How much do you know about your credit score?
What accounts should you keep open? Which should you close? What is actually hurting your credit score? More importantly, what’s the difference between “Good Financing” and “Good Credit”?
There are a million websites out there with great information about credit scores (MyFico.com, CreditKarma.com). But, I'm here to give you more practical advice.
Let’s start with something simple: What is good credit?
In the simplest of terms, good credit is having someone vouch for you in a positive light. It’s a referral TO new creditors FROM old creditors saying you pay your bills on time. “We billed this guy, and he paid us back, so he will probably pay you back.”
The concept of “Credit” makes even more sense if we peek behind the curtain into the Lending World:
Why would someone lend us money? Out of the goodness of their own hearts? No, they are in this business to make money. Let’s say we apply for a credit card and never use it; the bank never makes any money. But if we borrow money, and pay interest on the loan over the next few years, the bank makes a profit. As long as we keep making payments, the bank could care less if you ever pay them back. This is why “Interest Only” loans are so popular.
Fun Fact about Interest: When a bank lends money and charges interest; they are essentially “creating” money out of thin air. For instance, if you borrow all the money in the world, you would need to create even more money to pay the loan back plus interest... Does your head hurt yet?
So in theory, as long as you’re an obedient customer who pays his bills on time, even if it’s only the minimum monthly amount, you will get good marks on your credit report.
This is called “Revolving Credit”. You rack it up, pay it down, and rack it back up again. Unlike a car or a house, there’s no collateral, so the interest rates are higher. However, this is an excellent way to improve your credit score.
But, beware of a few pitfalls:
High balances on credit cards. Just because the bank gave you a $10,000 limit, it doesn’t mean you should put that much on there. Just to be clear, you totally can, but it’s probably not the best idea. Your best bet is to stay under 30% - 40% of your limit. Have a balance? See if the bank will raise your limit so your ratio looks better.
This can backfire. If there is too much potential debt, this can be just as bad as having maxed out credit cards because it terrifies the banks.
Opening up too much too fast. If you start opening up a bunch of credit cards, it looks like you’re about to go on a shopping spree.
Every time we talk about opening up new lines of credit, people will freak out about pulling your credit, and why that is a bad thing for your credit score. First off, it’s not. Whenever you hear someone say that, they're speaking from ignorance. The truth is, that’s what your credit score was BORN to do! Get pulled. Just don’t go nuts. In fact, if you take anything away from this article, “Don’t go nuts” is good advice for just about everything credit related.
Ever bought a car and got the loan at the dealership? Odds are, they sent your information out to 20 different lenders and they all pulled your credit. It’s called shopping around for the best rate and loan options, and it’s no big deal. In fact, if you have car and mortgage lenders pull your credit close enough together, it only counts as 1 pull on your score. One!
Theoretically, you could call a million lenders on the same day and have every single one pull your credit. Counts as One pull.
But not for credit cards.
Every single pull counts as one with credit cards. Why? Because you can open credit line after credit line. But you can’t buy house after house. Last note on credit inquiries: There is a time limit on this “eligibility window” for credit inquiries.
And, it's really confusing and ambiguous. The window varies depending on the different credit score formulas that lenders use. It can be anywhere from 14 to 45 days. "Lender A" might use a newer formula where the window is 45 days. "Lender B" might use an older formula where the window is 14 days. You can imagine how a difference in formulas can affect your credit scores when going from lender to lender, even on the same day. The truth is, nobody knows what's really going on!
So, let's confuse this even more:
Two different lenders use different formulas for one guy on the same day. The lenders get different scores which might dictate different interest rates and affect eligibility for different loan programs. And they're working off the same information.
So in theory, if you're over or under a credit score threshold (759 and 760 is a big difference), you might get completely different quotes. That means you can't get accurate quotes until they pull your credit. Then, they need AT LEAST another hour to give you all the options. How many lenders are you going to check? My advice: Find a lender you trust and stick with them.
Car & Home Loans:
These are the best way to increase your credit score because it gives your credit report “variety”: A few home loans, a couple of car loans, and a handful of credit cards. It’s diverse. That’s why older people usually have better credit scores than younger people. They have a long and diverse history of credit. And, since the loans use the home or car as collateral, the interest rates are lower. In some cases, the interest you pay is tax-deductible and can lower your tax liability.
These types of loans are tricky, mostly home loans. It's a smart idea to check your credit and make sure everything is good to go months before you plan on buying a new home. Just in case there are any mistakes or issues you weren't aware of. Cleaning up a credit report can take months, and if you wait until the last minute, you can have problems.
When to Close Credit Lines:
If you look at your credit report, you will probably notice old credit lines you haven’t used in forever that are still open. Should you close them? Sometimes closing a credit line can immediately hurt your score.
Credit history has a shelf-life of 7 years. But, that doesn’t mean if you’ve had a home loan for 10 years, that the first 3 years aren’t counted. However, if the loan or credit line has been closed and inactive for 7 years, it will drop off.
For example: Let’s say you’ve had a credit card for 20 years, and you used it all the time back in the day. But you haven’t used it in the last 8 years, so you close it. When that account closes, you lose decades of credit history and will most likely hurt your score. A good rule to live by is, if they’re not hurting anything, let them be. Who cares?
Good Credit vs. Good Financing:
There is a bit of conflict between the two. While using credit cards and getting bank loans can be great for your credit score, it may not be the best financing advice.
Consider this: Everyone has a crazy uncle that pays cash for everything and doesn’t trust the government. While he may be a very wise and conservative with his money, odds are his credit isn’t very good.
Why? Because there is no documented proof that he pays his debts. Somewhere in between is the fine line we all have to walk.
Good Financing: Paying off car loans early.
Good Credit: Paying on time each month for all 5 years.
Good Financing and Credit: Get a car loan, pay on it for a few years before you pay it off completely, so you can have proof that you pay your bills.
I’m not your financial advisor. In fact, this is not very good financial advice at all: Borrowing money when you don’t need to.
I’m just saying that if you want a good credit score, you have to play the game. Use credit cards and pay them off every month before they accrue interest, get low interest rate car and home loans, just don’t go overboard. Spend responsibly.