What’s Your Number?
As financial planners, we spend a good deal of time railing against the evils of credit cards and bad debt. But the truth is that establishing and maintaining a strong credit score is an important component of good financial health. Let’s face it: it’s not realistic or even prudent to pay cash for everything and in those situations where borrowing makes sense, having a good credit score will allow you to do so on favorable terms. So let’s start at the beginning.
What is a credit score and how is it compiled?
In short, it’s the number that alerts bankers, lenders – and these days maybe even landlords and employers – as to how reliable you are when it comes to repaying debt. It’s calculated from things like if you pay your credit card bills on time, how much you’re using of the total credit you have available, the average age of your accounts (more history is better) and whether you have a mix of different types of credit (mortgage, student loan, car loan, etc.). Lenders like to know that you can manage different kinds of accounts responsibly.
To make things even more confusing, there are two separate sources for credit scores: Vantage 3.0 (also known as the consumer score) and FICO. Though FICO is the most widely used, Vantage 3.0 is the score used by the three major credit bureaus: TransUnion, Experian and Equifax. The scoring range is the same for both – 300 to 850 – and the higher your score, the better. Generally speaking, any Vantage 3.0 score above 780 is considered excellent, while anything over 740 is considered excellent and will qualify you for the best rates on the FICO scale. Scores below 720 on the Vantage scoring system and below 650 on the FICO scoring system mean that you might have difficulty getting a loan approved in a competitive credit market.
Why it Matters
Your credit score will be important when it comes to some pretty big life events. Like buying your first home, buying or leasing a new car, or starting your own small business. A low score doesn’t always mean you won’t be approved. But assuming you are, it almost certainly means that you will be required to put down a larger deposit or borrow at a higher interest rate.
Even 20 points or so can make a big difference in what you’ll be charged for credit. Today, someone with a FICO score of 659 could get a 30-year mortgage at about 5.3%, while someone with a score of 680 might expect to qualify for the same loan at just 4.7%. That may not sound like a big deal, but over the life of a $250,000 loan, it’s a difference of more than $30,000 in interest payments!
Most people don’t give their credit score much thought until they need it – and at that point it’s too late to do anything about it. So plan ahead. Limit yourself to one or two credit cards. Unless it’s an emergency and you have no other options, don’t charge more on your card than you can afford to pay off at the end of the month. And if you don’t already have some money set aside for unexpected expenses, establish an emergency savings account that’s equal to at least 3 months of expenses. Practicing responsible cash management will strengthen your credit score – and that will give you a leg up on building the life you imagine.