“People who recognize that money won’t buy happiness are still willing to see if credit cards will do the trick.”
–E. C. MCKENZIE
About credit cards:
“You can’t go through life borrowing money at those (high) rates and be better off.”
–Warren Buffett
THE IMPORTANCE OF A GOOD CREDIT SCORE
Maintaining and raising your credit score is an excellent goal. A good score means you can get a relatively inexpensive loan if you want to buy a house, purchase a car, or borrow for anything else. You can apply for and receive a credit card.
And, if you have a good credit score, that means you are a good manager of your money, too, right?
Well, usually.
But there are exceptions. You can infer some of the pitfalls from the quotes I included above. Your credit score is only one of the things you should consider. That is what we will discuss in this post.
FIRST, SOME BACKGROUND: CREDIT REPORTING AGENCIES—WHAT THEY DO
Think of them as the first line of defense for lenders.
They give you a credit score that lenders use to help evaluate you. A credit score is a numerical rating. The higher the number, the better. A number around 800 is close to perfect, with lower numbers being less favorable.
To come up with a score, they analyze their data and assess the risk the lender takes by lending to you.
And in general, they do an excellent job evaluating your potential to repay a loan.
However, reporting agencies don’t always have complete information. For instance, they typically know your approximate income after applying for and getting a credit card–but little about your savings rate, job security, or savings. Those items get disclosed and analyzed when you get into the formal loan process–like when buying a house.
So they make a first judgment based chiefly on how reliably you have paid back previous loans—not on your saving and (non-debt) spending habits.
HOW DO CREDIT AGENCIES COME UP WITH YOUR CREDIT SCORE?
According to Experian, here are the primary factors that make up your credit score:
- Payment history. Lenders want to be paid back and paid on time. So payment history accounts for about 35% of the rating you receive. And that makes complete sense. So far, so good.
- Amounts owed. Your credit use ratio needs to be low. It is calculated by dividing the total of the revolving credit you currently use by the sum of all your revolving credit limits. Put another way, how close are you to being maxed out on all of your credit cards or other debt? The higher the use, the more risk to the lender. Lenders are negative toward those who use more than 30% of their available credit. Under 10% use is considered best. This factor accounts for 30% of your rating.
- Credit history length. The length you’ve held credit makes up 15% of your rating. So having a history and knowing your track record removes some perceived risk for lenders. But that fact often works against younger borrowers.
- Debt Mix. Lenders like it if you have a variety of loans. People with high credit scores usually have a wide variety of debt types. For instance, they might have an auto loan, credit card, student debt, home loan, or other debt. The more diversity, the better. This factor represents about 10% of the overall score.
- New credit—inquiries or loans. Lenders don’t like it If you shop around a lot for debt. If you have opened many new accounts and allowed potential lenders to make “hard inquiries” (i.e., to check your credit score formally), that can be a negative because it indicates unreliability. This factor is about 10% of the total score.
SO, WHAT IS WRONG WITH THE CREDIT SCORE RATING PROCESS?
Nothing. But getting a high score does not necessarily reward the financial behavior that is best for you. Instead, a high credit score indicates that you are an excellent candidate to repay a loan. Those are two different things. In the subsections that follow, you can see why.
Here are some concerns to consider.
REASON ONE: YOU SHOULD PAY OFF YOUR CREDIT CARD EACH MONTH—BUT YOUR CREDIT SCORE DOES NOT ALWAYS REWARD THAT
Don’t carry a balance if you have a choice.
Experts I know believe you should entirely pay off your monthly credit card balance. However, NONE thinks you should carry a balance. The reason? It is the most expensive debt you can have, sometimes topping 15-25 percent interest per year. So pay off your balances every month. Please.
The problem with trusting your credit rating alone for feedback is that you can maintain a high credit score even if you carry a small amount of extremely costly credit card debt. A high rating will not expose a wasteful and expensive spending habit if the problem is relatively small.
REASON TWO: HIGH ONE-TIME CREDIT CARD CHARGES CAN HURT YOUR CREDIT SCORE TEMPORARILY, EVEN IF CHARGING IS YOUR BEST DECISION
For instance, you might charge a significant temporary expense because some cards rebate part of the cost back to you—so it pays to charge the cost since you can get 2% or more back in cash. And that adds up. See here.
Moreover, you may make a one-time charge to get card benefits. See here for how credit card trip insurance saved me.
But a massive bill on a credit card will also cause a temporary dip in your credit rating. For example, I recently charged an expensive trip on a card. That caused my credit rating to go down almost 50 points. However, I have already saved for the trip, so next month, my rating will start to rise again after I pay it all back. In the meantime, I like the cash back bonus the card gives me when I pay off the balance.
REASON THREE: PAYING OFF DEBT OR REDUCING YOUR NUMBER OF ACCOUNTS IS NOT ALWAYS REWARDED WITH A BETTER SCORE
You are rewarded with a higher credit score for having a lot of different types of loans and for keeping your total use of credit cards under 10% of the total amount you can borrow.
So, if you have a very limited credit mix, you are downgraded. That can happen if you close an account too.
And if you want to stay under 10% of your borrowing limits, the easiest way is to apply for many credit cards or other revolving debt.
That can lead to problems.
For example, if you usually charge $5,000 per month, to stay under a 10% ratio, you need to apply for and get lines of credit that exceed $50,000. In either case, the rating system incentivizes you to keep numerous types of loans or to open new lines of credit.
But that is not necessarily your best financial decision. For example, I no longer have either a house or car loan. And so, I am undiversified–and have things paid off. That saves money but lowers my score.
Moreover, opening those new lines of credit creates a temptation to use them. It is a bit like asking a dieter to keep five quarts of ice cream in the freezer—and not to eat any.
REASON FOUR: NUMEROUS CREDIT INQUIRIES ARE TEMPORARILY COUNTED AGAINST YOU, EVEN IF YOU SAVE MONEY BY BY GETTING NEW LOANS
Sometimes you must shop around for a better loan. And depending, that often means a lot of “hard” loan inquiries.
For instance, we shopped for real estate refinance options during the pandemic. There was a period when it was advantageous to refinance my rental properties every few months. Rates were falling quickly, and refinancing made sense even if it was frequent.
That means we sometimes went to the “hard” inquiry stage with multiple lenders, where potential creditors request a complete credit report. But, raters, working under the theory that a lot of shopping and “hard” inquiries made me potentially unreliable, caused temporary downgrades to my credit scores.
I was trying to save money. And I did. But I did not get rewarded with a higher score.
With the successful refinancing, we cut our monthly bills—and cut them by a lot, so the temporary credit score dip was well worth it.
SOME CONCLUSIONS
Try to educate yourself about credit and the factors that affect your credit score. High credit scores are nice but sometimes come with a cost to your overall finances.
Instead, do what is best for you and your future.
Disclaimer: consult with a financial fiduciary before taking any steps outlined here. Not all advice may be suitable for your circumstances or investment style.
Photo Credit: Pine Watt
License: Unsplash