The Top Five Things to Know About Credit

To start this blog, I want readers to remember back to 2013. It was almost 10 years ago, and I was just eighteen years old. Obama had recently signed new credit reform laws, but unfortunately it didn’t do much to stop companies from preying on me. I can still recall the excitement of Victoria’s Secret offering me $25 off my purchase for opening a store credit card. I always will and always have loved a good coupon, so of course I applied. I was instantly approved (honestly no idea how) and I officially began my journey into financial adulthood: I received a credit score. I saved the $25, but did not understand the true cost of this decision. In today’s blog, I will list some of the things I wish I had known back then about the basics of credit, including actionable tips from the information I cover.

Credit Scores

Experian, Equifax, and Transunion are the three credit reporting agencies in the United States. These agencies have visibility into every line of credit we have open. A credit report is an incredibly detailed report with your credit story, and your credit score is a product of what your credit story tells. Your credit score updates as your creditors (lenders) report to the three credit bureaus. Creditors typically report to the bureaus once a month. If you have multiple lines of credit, this means your score may update multiple times a month since lenders may not update on the same date. Not sure if the financial decisions you’re making are hurting or helping your credit? Empower yourself by understanding the five factors that most influence your credit score:

1. Payment History

Your payment history is the most vital contributor to the health of your credit score. 35% of your credit score is based on payment history alone. Unfortunately, according to a recent WalletHub survey, 1 in 5 Americans will miss at least one credit card due date this year. Remember that just one missed payment can have a negative cascading effect on your credit score. The lower your credit score, the harder it will be to obtain credit and loans, and the more you’ll end up paying to have banks lend you money. 

What to do: The best thing you can do is pay your credit bill on time each month. There is no downside to paying off your entire balance every month or even more frequently. You might have heard the myth that carrying a small balance month to month will boost your score, but this won’t help and can actually end up hurting your score. 

What to avoid: As mentioned above, missing any payment is bad, and the more you miss the worse it gets. 

If you must: Even if you are only able to make the minimum required payment, you should do so on time to keep your credit score healthy.

2. Credit Utilization

The amount of credit you are using out of your total credit allowance is the second biggest contributing factor to your credit score: 30%. This is a crucial consideration when you are approved for a new credit card, or in cases where you are offered a credit increase.

What to do: It’s good practice to spend less than 30% of your total credit allowance.  For example, if your credit card limit is $10,000 use less than $3,000 of your credit limit at a time. If you know you need to spend more, get a credit increase (usually offered quickly to customers with high credit scores who reliably pay their balance off). 

What to avoid: Using more than 30% of your credit limit at a time. Remember that your limit is not the actual limit if you want to achieve a high credit score. 

If you must: If you find yourself using more than 30% of your credit limit each month, despite paying off the balance in full, you can request a credit limit increase to help reduce the total percentage of utilization. You can also try spacing out use of your credit card, or offsetting purchase totals with a debit card.

3. Length of Credit History

The amount of time you have held open credit accounts makes up 15% of your credit score. This one is straightforward and generally, the longer your credit history, the higher the score. Your length of history is based on the average length of history on all accounts. 

What to do: The age-old recommendation of keeping your oldest credit card open (why yes, I still have that old Victoria’s Secret card!). Maintain a small number of long term credit cards for the best results here. If you use credit wisely, adding your children as authorized users can begin to grow their length of credit history at a young age. Different credit card companies have different age and reporting requirements to the credit bureaus, so you will want to do your research beforehand. 

What to avoid: Closing all of your older credit card accounts, or continually swapping your cards for flashier promotions. These habits will harm your history if abused.

If you must: Sometimes it will be advantageous to upgrade your card, or take advantage of a promotion that serves your life (e.g., you get hired to a new job with lots of travel and want to earn airline or hotel points). It’s okay to close cards that are no longer serving you, but make sure the tradeoff is worth it in the long run. 

4. Mixture of Credit

The types of credit you have open, including- credit cards, student loans, mortgages, etc., makes up 10% of your credit score. In this area, credit bureaus are judging you on how well you manage having a range of credit lines open.

What to do: Over time, use credit effectively to purchase a home, car, and pay for college. Diversify your credit types in a thoughtful, intentional way (seeking advice from a financial advisor is a great idea for these decisions).

What to avoid: Too little credit or homogenous credit. Not having any lines of credit open is the worst thing you could do

If you must: This part of your score is tricky because it seems to relay the message that you need to have multiple types of credit lines open to have a good credit score. Remember that there is no rush for this one, and that it is only 10% of your total score. Focusing on payment history and credit utilization over diversification is a perfectly good decision if you don’t need other loans. 

5. Shopping for Credit

Lastly, the number of credit accounts you have recently opened through hard inquiries is the basis of 10% of your credit score. Too many hard inquiries can indicate risk of reliance on credit to the credit bureaus, thus decreasing your credit score. This is why your credit score takes a momentary “ding” when you open a new line of credit.

What to do: Spread out your purchases that require loans, and do not consistently open new credit cards. If you have a big purchasing year coming up, try to plan the cadence in advance (again, speak with a financial advisor to optimize this one!). 

What to avoid: Constantly open new lines of credit. This will result in credit score penalties in at least two areas.

If you must: Once again, since this factor only makes up 10% of your score, don’t worry too much if you do need to open a new account. Keep your focus on payment history and credit utilization, and do your best to space out loans Even if you can’t space things out, paying these loans or credit sources down on time and in full will have a much larger impact on your score.

Why is this important to me?

The entire purpose of growing a healthy credit score is to appear more attractive to lenders, and thus receive lower interest rate offerings when applying for credit. In fact, practicing efficient credit management in the present can pay dividends in the future. For example, let’s compare the following scenarios:

• Linda has a credit score of 720. She is purchasing a $1,000,000 home with 20% down and financing the remaining $800,000 through a mortgage over thirty years. She is offered a 2.717% interest rate. The total interest she will pay over the life of the loan is $370,706 with a monthly payment of $3,252.

• Brad has a credit score of 672. He is purchasing a $1,000,000 home with 20% down and financing the remaining $800,000 through a mortgage over thirty years. He is offered a 3.108% interest rate. The total interest he will pay over the life of the loan is  $431,059 with a monthly payment of $3,419.

Not only does Linda pay less in interest over time, her monthly payment is $167 less than Brad’s. If Linda invests her extra $167 over the same 30 year time period with an average annual return of 6%, she would have accumulated $162,743! 

Remember: Credit Health Is a Journey 

Even though I thought I was signing up to receive a coupon, my credit journey started the minute I left that Victoria's Secret. Just like regular health practices, mindfulness around credit will support your credit health journey. If you are just starting yours, or wondering whether you’re on track, here are a couple of places where you can begin: 

• Check your credit report for free on www.annualcreditreport.com. You can receive a free credit report from each bureau annually. If you space it out, you can review your credit report for free every four months. This is one of the only ways to check and see if you are a victim of identity theft.

• Sign up for an account on Credit Karma to monitor your credit score. Checking your own score is a soft inquiry and will not hurt your credit score, which is another common misconception. Using a credit score monitoring service can create awareness around your credit habits.

Opt out of those annoying pre-approved credit cards that come in the mail here. Don’t get me wrong, I love getting things in the mail; but this was one of the best things I have done for myself. Now when I see pieces in my mailbox, I am excited knowing that it is something from a friend or family member versus Discover or Citibank.

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Allison Cooley is an Associate Financial Planner at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. Allison focuses on the financial planning process, which brings client visions to life through their finances.