Credit Scores: The Mysterious Number That Has a Massive Impact on Your Financial Life
How to increase your credit score and make your life much easier
“If you don't take good care of your credit, then your credit won't take good care of you.”
― Tyler Gregory
This is the second post in a special three-part mini-series in the larger Dollars and Decades series. Last week, I reviewed the eight most common forms of debt that every young adult must navigate throughout their life.
Today, we talk about one of the more confusing—but important—aspects of managing debt: your credit score.
Read to the end of this post to learn how credit scores impact your financial life and how to improve yours.
The importance of a good credit score
Your credit score has a massive impact on your relationship with debt. The better your credit score, the more likely you are to get approved for a loan, and the lower your interest rate will be.
In the U.S., credit scores range from 300–850, while in Canada, they range from 300–900. Here is what is considered a good and bad credit score.
300–649 is considered a “bad” credit score.
650–699 is considered a “fair” credit score.
700–749 is considered a “good” credit score.
750+ is considered an “excellent” credit score.
Let’s consider the example of three people who have the same job, make the same income but have different credit scores, and are all applying for a mortgage.
1. James has a credit score of 450, which is considered bad.
2. Jill has a credit score of 678, which is considered to be good.
3. John has a credit score of 808, which is considered to be excellent.
They all apply for a mortgage with the same bank.
James is declined and unable to buy the home of his dreams.
Jill is approved for a $400,000 mortgage at a 5% interest rate.
John is approved for a $400,000 mortgage at a 4% interest rate.
Jill is clearly in a better position than James. The difference between a fair credit score and a bad credit score could be the difference between getting approved for a loan or not.
But how much better off is John compared to Jill? How much will he save on interest due to his excellent credit score?
John will pay $284,746 in interest over the next 30 years.
Jill will pay $368,515 in interest over the same time frame.
In this example, the difference between an excellent and fair credit score is $83,769. That is additional money that John could be using to either invest or make additional principal payments against his mortgage, saving him even more in interest and having his mortgage paid off sooner.
How to improve your credit score
Clearly, having an excellent credit score should be everyone’s goal. But what if your credit score is terrible right now? How does someone improve their credit score?
Your credit score is primarily determined by the following factors:
1. Your history of paying bills on time.
2. How far back your credit history goes.
3. The amount of debt you are currently carrying.
4. How much of your credit limits you are currently using.
5. The mix of credit accounts on your file.
6. The number of credit inquiries/applications you have made.
So, if you want to begin improving your credit score, the first step is to simply pay all your bills, including your loan payments, on time. Make a promise never to be late on a bill payment again. This is both the most critical factor in improving your credit score in the long run and the action that is most in your control.
The length of your credit history also plays a role. If you don’t have any history of credit use, applying for a credit card (that you will use responsibly) might be an excellent way to establish a credit history.
Another important factor impacting your credit score is what is called your “utilization ratio”. This is a measure of how much of your available credit you are currently using.
Let’s say you have a credit card and a line of credit.
The credit card has a $10,000 limit, and you have a $7,000 balance.
The line of credit has a $50,000 limit, and you have a $10,000 balance.
That makes for a total of $60,000 in available credit and a combined balance of $17,000
That works out to a 28.3% utilization ratio. A low utilization ratio has a positive impact on your credit score.
To improve your utilization ratio, you can do two things:
1. Begin paying off debt.
2. When you pay off debt with a revolving balance, don’t close the account—so long as you can avoid abusing revolving debt.
In the above example, if you could pay off the balance on your credit card and your line of credit but you did not close either account, it would bring your utilization rate down to 0%. You would have a total of $60,000 available to borrow, and you aren’t using any of it. That shows lenders that you know how to manage credit responsibly.
You also want to make sure that you aren’t applying for too many credit products. If you get denied a loan due to low credit, the worst thing you can do is turn around and make five more applications at different banks. The more credit inquiries (loan applications) you make, the worse it will be for your credit score.
You shouldn’t be afraid to apply for credit when you need it, but be careful not to make too many applications in a short period.
Next week, we wrap up this three-part mini-series on debt by breaking down in great detail the two most effective strategies to pay off debt as quickly as possible.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.