinking multiple cards is helpful or balanced. It can be tricky and detrimental to try this.
Last but not least, if you have any inaccuracies in your credit reports, then you should dispute them. Incorrect information can drag your score down. When you receive your report, verify that all the information in it is accurate and pertains to you. Make sure the agencies know if anything isn’t right. If there are things you can work on, make sure and do them as soon as possible to boost your score. It may take time, but it’ll help you considerably in the long run.
Some other things you can do to improve your score:
- Don’t apply for too much credit at once
- Don’t close unused cards (unless there are annual fees)
- Only use credit and cards as needed
So with that in mind, let’s dive into some ways in which we hurt our credit.
A huge issue many people run into is only making the minimum payments on their credit cards. It increases your debt for one, and slowly creeps up your tab with the card. If you end up carrying a high balance on your credit card, this can hurt your aforementioned credit utilization ratio. Especially if you owe lots of money for many accounts, paying just the minimum each month and slowly increasing debt is a good way to lower your credit score.
Applying for multiple credit cards at once can hurt your credit score. Every lender runs what is called a hard inquiry when you apply for a loan, which helps them determine if they want to approve you for a loan. Applying for a credit card is different than applying for, say, a mortgage or auto loan. When you apply for one of those, it only counts as one inquiry, so multiple requests for reports going to multiple places won’t hurt your credit score much and likely won’t put off lenders. Credit cards are a different story. Checking on your credit score may drop you a few points if anything at all—but multiple compounded checks add up and seem riskier. With credit cards, multiple inquiries in a short period of time makes you seem like a riskier borrower.
Taking on unnecessary debt or debt too large for you to handle is also a credit score damager. We’ve all seen the news reports about student loans, and the various political issues associated with them (such as student loan and debt forgiveness, predatory loans, etc.). Those issues are too broad to get into here, but the fact remains taking out student loans and being unable to pay them in a timely manner is detrimental to your credit. If you have other loans at the same time, such as mortgages or auto loans, non-timely payment can result in compounded hits to your score that can potentially decrease it many points.
Not paying your bills on time, as mentioned, is a recipe for a hurt credit score. Being unemployed won’t hurt your credit score, but being unemployed and unable to pay your bills on time will. Missing payments, being late, not knowing or checking on your credit score, and unpaid loans are common credit score injurers.
But they aren’t the biggest.
The very worst things you can do for your credit score are:
- Repossessions
- Bankruptcies
- Foreclosure
- Debt collections
- Charge-offs
You’re likely already aware of many of these, but they bear repeating for a simple reason: they still happen all too often. They are often avoidable with a good financial advisor and some long-term planning, but still they happen. And it’s important to realize just how harmful these things can be to a credit score.
Repossessions are when you can’t pay on an auto loan and your vehicle is taken. A report of a repossessed vehicle will stay on your credit score as a negative strike for seven years. That’s a long time for a few missed payments for that car.
Filing bankruptcy lets you to legally remove liability for some or all of your debts, depending on which type of bankruptcy you file (Chapter 7, Chapter 11, etc.) They’re most famous for businesses. Your credit report will reflect each account you included in your bankruptcy. Bankruptcy information will remain on your credit report for seven to 10 years, but you can sometimes begin rebuilding your credit score after your debts have been rectified. A bankruptcy is also the only public record information that appears on credit reports.
foreclosure is when you cannot pay your mortgage loans and the lender repossesses the house. A foreclosure will stay on your report for seven years. When your home is foreclosed, it severely damages your credit score. Some home lenders don’t offer home loans to borrowers with foreclosures on their report, so the potential for negative future life impacts from this are substantial. Subprime mortgage lending and predatory loans also made the news in 2008 during the global economic downturn, and for good reason: this sort of strike on a credit report is catastrophic.
Debt collection is when a lender hires a third-party to collect payment on delinquent loans or bills. Debt collectors report the collection action on your credit report, which stays there for seven years after the repayment has been completed. The only silver lining here is that when you pay off a collection it is reflected on your score as being paid in full, which can slightly help you with your score.
A charge-off is when you’ve missed a consistent amount of payments, usually over a period of months, and the credit card issuer writes off your debt as uncollectible and closes the card and the account. You still owe the debt even if it’s charged-off, and the issuer can still pursue you for the delinquent payments. Many people make the mistake of thinking it’s a get-out-of-jail-free card, when in fact it’s anything but. These also last seven years on a credit report after being paid in full. It may, however, have less of an impact on your score if it’s paid off in full.
A number of factors used to influence credit scores but no longer do. Tax liens, lawsuits against you, and judgments are no longer factored against you on credit scores. A tax lien is when you owe back taxes to the IRS. Judgments are what creditors and debt collectors are awarded after filing a lawsuit to collect a delinquent debt. Of course, these things are all bad and should be avoided, but we’re talking about credit scores specifically here rather than overall financial decisions.
Many of these things, especially bankruptcies and foreclosures, can be staved off with a good financial advisor who helps you with your planning. An advisor worth his fee will help you determine if that business loan is worth taking out, and if your portfolio is diversified and solid enough to withstand the shocks and shakes of the market that could affect the financial standing of the company or your home. A financial advisor can also help you with matters related to repossession (way too many sports cars that started as impulse purchases turn into credit report nightmares for the better part of a decade).
While there are many things to do to boost your credit score, there are also clear things to avoid. Where the financial advisor comes in is helping you balance your risk tolerance and your financial standing to a place where you’re both comfortable and thriving. Nothing is more essential than a clear picture for your credit. A little bit of financial planning goes a long way in all aspects of your life.
