Did you know that March is National Credit Education Month? This is an important topic for Financial Fitness for Life because we are constantly educating employees about what a credit score is and why it’s crucial in establishing and maintaining overall financial wellness. In this piece we will cover three key topics relating to consumer credit:
- What is a credit score?
- Building and maintaining good credit
- Benefits of good credit
What is a credit score?
A credit score is a number based on your credit history using a computer model that analyzes a consumer’s credit report for things like, open lines of credit, balances, limits, bankruptcies and foreclosures among other things. The intent of a credit score is for creditors to determine the likelihood that a consumer will repay their debt. There are three national credit bureaus, Transunion, Equifax, Experian, that collect data about consumers and how they’ve used their credit. Each bureau will generally have a different credit score and creditors will typically utilize the middle score to determine credit worthiness. Why are there three bureaus? Historically, each one served a different geographic region, but as they continued to buy other smaller credit reporting agencies, they’ve now grown into national entities. So, what’s the difference? Each bureau has an algorithm that weighs various components, rent, mortgage, vehicle loans, utility bills etc., differently. One major similarity between the three is the emphasis put on balance, relative to limit. This essentially means the higher the balance relative to limit, the more it will negatively impact a credit score. For example, if a consumer has a $10,000 limit and a balance of $9,000, it will more negatively impact a credit score than a consumer that has a $7,000 balance. For most lenders a high credit score is somewhere between 700-800 and a low score would be anything under 580. It’s important to know this score and we will cover why in the last section of this piece.
Building and maintaining good credit
There is a little-known fact that no credit is just a bad as bad credit and many times that lesson is learned the hard way, resulting in high interest rates or worse yet, no credit availability. From a creditor’s perspective, it’s extremely difficult to lend money to someone you know very little about and don’t know whether they’re capable of repaying any debt they might accumulate. Building credit doesn’t happen overnight and maintaining good credit isn’t as easy as it seems. Education is a vital step in building credit because it takes some level of planning from a young age. All too often we see young adults graduate from college with high student loan balances, eager to enter the workforce and venture into the “real world” in which they’re independent, both financially and emotionally. The result? A rude awakening when applying for a lease on an apartment or home, resulting in a large deposit or simply not qualifying. Avoiding a scenario like this is possible with a plan that can be implemented as a young adult, often times in college. Let’s take a look at what a plan could possibly look like. As we mentioned previously, lenders often times will not lend to someone that doesn’t have credit history or a credit score, but there are plenty of credit card lenders that will provide credit with low limits, around $1,000 for the purpose of establishing credit history. Once that line of credit has been established it’s important to use SOME of that line, but pay it immediately. For example, use the line of credit to pay for gas, groceries or items that you have the money to pay off immediately. Utilizing the line of credit and paying it immediately will show the credit reporting bureaus that you have the ability to use credit responsibly, resulting in a credit score that indicates your ability. Maintaining a good credit score is dependent on your ability to continue to pay off balances as the line of credit is used. A good rule of thumb is to never carry large balances for extended periods of time.
Benefits of good credit
There are many benefits to establishing good credit, but two that stick out to us at Financial Fitness for Life are savings and availability. You might be asking yourself how good credit has anything to do with saving. It’s quite simple! Good credit allows a consumer to benefit from lower interest rates on major items that generally impact monthly spending; things like mortgages and or cars. The difference in interest rates for good credit borrowers can have a substantial impact over time. For example, a borrower with good credit that applies for a mortgage of $350,000 and pays an interest rate of 3% will pay $875 in interest per month. That same borrower with bad or less than “good” credit, receiving an interest rate of 6% would pay $1,750 per month in just interest. Over the course of 30 years, the standard loan term for a mortgage, that’s an additional $315,000 in interest they’ve paid to their lender over those 30 years. Let’s look at that example through a different lens. If a borrow has good credit and receives the lower interest rate of 3%, but takes the savings of $875 per month, they would have otherwise paid a lender because their credit wasn’t good, and invests that into a mutual fund that generates a return of 6% per year, they would have $883,345.42
from that monthly investment. So, going back to our original point, saving money on interest doesn’t just mean saving money every month, but it also provides the ability to save more for the future if utilized properly!
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