An informative episode of the Personal Finance Hour this week has me thinking about credit scores. There will be my recap of the most recent episode posted on the PFH’s website later on today/tomorrow but I wanted to share some information with the readers of this site that I thought would have value.
Credit score myths:
- Having too many accounts can negatively affect your credit score. This is not the case because of how your credit score is calculated (see below).
- Checking your own credit score will lower your score. This is not true. However, if you have a friend at the local bank check your score, it is possible this will be seen by the credit bureaus as you “shopping for credit”. This can be a red flag to creditors and drop your credit score.
How a credit score is calculated:
The specific calculation methods of your credit score is hidden in a multi-variate model by FICO. However, we do know some of the major components.
- 35% of your credit score is based on your payment history. If you have not missed any payments, you can expect this section to be in your favor.
- The next 30% is based on your credit utilization. To figure out your credit utilization, take the amount of revolving debt you have (credit cards) and divide it by the credit limits of your cards. That percentage is your credit utilization. The smaller the number, the better.
How you can hurt your credit score:
- Missing a payment! Missing a payment is one of the worst things you can do to demolish your credit score. Liz Weston stated that your score can drop as much as 100 points based on one missed payment. If this isn’t enough of a reason to automate your bill payments process, I don’t know what is.
- Having a low credit utilization percentage. If your cards are near maxed (even if you pay them off in full) makes the credit bureaus worry. They will ding your credit score as they think you are starting to over extend yourself and that this behavior may become a pattern. In reality, you may have just charged a couple of airline tickets for a trip 6 months from now that you have the money saved for.
How you can help your credit score:
- Paying your bills on time. This shows responsibility and that creditors can rely on you to pay them on time.
- Pay off your installment loans. Paying off installment loans may not help your score much initially, but the more that are paid off, the larger of an affect they have on your credit score. Also, it will feel great to not have to worry about your car payments, mortgage, or student loans anymore.
- Get a secured Credit Card. Using a secured credit card will give you the opportunity to show your reliability to creditors. Eventually this card can evolve into a normal unsecured credit card. As Weston put it, if you aren’t using credit, the credit bureaus can’t track your usage of credit and can’t affect positively affect your score when you are acting responsibly.
A saddening tale that Liz discussed on the show was a couple that had driven themselves into such financial damage, that they emptied all of their home equity and retirment accounts in an attempt to avoid bankruptcy. Unfortunately, when all was said and done, this couple had to declare bankruptcy anyway and lost all of their equity and their retirment accounts in the process. These things can be protected in bankruptcy court. It is not advisable to declare bankruptcy, but if you are in that deep of a whole, it may be best to consult financial advisors to see if nuking your credit report is the best way to try and repair the damage you have already done.
This personal finance hour episode was very informative as it discussed something that affects every one of us. Not everyone deals with debt, not anyone needs tips on retirement accounts, or high yield savings accounts, but everyone does have a credit score, and that score can impact your life drastically be it high or low. Learning more about your credit score is the first step you can take to ensuring your credit is helping you and not hurting you. For more information, I suggest listening to the Personal Finance Hour episode for this week by clicking here.