Many Americans struggle to achieve financial well-being for many reasons. However, it’s never too late to pursue a 700+ credit score, a diversified savings and investment portfolio, and all the other hallmarks of financial empowerment and resilience!
In this first installment of ‘How to Get Ahead With Money’, we’re going to explore all things credit! How do you establish or rebuild good credit? How do you maintain good credit? Why is carrying a balance and using credit not such a bad thing after all? Why is it important to use your credit card responsibly, and what types of transactions should you avoid? Let’s find out!
In This Article
Credit is the ability to borrow funds in order to make purchases or access services and pay later. Creditors grant this credit based on their judgment that the borrower will successfully repay the borrowed amount. They typically charge interest each month, usually assessed as a percentage of the amount borrowed. These interest charges vary based on whether a loan is secured or unsecured with collateral, and a creditor’s judgment of the risk of the loan (the chances you’ll pay them back in full) based on data that they gather about your financial circumstances and history.
Some loans are lump sums that are then paid back in set monthly installments, such as mortgages or personal loans. Others are revolving lines of credit, where the borrower can access funds whenever they want up to a limit set by the borrower.
A secured loan is a loan that is secured by some form of collateral, such as a house, car, savings or investment accounts. If the borrower fails to pay the loan back, then the lender can take the collateral as recompense. Secured loans often feature lower interest rates than unsecured loans.
How Interest Works
Interest is the price you pay to borrow money (in addition to any upfront fees). When a loan is made, one must pay a percentage of the funds borrowed each month as a fee for the loan. The lender uses various common rates, known as benchmarks, as the foundation of the interest rates they offer. The lender then looks at the borrower’s credit and the type of loan they’re applying for. They use this information to calculate the interest rate you’ll be expected to pay for a loan .
What’s the prime rate?
The prime rate is the interest rate commercial banks charge to their most creditworthy corporate customers—basically, the best possible interest rate on the market. It is a common measure that banks use to determine what interest rates they’ll charge for loans. Variable interest rate loans often have their rate vary in lockstep with the prime rate.
Fixed vs Variable Interest Rates
There are two types of interest rates on loans: fixed and variable. A variable rate is a rate that is automatically adjusted up or down, usually monthly or quarterly, based on current interest rates on the market.
A fixed rate does not automatically vary based on market conditions. However, the term fixed rate doesn’t mean it’s fixed forever. It can still change with notice from the lender or under certain conditions.
For example, late payments on a credit card may result in an increase of the interest rate. Promotional interest rates on credit cards may have expiration dates or be contingent on certain criteria. It’s crucial that you read the fine print on any loan, credit card, or other credit arrangement you may make, no matter how tiny the type is!
What’s an APR?
Lenders calculate loan interest as an Annual Percentage Rate (APR). The APR is the amount of interest you would pay on your loan balance over an entire year, expressed as a percentage of the loan amount. This provides a standardized way to compare loans and understand how much you’ll pay in interest.
Credit Bureaus and Credit Scores
How do lenders evaluate the level of risk involved in offering you a loan? Through your credit file and credit score.
There are three credit bureaus in the United States: Experian, Equifax, and TransUnion. Each one maintains a credit file on every adult American who has ever applied for credit or engaged in a financial transaction reported to them. These transactions typically include:
- Rent and mortgage payments
- Medical bills
- Utility bills
- Credit card and loan bills
- Student loans
- Bankruptcies and tax liens
Lenders can pull these files when determining whether to make a loan to a consumer.
Federal law entitles every American to receive a free copy of their credit report from each of the three bureaus every year by visiting www.annualcreditreport.com. It’s important to do so, because the credit bureaus make mistakes. You may dispute any items on your credit report that you believe to be errors. The credit bureau then notifies the company or organization that placed the item on your credit report, who then must prove that the disputed item is your responsibility.
In addition to the credit bureaus, there are companies that provide a credit score based on your credit report. The most commonly known one is the Fair Isaac Corporation, or FICO® score.
Credit scores range from 300‒850. In general, anything over a 700 credit score is considered good credit, anything over a 600 credit score is considered average to below average credit, and anything below 600 is usually considered subprime credit.
FICO® generates your credit score by applying its proprietary formula to the information in your credit report. While the exact formula is a trade secret, most industry experts believe that it’s calculated with the following criteria, listed in order of most to least impact on your score:
- Paying bills on time: The single biggest factor in your credit score is your payment history. Making your payments on time is critical to a good credit score. A single payment 30 days or more late will stay on your credit report and affect your credit score for years.
- Credit utilization: The second factor they look at is the amount of credit you use on your open accounts. For example, if you have one credit card with a credit limit of $10,000 and your balance is $3,000, you’re using 30% of your credit, which is the maximum most experts recommend on revolving credit accounts.
- Average account age: Lenders want to work with consumers that have established credit histories and accounts, so the credit score considers the average length of your credit accounts. The longer you’ve had your credit accounts, the better. Many experts recommend leaving unused accounts open so they continue to contribute to your credit.
- Credit types: Your credit score will be higher if you have a diverse portfolio of credit types represented on your credit report. For example, all other things being equal, someone who only has credit cards on their report will have a lower score than someone who has credit cards, a mortgage, and a personal loan.
- Recent credit applications: Attempting to take out multiple loans in quick succession is a red flag for lenders, so multiple recent credit applications can have a negative effect on your credit. It’s usually best to not let a lender pull your credit until you’re satisfied they meet your needs in all other ways. It’s also recommended that you avoid any credit inquiries right before making a large purchase such as a house or a car, as even a slight change in your score can mean a big difference in your interest rate.
Why Is A 700 Credit Score (or Better) Important?
The higher your score, the more likely it is that a lender will not only extend you credit, but will do so on the most advantageous terms possible. If you’ve got excellent credit, banks are competing for you as a customer and will offer you their best interest rates. This is useful with credit cards and loans, but it’s especially useful when buying a home or a car.
A difference of 100 points on your credit score can mean a difference of hundreds of dollars a month on your mortgage payment, and potentially tens of thousands of dollars over the course of a mortgage. The difference is smaller but still significant even on a car loan. A higher credit score isn’t just about being approved or not; it saves you money.
And it’s not just loans. Even renters save money with better credit. When applying for an apartment or rental home, great credit can mean a lower deposit, and utilities often charge deposits for customers with subprime credit as well.
Establishing Credit and Credit Invisibility
One big problem for many people is credit invisibility. Credit scores, when they were first implemented, were touted as making credit decisions more fair and even-handed by basing decisions on data instead of personal relationships or other factors. However, to have a credit score, you must have a credit history.
You build credit by having and using credit. For recent immigrants, younger people, or people who just haven’t had a chance to build credit before, credit invisibility—or the inability to start borrowing because of a lack of credit history— is a major concern. It’s estimated that 26 million Americans fall into this category.
Credit not only impacts your ability to finance a home or a car, it can impact your ability to rent an apartment, get utilities turned on, get a cell phone, or many other things.
Building credit can be a challenge at first, but don’t despair! There’s a few solid options to build a foundation.
- Become a cosigner or authorized user on someone else’s credit account: If you have a family member or close friend with good credit and they’re willing to add you as an authorized user of their account, then you can begin building a credit history based on their card. It’s important to make sure the account owner is responsible with their credit card so you go from no credit to good credit instead of no credit to mediocre or poor credit.
- Open a secured credit card account: Secured credit cards are perfect for building or rebuilding credit. The basic principle is that you pay a deposit and receive a credit card that’s secured by that deposit. They usually set your credit limit at the amount of the deposit, and you have to pay the balance in full each month. This isn’t cheap; many cards require you to pay at least $500 as a deposit. However, you then have a $500 credit limit available, secured by that deposit. You can simply make everyday purchases and then pay them off each month. You’ll also want to read the fine print carefully. Some cards have annual fees or additional costs.
- Open a store credit account: Some retail stores offer their own credit cards. They typically carry high interest rates and aren’t as flexible since they can only be used for those stores. However, they’re often easier to qualify for, so they can help build credit in many cases.
- Credit boost products: Services and apps like Experian Boost give users credit for paying eligible utility and cell phone bills.
It’s not uncommon for people that have good credit to hit a series of challenges and see their credit score drop significantly. And it can seem like an overwhelming task to get your score back up again. The important thing to remember is that you CAN rebuild your credit, and that there’s no shame in stumbling as long as you get back up again.
A 700 credit score is a good goal for people trying to rebuild credit; there’s nothing stopping you from pushing on to 800, but 700 is attainable simply by changing habits and making smart credit decisions. How do you rebuild your credit? Here’s a few steps to follow.
All the items listed for building credit will also help you rebuild your credit as well.
- Check your credit report: The credit bureaus aren’t infallible. They rely on accurate information from other businesses to produce your credit report. While the burden of proof is on the reporting business to prove that the information they provided is accurate, the consumer must dispute the information before an item is reviewed. Fortunately, consumer protection laws are fairly robust in this regard: you can visit www.annualcreditreport.com for a free credit report once a year. You can dispute any item with the credit bureau; they then investigate it and if the reporting organization can’t prove its validity, the credit bureau removes the item. If you have multiple errors on your credit report, this can result in a huge swing upwards for your credit score!
- Pay Down Debt: If you’ve got a lot of debt, paying that down will not only help your credit score, it will help your eligibility for credit products in other ways. While income and total debt don’t directly affect your credit score (other than your credit utilization), lenders still consider these items when making a credit decision. And paying down total debt can not only help your credit utilization, it can help you manage your finances better overall. There’re a few options to look into if you’re trying to rebuild your credit and pay down a lot of debt:
- Credit Counseling: Most reputable, certified credit counselors work for nonprofit organizations and will work with you to build out a plan and manage your debt. The U.S. Department of Justice maintains a searchable list of approved credit counseling agencies; a reputable agency provides professional, specialized help to get out of debt.
- Debt Management Plan: One tool credit counselors can offer is a debt management plan, or DMP. A credit counselor negotiates with your creditors to lower your interest rates and monthly payments if possible and sets up a single monthly payment with the goal of paying off your debt in 3-5 years. These plans typically don’t include secured debt or student loans, but can be hugely beneficial for consumers with high credit card debt. One downside is that the cards included in the DMP are closed as part of the deal. You won’t be able to use those accounts to improve your credit utilization ratio or account age.
- Debt Consolidation: Taking out a debt consolidation loan can help reduce your monthly payments and interest without losing access to your credit card accounts. In some cases, qualifying consumers can also utilize balance transfer offers from a new credit card to pay down debt with lower interest for a period of time.
How Long Does It Take To Rebuild Credit?
There’s no set formula to calculate how quickly you can improve a credit score, and there are many variables that make even an estimate difficult.
How long do negative credit items remain on your credit report?
- Late and missed payments, judgments, and collections activity: Seven years.
- Bankruptcy: 7‒10 years.
- Paid tax liens: Seven years after the filing date.
- Unpaid tax liens: 10 years after the filing date.
Don’t let this discourage you! Since your credit score is weighted toward your most recent history, a focus on improving your credit will usually achieve good results in a reasonable timeframe. And maintaining good credit is much easier once you’ve rebuilt your credit, both because you get access to lower interest rates and because you’re able to leverage the lessons you’ve learned as you’ve grown toward financial empowerment!
Note: A tax lien is a legal claim against the assets of an individual that fails to pay their taxes.
Maintaining A 700 Credit Score (or Better!)
Knowing the factors considered in your credit score provides a road map to maintaining excellent credit. Once you’ve built or rebuilt your credit, here’s how to keep that score high.
- Make payments on time, every time: Many experts recommend setting up automatic payments to ensure you make at least the minimum payment each month on time. Even if you have inconsistent income and can’t always make the same payment, set up AutoPay for the minimum and then make an extra payment when you can.
- Always try to make more than the minimum payment: On most credit cards, the minimum payment only covers the interest in a given month, if that much. This is great for your flexibility; if you have a tight month, it’s easier to keep your account current. However, making the minimum payment each month will not pay down your balance and will incur more interest payments. Paying over the minimum helps knock down your principal so you save money in the long run.
- Only use what you need: A good rule of thumb for credit cards is to use 30 percent or less of your available credit limit. Since your credit score takes how much you use of your available credit into account, this helps keep your score high.
- Keep your accounts open: If you have accounts with no balance and no annual fee, keep them open! This helps maintain a long credit history since those accounts continue to be reported to the credit bureaus.
- Limit your applications: Only apply for credit you need and don’t apply for too many credit cards in a short span of time. This is especially important if you plan on applying for a mortgage or car loan in the near future.
- Check your credit report: Don’t forget you’re entitled to a free credit report every year! It’s important to check your report each year to make sure everything has been accurately reported and there aren’t any new errors.
- Develop a budget (and stick to it): Having a budget not only helps lessen your reliance on credit, it can help you use credit intelligently by knowing how much you can afford to pay toward your credit cards and other loans each month. Track your spending, set financial goals and develop a budget. By doing this, you can thoughtfully use credit to support your financial goals and include it as part of your overall financial strategy. Nerdwallet has a great rundown of online budgeting and tracking tools; there’s a variety of apps out there, so pick the one that works best for you!
- Communicate with your creditors: If you do have a rough month or two and can’t make a timely payment, reach out to your creditors. There may be ways they can help you avoid a negative impact on your credit score if you reach out in advance. Once you have good credit, a proactive approach can help you keep it that way so you don’t need to rebuild it again.
When To Use (& Not To Use!) Credit
Credit cards have some great benefits that make them an excellent choice for your purchases, but in some cases, a credit card may not be your best option. It all depends on your individual situation.
Everyday purchases: Many credit cards have rewards programs where customers get cash back or reward points for purchases. This makes credit cards a smart choice for everyday purchases; you can pay the balance off in full each month to avoid interest and still rack up rewards on the purchases you would make anyway.
Debt consolidation: Credit card offers often include a balance transfer offer, where you can transfer balances from other cards to a new card and receive a promotional rate as low as 0 percent for a period of time. This gives you the opportunity to consolidate other debts on your new card at a lower rate than you had. However, these offers work best when you’re disciplined enough to keep making big payments and knock the principal down, as the promotional rate is often for a limited period of time. Another thing to consider is that payments are usually allocated to the transfer first, which means anything you purchase with the new card will sit there accumulating interest at the purchase interest rate until you pay off the transfer. Read your terms and conditions carefully.
Online purchases: When making online purchases, a credit card has one big advantage over a debit card. You’re paying for the item with borrowed money and making a payment at the end of the month. Why does this matter? Simple. If you need to dispute a charge on a credit card, you won’t need to pay the charge until the dispute is over. You can still dispute a charge on your debit card, but since it debits your checking account, you may not have access to those funds while your dispute is in progress.
Major Projects: This makes sense for the same reason as it does for online purchases. Let’s say you have a home remodel project done. If the contractor did a terrible job, paying by check means you may not have the money to get it fixed. By using a credit card, you retain the right to dispute the charge if work is subpar or left undone.
Travel: Many credit cards carry anti-fraud protection, travel insurance, and other benefits. Also, just as with online purchases, the ability to dispute a charge without tying up your checking account funds can be advantageous, especially when traveling internationally. This makes credit cards a strong choice for travel expenses.
Cash advances: Many credit cards offer a cash advance option. However, read your terms and conditions carefully before using a cash advance. Cash advances often carry a higher interest rate than other types of credit card transactions. If you need cash for a project or an unexpected expense, a personal loan may be a less costly option for you.
Getting Ahead with Credit
Trying to build credit can be intimidating and trying to rebuild credit can be even more intimidating, but with reliable, straightforward information at your disposal, you are empowered to make it happen.. It’s never too late to rebuild your credit and reach for that 700 or better credit score, and once you’re there, good credit unlocks doors for you.
Stay tuned for our next How to Get Ahead with Money installment, in which we’ll do a deep dive into debt and debt management!
Results not guaranteed.