One of the most misunderstood areas of our financial planning practice is credit. We have found that people in all walks of life seem to find consternation in its complicated formulas and seemingly arbitrary methodologies. Yet, it is a critical element of sound financial planning. Mistakes can be costly and have a long-term effect on your finances. For some of the most dysfunctional credit abusers, it can be like alcohol, food or gambling: difficult to control bad behavior.
Understanding your score and using it to your advantage can be the difference between financial success and failure. The simple premise is that creditors reward those that honor their commitments and punish all others.
In this edition, we will discuss your FICO. In our next 2 Newsletters, we will cover:
- The Importance of Bureaus.
- Your Credit Cards.
What is FICO?
FICO stands for Fair Isaac Corporation, the largest and best-known company providing software to the bureaus. This software is used by over 90% of lenders and all three credit bureaus. Although the algorithm may be complicated, the FICO software and the 3-digit scores they produce predict to lenders how likely you are to repay them within the terms and it is also used to set the interest rate you will pay. They don’t divulge the secret sauce, but we can tell you what the ingredients are and how much of each goes into it:
- Payment history (35% of your score): This concerns whether you’ve paid on time. Late payments can ding your score, although 30 days late isn’t as bad as 60, etc. A bankruptcy or accounts in collections could also hurt you.
- Amount of debt relative to credit limits (30%): This is how much of your available credit you are using — the less, the better for your score.
- Age of credit (15%): This refers to how long you’ve had credit and the average age of your credit accounts.
- Recent applications for credit (10%): A so-called “hard inquiry” when you apply for new credit can nick your score for up to six months.
- Whether you have more than one type of credit (10%): Having both installment loans (those with level payments, like a car loan or mortgage) and revolving credit (like a credit card) can help your score.
As you can see, paying on time and keeping balances low account for about two-thirds of your score. You should manage your FICO score. It can and should be done.
The Importance of Credit Bureaus
It is important to note that virtually every single creditor we have ever done business with has an entry in one of three (or all 3) credit bureaus for each of us: TransUnion, Equifax, and Experian. If it is imperative to manage your FICO score, it is equally important to know what is on your profile for each one. If you know one it is not enough. Keep in mind they are competitors and they do not share their data. Once a year, you can access a copy of each bureau’s report by accessing the following website free of charge:
You will not be dinged as a “hard inquiry”. Please avail yourself of said privilege. Bureaus can be wrong about things and creditors often make reporting mistakes. It is up to you to dispute the erroneous information. It can save you lots of money.
Your Credit Cards
Credit cards are like cars. If you use them too much too fast, you get a ticket and have to go to court and your insurance goes up (your score gets dinged). Don’t use them enough, they get rusty and the motor goes stale (your score gets dinged). Should you tend to think of a card as free money, you may be surprised when you don’t have the money to pay the balance, with interest added; how could you, when you didn’t have the money, to begin with – the whole reason you used the credit card! This means a bigger portion of your payments are going to interest and the balance keeps growing and growing.
Interest rates on some cards have gotten out of control – some up to 30% APR, which means the compound interest you are paying could be double that amount. Pay attention to teaser rates and offers for 0% for 12-18 months and use them until they start charging and then move on to the next one.
Are you doomed to accepting the card rate you have? Absolutely not! A March 2017 study found that 69% of cardholders that asked for rate reductions got one. But, only 1 in 4 actually asked. If you are going to ask, contact us and we will send you a script that will hopefully work for you. It’s worth a try!