By Grace S. Yung, CFP
Maintaining a good credit score is essential to your overall financial health. Many
of the things that you want to purchase, lease, or rent—such as a home, apartment, or car—require good to excellent credit. Having bad credit—or no credit at all—can put you in a bad position.
Knowing your credit score—and ensuring that it is accurate—is a good place to start. If you already have good credit, then keeping that score in good standing by reviewing your credit report at least annually will help you avoid getting off track.
How Your Credit Score Is Determined
When it comes to your finances, there are few things that can hurt you more than having bad credit. Your credit report, which is the history of your bill-paying activity that the credit bureaus keep track of, could essentially be the best asset, or the worst liability, that you have.
According to the Federal Reserve, outstanding credit-card debt is set to hit the $1 trillion mark in the United States this year. That is a level that hasn’t been seen since 2008, prior to the economic crisis.
When you fill out an application for credit from a bank, lender, retail store, or credit-card company, that information is then forwarded on to one or all of the credit bureaus, along with constant updates on the status of your account.
However, not all creditors will report what they know about you to the credit bureaus—or they might not report the entire contents of their files. For this reason, it is important to know exactly which details are included in your credit report.
It is also important to know how your credit score is determined. First and foremost, your credit score is not just a single number. Each of the three big national credit bureaus—Equifax, TransUnion, and Experian—has its own specific way of calculating your creditworthiness.
Most credit scores fall somewhere between 300 and 850, with a score of 700 being considered good. A credit score of 620 is considered not good, and will cause you to pay higher interest rates for loans because lenders will assume you are a bad credit risk.
According to Fair Isaac Corp., the company that created the FICO credit-scoring system, the median credit score in the United States today is 720. In addition, more than 80 percent of lenders use FICO scores as a part of their evaluations.
There are several factors that go into calculating your credit score, and each component has various weightings in terms of importance. These categories include:
• Payment History – 35 percent
• Amount(s) Owed – 30 percent
• Length of Credit History – 15 percent
• New Credit – 10 percent
• Credit Used – 10 percent
Each year, you are allowed to request a free credit report by visiting annualcreditreport.com. You should read your report carefully, as mistakes can occur. If you do find any errors on your credit report, you should report them immediately and make sure they are removed.
How to Build Good Credit Starting from Scratch
Just like with a savings or investment account, in order to build good credit, everyone has to start from square one. The good news is that there are some ways that you can do so quickly—and in the process, you may even be able to reap some nice rewards.
One of the best places to start building good credit is to borrow a little money and then pay it back quickly and on time. There are several ways that you can do that without “breaking the bank.”
Obtain a Credit Card
Obtaining a credit card can help you build your credit—provided that you do not let
the balance get out of hand. There are
several ways to go about doing this—and you don’t have to be a big spender in order to see your credit score rise, so consider starting off small.
You could even go the route of a secured credit card. These cards require that you first deposit money in your account to cover future purchases. This essentially removes the risk of default for the lender or card issuer. Secured credit cards can be a good option if you may have had credit issues in the past, as most anyone can qualify for them.
Before signing up for this type of credit card, though, be sure that the card issuer will be reporting your transactions to the credit bureaus. This way, your payment history with the card will help to build your credit score.
Or you can apply for a retail or gas credit card, since they are usually easy to obtain. A retail credit card could also get you some nice discounts at that store. Just be careful not to have too many cards in your wallet, so the number of bills coming in each month doesn’t get out of hand.
If you don’t have a credit history at all—or you want to raise your credit score from good to excellent—then you may want to go the route of applying for a traditional MasterCard, VISA, or American Express card.
Many of these cards are linked to some type of reward or point system that lets you obtain additional rewards such as travel or free merchandise at various retailers, or even cash back. In many cases, you can really cash in on the rewards offered with these cards. For example, American Express offers several cards that provide points toward free hotel and airfare once you’ve spent a certain amount.
Most of these cards offer multiple points if you spend in certain “categories” such as gas stations or office supplies. And, most also offer a sign-up bonus where you can receive additional points if you spend a stated amount of money on the card within a set period of time.
If you tend to use a credit card for your everyday shopping needs, or if you are a business owner who tracks company spending through credit cards, going this route can really pay off in rewards. Just be sure that you read over your card agreement carefully before applying so that you understand exactly how the reward program works. You may also want to compare several cards, as different cards offer different types of rewards programs.
In any case, you will want to be sure that you pay off your credit-card bill in full each month—and that you pay it on time. Otherwise, you could be facing high interest charges, substantial late fees, and a lowered credit score.
Get a Small Personal Loan
Getting a small personal loan can be another way to build credit. In doing so, however, it is important to be smart with the money. Here, you could take the funds that you borrow and pay off any debt that carries a higher interest rate. Then, make regular and prompt payments to the personal-loan lender to pay off that loan.
The credit bureaus look favorably on people who make payments on time. They also favor those who do not have high balances on credit cards and other high-interest accounts.
Using Cash or Debit Cards Doesn’t Always Pay
While some financial gurus may advise you
to use cash or debit cards in order to stay out of credit-card debt, doing so will not help you improve your credit score. In fact, going this route can actually be a security risk in terms
of potential identity theft. And if you have a transaction on your card that appears to be fraudulent or in error, it will be much easier to dispute if it is on a credit card rather than a debit card.
The key here is having the discipline to pay off your credit card every month—maybe by setting aside a certain amount of money each week in your savings or checking account to use for the monthly payments.
Don’t Cancel Old Credit Cards
Believe it or not, if you have old credit cards in your name—even if you have not used them for years—you don’t want to cancel them. This is because part of your credit score is based on credit history, so a credit card that you’ve had for many years can actually help your score. Canceling that older card leaves you with only “new” debt on your record, which can actually be seen as a negative.
Additional Credit Alternatives and Considerations
In addition to keeping tabs on your traditional credit score, there are other ways to smooth the financial-planning process. For example, recently, John Hancock Financial came out with life insurance that allows policyholders to pay lower premiums if they have healthy lifestyles—similar to auto insurance carriers that offer “safe driving” discounts. Those who wear a Fitbit device and meet other qualifying criteria may be able to save up to 15 percent on their life-insurance coverage. While these types of benefits may not help your credit score, they can give you “credits” toward lower insurance premiums.
People who are in relationships need to be especially cautious about keeping their individual credit in good standing. For example, if you are married or are considering tying the knot, becoming a joint account holder on your partner’s credit cards could have a negative effect on you. Simply getting married won’t impact your credit score, but any missed payments on a joint account—even if it is your spouse’s account with your name added as a joint account holder—will show up on both of your credit reports.
The Bottom Line
Having good credit can allow you to get ahead in your financial life—and with life in general. That’s because good credit allows you to obtain loans easily, and at favorable interest rates. By having your credit situation under control, you will also be able to save and invest for the future, thus completing your overall financial plan.
In order to develop more specific blueprints for that plan, it can help to meet with an advisor who can work with you on your entire financial picture, incorporating your personal goals. Partnering with an advisor who understands the needs of the LGBT community can be extremely beneficial in today’s changing legal and financial environment.
Personal finance-related questions may be emailed to [email protected].
Grace S. Yung, CFP, is a certified financial planner practitioner with experience in helping domestic partners plan their finances since 1994. She is a principal at Midtown Financial LLC in Houston and was recognized as a “Five-Star Wealth Manager” in the 2014 September issue of Texas Monthly.