NEWS: The latest US Federal Reserve numbers, released Jan. 7, showed that by the end of 2021, Americans owed almost a trillion dollars on credit cards and paid $120 billion in interest.
WHAT IT MEANS TO YOU: A friend recently complained to me that though she had more than five figures in savings, her credit score of around 740 still went down a couple points. That spurred me to ask around and I found that most people had just a vague idea of what a credit score is and even less idea the impact it has on how much money they have in their pocket.
First of all, a credit score is not a measure of wealth. My friend is obviously good with her money – a 740 credit score is nothing to feel bad about. But her savings account has nothing to do with that number. You can be the poorest person in room and still have the best credit score.
A credit score is all about how you handle credit, including paying it back. The impact of your habits can also have a huge impact on how much your monthly credit card payments are, what kind of mortgage you can get and more.
Three reporting agencies – Experian, Transunion and Equifax – use scores measured by Fair Isaac Corp. (FICO) and Vantage to determine how good you are at managing credit. Scores range from 300 to 850, and you don’t hit “good” until 620 or higher. You want to shoot for more than 700, and you’re in trouble if you’re below 620.
The higher your score, the lower interest you pay on credit cards, auto loans, mortgages, as well as insurance premiums. You also have more options when buying a house or car, pay fewer fees, and generally pay less for everything. The philosophy behind “low score pays more” is that lenders and other businesses want to make money. A low score means you’re a bad risk because you haven’t paid bills on time and depend too much on credit cards, which means they’re not sure if they can depend on you to pay them.
Your score can change weekly, depending on how you use credit. The good news is, that means you can start working to improve your credit score right now.
The high cost of a low score
The difference between a 620 credit score and a 720 one could be 5, 10 or more percentage points in interest on a credit card. If you don’t think that makes much difference, consider this:
Say you have a $4,000 credit card balance and a credit score of 720. Your interest rate will be on the lower end, let’s say it’s just below the average of 16 percent. A minimum payment of interest and 1 percent of balance is $93.33. If you only pay that (and don’t charge any more on the card), it’ll take you 246 months (20 years, six months) to pay the card off. You’ll pay an extra $792.87, for a total of $4,792.87
Your friend has a credit score of 670, and her card has 20 percent interest and a $4,000 balance. With a minimum monthly payment of $106, it’ll take her 255 months (21 years, three months) to pay it off, and she’ll pay $2,056.77 interest, for a total $6,056.77.
Your other friend also has a $4,000 balance, but missed some payments so her credit score is 605 and she pays a penalty rate of 29 percent. Her minimum payment is $136.68 and it’ll take her 272 months (22 years) to pay the card off. By then she’ll have paid $4,938.32 in interest, for a total $8,938.23 on the original $4,000 balance.
You probably didn’t know that a minimum payment is mostly interest. These examples represent the lowest allowable minimum, and some cards may have a minimum that covers more of the principal. But it’s a great way to see how much a lower credit score will cost.
If you’re 60 days late on payments, your credit card company can start charging a penalty interest rate, usually around 29.9 percent.
Credit card companies are required by law to show on your monthly statement how long it’ll take you to pay it off with the minimum, and how much you’ll pay over that time.
How to increase your credit score
So, it’s pretty clear that the lower your credit score, the more money you’ll have in the short and the long run. Your monthly payments will be lower, you’ll pay it off faster and you’ll pay less over time.
While you’ve seen apps that promise to help you increase your credit score, they only work if you do the same thing you’d do without them. Here is what you can do right now to increase your score:
- Pay-on-time. The absolute biggest factor that determines a credit score is on-time payments. Missed payments plummet credit scores. This counts for a third or more of a credit score.
- Keep “credit utilization” below 30 percent. How much credit you use compared to your limit is the second-biggest factor. If you have a $3,000 limit, you want your balance to be $1,000 or below. The closer the balance is to the limit, the lower your credit score.
- Don’t apply for every credit offer you get. “Hard pulls” on your credit report count against your score. When a credit card “preapproves” you for a card, that’s a “soft pull,” and it doesn’t count against your score. When you go online to apply for that offer, the company does a hard pull, more than six or so in a two-year period will bring your score down.
- The longer you’ve had an account, the better. It shows you have an established credit history. The shorter your average credit history, the more wary lenders are of you.
- Credit mix. Similar to length of credit history, the more different types of credit you have – credit cards, a mortgage, etc. – shows lenders you have experience at efficiently managing different kinds of debt.
Credit score boosting hacks
So, paying on time, keeping balances low and not going nuts applying for cards is how to improve your credit score. But it’s another to make it work. It means taking charge of your finances. Sorry. But it’s not as hard as it seems.
- Create a budget and live by it. I know. What a pain! But it can be as simple as listing your monthly bills and income on a Google doc or legal pad, and checking it frequently to make sure you’re on track. There are all sorts of budget apps available, but you still have to do the work. Most apps require you to add all your account information before they can keep track. If that seems overwhelming, then do something simpler. The important thing is to know how much you owe every month, how much you make and pay the bills you owe. You can’t do that if you don’t monitor it.
- Set auto pay for your bills. When bills are automatically paid out of your bank account, you don’t have to remember to pay them. You do, however, have to remember they’re coming out of your account. That’s where the budget comes in.
- Set auto pay for your credit card minimum payments, then pay more during the month. Paying your credit card bills on time is vital. You know now what the minimum payment is costing you, so be sure that the minimum will be paid, then when you have a little extra money, go on during the month and pay a little more, too.
- Try not to use credit cards and when you do, pay as much of the balance as you can, or all of it. Very hard if you don’t have a lot of cash coming in, but not impossible. Get tough with yourself about cutting expenses. It won’t be long before you find more money in your pocket as your balances go down.
- Check your credit report. Credit reports can be accessed for free from all three reporting agencies every week until the end of April (a COVID concession). Traditionally, you can get free copies once a year. They’re available at annualcreditreport.com. As many as 25 percent of credit reports are estimated to have errors. You can get them removed. You can also add a note to explain credit issues you may have had in the past.
Many banks and credit card companies offer weekly credit score updates to customers. If yours does, opt in. Some also provide an analysis of why your score changed. Now that you’re credit score savvy, you’ll be able to use that information to your benefit and start living a less expensive life.