Whether you’ve just graduated from college or are a few years away from retirement, you’ve probably taken on various kinds of debt at one time or another. Student loans. Auto loans. Mortgages and home equity loans. Credit cards. Margin accounts.
Yet, unlike mutual funds, past performance may predict future results. At least, that’s what banks and other lenders think when they’re considering your application for a new loan or credit card.
How much debt you’ve accumulated—and how efficient you are at paying it off—are the main factors that determine one of the most important three-digit numbers you’ll want to keep a close eye on throughout your life—your credit score.
You’ve probably seen this number at some time or another. Maybe it was on one of your credit card statements. Maybe you saw it on a report from one of three main credit reporting agencies (more on this later). Or maybe you signed up for one of those online credit monitoring services offered by banks and credit card companies.
But what does this number really tell you—and creditors? What is a “good” credit score and why do you want it to be as high as possible?
Creditworthiness at a glance
At its most basic level, a credit score tells potential lenders—in a purely quantitative way—how much of a credit risk you are.
Several different companies calculate credit scores used by banks and lenders, and some institutions use their own scoring methodologies. For the purposes of this article, however, we’ll focus on the most well-known metric, the FICO® credit score.
The highest possible general FICO credit score is 850. (Other specialized scores go up to 900.) Less than 2% of Americans have attained that numerical holy grail of creditworthiness. 710 is the average score.
A credit score isn’t the only factor that creditors use to evaluate your creditworthiness. But it’s a good all-purpose number you can use to estimate your chances of being approved for future credit cards and loans—and what terms you may be offered.
How is your credit score calculated?
Your credit score reflects a number of factors, including your payment record, your outstanding debt, the length of your credit relationships and your credit utilization.
If you’ve recently completed paying off ten years of student loans, you’ve probably thought, “Good riddance!” But one important benefit of making on-time payments month after month, year after year, is that it helps you establish a favorable payoff record.
After all, it’s hard to gauge your creditworthiness if you’ve never taken out a loan or opened a credit card. But, unless you’re one of the few people who has never borrowed money and pays for everything with cash or debit cards, you’ve probably established a history of debt payments.
If you’ve got a good payment record, it will raise your credit score. Conversely, your score gets docked when you miss payments. And, unfortunately, negligence has a disproportionate impact.
The good reputation you’ve slowly built over years of regular, on-time car loan payments can be significantly derailed by the one credit card payment you forgot to make last year.
The best way to atone for missing payments in the past is to make sure you make all payments on time in the future. The more regular, on-time payments you make over time, the higher your credit score will gradually rise.
Your outstanding debt
A credit score also reflects how much debt you have. This is often calculated as a debt-to-income ratio. You can calculate this by dividing the total amount of all your minimum required monthly debt payments by your total gross monthly income. Multiply the result by 100 to get your debt-to-income ratio expressed as a percentage.
Creditors often get nervous when your total minimum monthly payments exceed 30% of your monthly income, so if you’re hovering close to this percentage you should try to lower it as much as possible. A good way start is by fully paying off your outstanding credit card balances. Or pay for more purchases with cash or debit cards.
The length of your credit relationships
Ever thought about closing an inactive credit card you’ve had for many years? Don’t. Lenders like borrowers who keep their credit card accounts open indefinitely, even if they don’t use them. If you’re worried about someone hacking into a particular credit card account, call the issuer and see if see can freeze your account so that it rejects any future charges.
If you have a dormant credit card with a high credit limit, here’s another reason not to cancel it. Doing so may negatively impact your credit utilization ratio, a key factor that often determines whether or not you may be approved for new credit cards.
Fortunately, this is another number you can calculate yourself. How? By dividing the total outstanding balances on all of your credit cards by the combined credit limits on all of your credit cards (including cards you don’t use). Multiply this figure by 100 to view your credit utilization ratio as a percentage.
Like the debt-to-income ratio, you should try to keep your credit utilization ratio below 30%. While the best way to reduce this number is to pay off your credit balances, there are some “tricks” you can also use, such as asking for credit limits to be raised on cards you use most often, or opening new credit cards with higher credit limits and only using them for very small purchases.
What magic doors does a good credit score open?
If your FICO credit score is at least 670 and you have a good payment record and relatively low debt-to-income and credit utilization ratios, you’ll probably be approved for most standard credit cards and pass through the first “approval hoop” for mortgages and car loans.
But if you plan on taking out various loans throughout your life or want the best credit terms, you should aim to get your credit score to the 740 “Very Good” plateau.
Getting your score to this level or higher may result in more favorable terms for credit cards and loans. For example, a higher score might allow you to open more credit cards with 0% introductory interest rates or enable you to get the better interest rates for mortgages and auto loans.
Checking your creditworthiness
A FICO score is an important element of your credit profile, but it’s not the only thing creditors consider. Whenever you apply for a loan, most lenders or banks will check your credit record at one of the three main credit reporting agencies: Equifax, Experian and Transunion.
As a consumer, you’re also entitled to view your credit records. Federal law allows you to receive one free credit report each year from the three agencies. And, until the COVID-19 crisis is officially declared to be over, you can sign up for free weekly credit reports. You can request these reports online at www.AnnualCreditReport.com.
Since your credit score will rise and fall all the time to reflect added debt and payments, these reports will be useful if you’re planning on taking out a major loan soon and want to see where you stand, creditwise, before you apply.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult an accountant or financial advisor if you need professional guidance.
This article was authored by David Jaeger and Jeffrey Briskin. David is a financial advisor at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or firstname.lastname@example.org. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.
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