Chapter 3: Credit Scores – What’s the BFD?
Improving Your Score
Payment history accounts for 35% of your total credit score. It’s the largest part of your score. It’s also the easiest part of your score to impact directly through your behavior. And the time from behavior to score impact is relatively short. If you’re looking for maximum impact with minimal effort, this is the place to start.
You have no history of credit activity.
If you don’t have a credit card and have never had an installment loan (student loans not yet in repayment don’t count), then you’re probably “credit invisible.”
As crazy as it might sound, being credit invisible is just about the same as having “poor” or “bad” credit. Algorithms can’t cope with a lack of data. No history, no data. No data, no score.
Update: “Fixing” this problem isn’t quite as easy now as when I first wrote this guide. The U.S. is dealing with a pandemic that has led to unprecedented levels of unemployment. At times like these, just as during the Great Recession that began in ’08, banks tend to get very stingy with credit. Credit card applications that would have sailed through two years ago are now being denied. And existing cardholders are opening their email to find their existing credit limits have been reduced.
Don’t let this period of tightening credit discourage you from your efforts to establish credit. Credit might be harder to get right now but it’s also more important than ever. Credit begets credit. Believe it or not, it’s generally easier to get credit when you’re young. A credit invisible 18-22 year old is not unexpected. A 30 year old with absolutely no credit history raises eyebrows.
That’s not to say that credit cards are no longer the easiest and fastest way to establish and build credit — just that you might have to be a little more creative and flexible in how you get started.
Get a credit card — and use it.
Option 1: If you’re young and in college, consider applying for a student credit card. All of the major credit card issuers offer a card targeted specifically at college students and, therefore, expect the applicants to be credit invisible and have little to no income.
Of course, they also expect you to fall for all of their tricks. They expect you to get yourself into debt. They expect you to not understand the billing cycle or know how the grace period works.
If you’re considering a student credit card, please do yourself a favor — write down the (much higher than average) interest rate on your card to help remind yourself of the high cost of daily compounding interest.
Option 2: Have someone add you as an authorized signer on an existing credit card.
Being an authorized signer on a card is different than being an owner (or a joint owner) on a credit card. An authorized signer has full legal authority to use the card but no legal responsibility for paying the debt incurred.
Being an authorized signer on a card does build credit — but it’s not full credit. Let’s call it “gateway credit.” As an authorized signer, the history of the card owner’s payment activity and credit utilization will be reported on your credit report. Also reported, however, is your “responsibility” for the loan. Activity and history as a full or co-owner will carry more weight than activity and history on an account where your responsibility is simply “authorized.”
A cardholder can add anyone as an authorized signer to a card they own: a child, a parent, a spouse, a partner, an in-law, and even a friend. It is not a decision to be lightly — by either party. The cardholder is legally agreeing to take responsibility for all charges made by the signer. As a cardholder, if you have a credit limit of $10,000 and you add an authorized signer, you’re accepting legal responsibility for the potential $10k pile of debt they rack up. On the flip side, the cardholder’s credit activity on that card will be reflected on the authorized signer’s credit report. If the cardholder misses a payment, that missed payment shows up on the signer’s history too.
Option 3: The next step up from being an authorized signer is being a co-owner of a credit card. Opening a co-owned credit card requires that each party submit an application and be approved. Or, in the case of adding a co-owner to an existing account, the person being added will have to go through the application process and be approved before being added as a co-owner.
This is a good option for adding a spouse or life partner to an existing account or for a couple wanting to combine their finances as they build a life together.
It might also be a stepping stone in the process of transferring ownership from an authorized signer into a full owner of a card. Let’s imagine, for example, you opened an account with a major credit card and made your 16 year old an authorized signer. That child is now 22 and gainfully employed. That card is their oldest card so you want to preserve the credit history for them (see below for why this is important). You decide to have your child apply to be a co-owner of the account. Now they have full legal control over the card and their credit reports will reflect that they are a co-owner.
Be aware that if your plan is to fully transfer ownership by adding a co-owner and then have the initial owner extricate themselves by taking their name off the account — not all credit card companies will allow this. If the card has no carried balance and has always remained in good standing, then a bank that considers these requests might well approve it. But some banks may have a hard policy of simply not considering such requests. In that case, the original owner could remain as a co-owner and simply never use the card. But as long as your name is on a jointly owned credit card or loan, you can and will be held legally responsible for the other person’s debt on that account. Again, not a commitment anyone should take lightly.
Consider taking on an installment loan for a purchase you otherwise would have simply paid for in full.
This solution is described in detail in the Types of Credit section below.
You have a credit card but no credit history.
Let’s say you already have a credit card and you use it occasionally but you’re afraid of messing up or going into debt so every time you charge something to your card you go online soon afterward and pay the balance to $0. Or you heard from a friend that a good habit is to log in and pay your balance to $0 every Friday. Sound familiar?
I can’t tell you how common this is! My own daughter, well-versed as she was with billing cycles and grace periods, admitted that for the first few years as a cardholder she routinely paid her balance to zero during her billing cycle because having a balance made her extremely nervous.
Stop it! (just kidding. kinda.)
Seriously though, this behavior means you’re depriving yourself of most of the benefits of having a credit card! Really, why even bother?
My best advice with a credit card is to use it like a debit card. Never charge anything to your card that you wouldn’t otherwise purchase with your debit card or cash.
If you’re intimidated by your credit card, ease into it. Pick one category of spending — food or gas or dining out, etc. Pay for that one category with your credit card, making at least one charge every month. Then set a reminder in your calendar for one week after your billing cycle closing date and pay your statement balance. Or, better yet, set up autopay. You can have your statement balance paid automatically a few days before your due date each month.
The key here is to make sure that your credit card company has at least one instance of activity each month to report to the credit agencies. This will result in a consistent history of credit use and on-time payments.
Remember, your payment history consists of 35% of your total score!
You have a history of missed or late payments.
In my practice, I encounter three common reasons for missing or late payments:
– busy schedules, chaotic lives, and/or extreme emotional stress related to finances leads to missing due dates;
– a general plan to pay more than the minimum but confusion and the stress of trying to figure out how much you can pay without leaving yourself short for the month leads to missing dues dates;
– having a due date that clashes with other financial obligations such as rent or car payments and/or is poorly timed with your paychecks makes it very difficult to get a payment in before the due date.
Depending on the reason for missing payments or paying late, I offer a few suggestions below.
Autopay is your friend.
Set up your account to automatically make a payment just before the due date. This ensures that, even if you get busy, you won’t miss a payment. Even if you’re simply making minimum payments at this point, set it to autopay. Nothing worse than incurring a $35 late fee because you forgot to make a $25 minimum payment.
Don’t engage in self-sabotage.
Trying to pay down your debt is admirable but self-sabotaging your efforts by missing payments is not. Set up autopay for your minimum payment. Later in the month or in your paycheck cycle, when you know your budget can absorb an extra debt-reduction payment without having to add new debt right back onto your credit card, log into your account and make up another payment.
[Most credit card companies will limit the number of payments you can make in a given 30-day/billing period but I haven’t seen any that won’t accept at least three payments in a 30-day period. That allows for the minimum payment plus two additional payments in each one-month period.]
Move your due date. [Yes, you can do that!]
If your credit card (or other loan payment) due dates are inconvenient in respect to your paycheck cycle and other regular monthly bills, call customer service or go online and request a different Due Date. Yes, you can do this! Most cards and creditors will allow you to adjust these dates but be sure to put some thought into the new date before submitting your request because lenders typically will restrict the number of times you can change your account’s due date.
Credit Utilization Ratio
Credit utilization ratio accounts for 30% of your credit score. It is also known as the debt-to-credit ratio. Credit utilization refers to how much of your total available credit do you use each month. This number is interpreted as how much do you need to borrow each month to meet your monthly needs and obligations. If it take over 30% of your total available credit to stay afloat every month, you’re going to be seen as a higher credit risk than someone who only borrows 5% of their total credit every month.
You never use your credit card so nothing is being reported to credit agencies.
If you’re paying your account balance off before your due date, don’t.
I’ve seen people do this because they’re terrified of going into debt and they don’t really understand how all the dates and balances work. Well, that’s no longer an issue for you, right?
If you pay your balance before your reporting date, nothing gets reported. It looks as if you aren’t even using your card. Nothing reported, no history built. No history built, no credit score. So, wait until after your closing date rolls around and your monthly statement is issued. Then you can pay off your balance.
You’re using too much available credit each month.
Call and ask for an increase in your credit limit. [Yes, you can do that!]
I see quite a bit of misinformation being passed around about credit limits. Having a large available credit limit is not a bad thing in terms of your credit score. [If you’re a compulsive shopper, then keeping your available credit limit low might not be a bad idea if it helps you keep your spending under control. But otherwise, having a $5k credit limit is not better than having a $50k credit limit. My credit limit is well over $100k and my (educational) credit score hovers around 840 (out of 850). Where you credit limit can and most definitely hurt you is if it’s so low that your normal monthly spending regularly exceeds 30% utilization.
And asking for an increase in your credit limit is a much better solution than applying for a new credit card in an effort to increase your limit. More about that below.
Make a partial payment before your closing date.
This fix is in direct contradiction with an earlier fix, I know. It’s all about understanding the circumstances.
If a large purchase or if a larger-than-normal number of purchases means that your statement balance will represent more than 30% of your total credit line, go online and make a partial payment before your closing date. Then let your billing cycle close with the new smaller balance. This smaller amount due will be reported to the credit agencies. When it’s time, pay your statement balance.
As an example, let’s say your card’s credit limit is $1,000. Your normal spending tends to range between $100 – $200. Great. That means your normal credit utilization rate is 10-20%. This is perfect. But now you decide it’s time to buy that nice $800 couch you’ve been wanting. You want the benefit of your cash rewards for such a large purchase but you know that an $800 charge will result in a debt-to-credit ratio of 80%! That’s way over the industry suggestion of 30% and four times higher than my suggested max of 20% utilization.
You can have it both ways: earn the rewards on $800 and get reported for < 30% utilization. Here’s how: purchase the couch putting all $800 on your credit card. A few days later, log into your account and make a payment of $500. That brings your Account Balance to $300 — that’s 30% utilization. Now wait for your closing date to pass. Your credit card company will report a 30% credit utilization ratio to the credit agencies. The final step, of course: pay your statement balance by the due date.
Length of Credit History
The length of your credit history accounts for 15% of your overall score. I wish I’d known about credit scores and credit history back in my early days of establishing credit. If I could do it over again, I’d take a lot more care to consider which cards I’d want to own for the next 50-60+ years. There’s no shortcuts to building a lengthy credit history. Choose your cards wisely, Grasshopper.
You plan to close your accounts as soon as your debt is paid off.
Don’t do it!
Look, I understand the sentiment. You’ve worked so hard to get out of credit card debt and now you can finally see the light at the end of the tunnel. You never, ever want to return to that dark place of credit card debt and so it seems the smartest thing to do would be to close your credit card accounts, right? Wrong!
Again, I get it. That’s an understandable emotional response but it’s completely contrary to the logical response.
A credit card is the simplest and easiest way to build credit. An old account, even one with a troubled history, is more valuable than a new account. Closing the old account doesn’t make the troubled history go away. All that goes away is the value you’d gain by having an older account.
If you close the account after doing the hard work of paying off the debt, you’re throwing away one of the best tools you have to start building positive credit again. Paying off the debt is only the first step in the process; now you have a chance to prove your creditworthiness on a whole new level. Think about it: a former debtor who falls off the credit radar is a much less attractive credit risk than a former debtor who has paid off their debts and then builds a demonstrated history of good credit practices. Ask yourself who you’d be more likely to lend money to. And don’t make the mistake of thinking you’re never, ever going to need a good credit score. Remember, your credit score is important to industries other than lenders.
Use it occasionally, pay in full — let it age, like fine wine. The older your history, the more valuable it is. If you cut up your cards and close your accounts, you’ll have to start all over with a new account once you decide to try reestablish your credit.
Types of Credit
Having a range in the types of credit you’ve applied for and demonstrated reliability and responsibility in repaying accounts for 10% of your overall credit score. Not everyone will have a mortgage in their lifetime and certainly no one would expect to see a 20-something have all three types (revolving, installment, and mortgage) of loans in their history. But showing some depth in your loan portfolio will improve your score. Ten percent isn’t a huge chunk of the overall pie but it’s not nothing either.
You only have credit card debt.
Consider an installment loan for a purchase you could cash-flow.
This percentage of the overall credit pie is too small to make it worth extraordinary effort. But there are times when it might make sense to borrow instead of paying cash — with the added bonus of broadening your borrowing history and ticking the “multiple types of credit” box.
Let’s say it’s time to buy a new phone and you can make twelve installment payments at 0% interest. Even though you’ve saved up the cash to buy the phone outright, consider taking the payment plan instead. You’ll diversify your credit history and can keep the cash in your savings account a little longer than planned. [Just make sure you don’t spend it on something else in the meantime!]
Although it’s a much larger purchase, I’ve purchased cars this way. I had the cash saved to buy a car but the interest rate being offered was so low that it made sense to finance the car and make payments.
Another option, if 12 months of phone payments or four years of car payments don’t appeal to you, you can take out the loan, make a few payments to show credit activity and a history of on-time payments, and then pay the loan off early. Just make sure the loan doesn’t have a pre-payment penalty.
Number of New Accounts
The number of new accounts you’ve opened makes up the final 10% of your credit score. In general, an account counts as “new” for three years. There’s nothing wrong with opening new accounts when you need them. And new accounts eventually become old, established accounts — and those are good. Too many new accounts opened in too short a period of time will hurt your score.
You’re considering a new credit card to increase your overall credit limit.
I see this frequently with clients. Once they fully understand how to leverage the advantages and rewards of using a credit card (and they have a reliable system in place to manage spending), they find themselves bumping up against the 30% credit utilization ratio threshold. Making extra payments works if the need arises occasionally but it’s not a sustainable practice if it’s needed month after month, year after year.
Instead of opening a second credit card, consider asking for credit increase on existing card.
It’s standard practice for card issuers to initially approve accounts but place low credit limits on cards based applicant age, lack of credit history, or a poor credit score. Once you’ve proven your ability to handle credit responsibility — both to yourself and to the creditor, they’re likely to be more than willing to increase your credit limit. Often all it takes is a quick call to your card’s customer service number.
If you’ve established yourself as a good customer with a solid track record, the agent will be able to approve a credit increase right then and there.
However, if the customer service agent indicates that they’ll need to run a credit check before approving a credit limit increase, politely decline. Make a note of when you made your request, get back to work using your card and doing everything right, and then try again in another 6-12 months.
If you get turned down the first time, don’t get discouraged. Having a credit increase request might hurt your feelings for a minute but it won’t hurt your credit score. Letting them run a credit check, on the other hand, will “ding” your score — whether or not you are approved.
Bonus: Scores, Privacy, Security
You’re still curious and want to see your score.
Believe me, I get it!
Once you get in the habit of “knowing” your score, it’s nearly impossible to stop being curious about it. You might not need to ever know you score but that doesn’t mean you don’t want to.
Check to see if any of your credit cards offer it as a perk.
The best way to get a peek at your educational credit score is through an existing credit card account.
Several years back, Discover’s big marketing play was to offer cardholders access to their score as one of the perks of a Discover IT card. But now every major credit card issuer includes an educational score as part of their cardholder benefits package.
The advantage to obtaining your educational score through your credit card is that you have an established relationship with them. They already know everything there is to know about you — demographics, income, social security number, address, contact info, etc. You’re not inviting anyone new to invade your privacy.
Buy one through one of the credit reporting agencies: Equifax, Experian, or TransUnion.
If you don’t have a credit card that provides educational credit scores to cardholders or you don’t have a credit card yet and you can’t suppress your burning desire to “know your number,” my recommendation would be to pull a credit report from annualcreditreport.com and pay the upsell price to see your score.
Maybe you’re asking, “But why pay for my score when I can get it for free from CreditKarma?”
Because nothing is ever free. You might not be exchanging money for you credit score but you are exchanging something you should consider just as valuable — your privacy!
My logic here is the same as above — the credit reporting agencies already know everything about you. They know your name, every single address and phone number registered to every single account your name has been associated with, your social security number, your age, your demographics — everything. Using a 3rd party site like CreditKarma is, in effect, trading your privacy and information and data for a “free” peek in a funhouse mirror. [Nope, no strong opinions here.]
next >> Chapter 3 Quiz
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