Know Where You Are Today
In my article titled Fix Your Finances, I outlined a variety of things that are related to the health of your financial being. This article is Part 1 in a series that will get into more details of items covered in my first post so that you can get started on improving your financial health. The very first thing to do when trying to better yourself financially is to discover the true state of your current finances. In this article, I will offer ideas on how to do that.
Credit Scores and Reports
The single most important aspect of your financial health is understanding how you are seen by others. There are three major credit reporting agencies that companies will rely on when they are evaluating doing business with you. These companies are Equifax, TransUnion, and Experian.
Your Credit Score is used by many different companies when you do business with them. Insurance carriers use your credit score as part of their rating system to determine how much to charge you for coverage. Financial agencies use your credit score to determine whether or not to extend you credit, how much to offer, and at what rate of interest. Companies that offer contracted services (think: Mobile Phone service providers) will use your credit score to determine whether they may require deposits or pre-payments on your account in order to maintain cellular services. Landlords may use your credit score as part of how they determine whether or not to rent to you and how much of a deposit to require. In short, your credit score is a very important part of how much you pay for various things that you need.
Your Credit Report is the primary source of input used to calculate your Credit Score. Since credit reports can be subtly different from one agency to the next, this accounts for why your credit score is sometimes slightly different from one agency to the next.
The first step to take when getting started on improving financial health is to get a free copy of one of your credit reports. Pick any of the three agencies, log on to their web site, create an account, and request and download a free copy of your report. Set up a calendar reminder to do the same thing with one of the two remaining agencies in four months, the last agency in eight months, and then repeat this process every single year.
Understand Your Credit Report
Once you have a copy of your credit report, look it over carefully. The report is divided into sections such as: Payment History, Credit Usage, Credit History / Age, Credit Mix, etc. The key thing to do with each category is to understand how it impacts your score.
Payment History has a high impact which means that good and bad marks here make it into your score quickly. If your payment history has been very good for a long time, and then you miss a payment or two on a loan, the impact to your credit score will happen quickly.
Payment History will also have a high impact because it accounts for 35% of your total score calculation. This section of your credit report needs to be keep as clean as possible at all times.
Amount of Debt / Credit Usage is another area that has high impact. For credit cards, have a goal of using no more than 30% of the total amount of credit at any one time for every single card. Once each card is below 30%, the next goal would be to get your TOTAL credit usage below 10%.
Derogatory / Negative Remarks will be where any information from a creditor will appear that reflects things like missed payments, defaults, charge-off’s, etc. This section can also contain items that come from Public Records documents like tax liens. If your credit report contains any derogatory comments, do whatever you can to get them removed either by requesting removal for items that are inaccurate or correcting problems with things like liens and missed payments.
Credit Age / History has a more moderate level of impact on your credit score. Largely, this section is looking at the age of your accounts to know how long your oldest account has been open and then averaging out the age of all of your accounts.
Payment History has a large impact on your score, so you need to keep this area completely clean. That means you need to make your payments ON TIME. 100% on-time payments in the goal, 99% is acceptable, but 98% or less and your score starts to go down quickly.
Before you dismiss this thinking that 98% is still a high number, considering this as an example – Let’s assume that you have five different accounts (four credit cards and a loan) that you have had for two years and these are the only accounts you have. Over the course of two years, you will have 120 payments that may have been needed (if you had no balance, then no payment would be necessary). Missed payments are bad, everything else is good. All it takes is THREE missed payments out of the total of 120 to drop your score down below 98% and put you “in the red” in terms of quality.
Suggestion: Don’t miss payment due dates – make sure your payments are being recorded on time.
Amount of Debt / Credit Usage needs to be an area of scrutiny and focus. Improvements here will help a lot, but they will likely take time if you are carrying balances on your credit cards. You need to find ways to stop certain spending and use that to pay down your balances. If you search for “snowball method”, you should find a number of resources that will tell you about how to identify ways to pay your debt down and then pay it completely off. I went from carrying about 30% of my available credit in credit card debt every month to none by focusing my “extra cash” each month on one card. As I would get a card paid off, my extra cash would increase (because I no longer had a liability to that paid off card) and I would go after another one. Getting the first one paid off is often the hardest, but the feeling you get when you achieve it makes you work even harder for the next ones.
The most important piece of attacking the process of paying down debt is to have a plan that will work for you. Many resources will tell you to go after a certain account first based on one specific variable (lowest balance, highest interest). The reality is that you may need to strike a balance between low balances and high interest based on calculating the actual financial cost of maintaining that balance.
Suggestion: Pay down balances. Not only will you improve your credit score, but you will also reduce your financial burden by not spending so much money to maintain balances.
Derogatory / Negative Remarks will bring your score down, so you need to be sure that there is no incorrect or false information present. If you find an entry that you are unsure of, reach out to the creditor that placed it there to have a discussion with them as to why they did so. If the entry was an error on their part, they may be able to write in and get it removed. If there is an entry that is false and you can’t get the original author to remove it, you may be able to petition the reporting agency to remove it if you are able to provide written documentation as to why it’s false.
Suggestion: Request removal of any remarks that should not be present, but be sure to understand what remarks are actually able to be removed.
Credit Age / History will increase for you organically as you maintain your open accounts. While there is absolutely nothing that you can do proactively to improve this number, there are ways you can cause this number to get worse. The most straight-forward thing you can do is to keep your oldest accounts open. If you are thinking about getting rid of a credit card, be sure that you are not closing your oldest account unless you absolutely have to because the impact to you will be doubly bad – you will decrease your average credit age and you will also reduce your total available credit.
Suggestion: Don’t close your oldest credit cards as these bolster your average credit age. Make a small purchase once every six months on a card with no balance and pay it off to keep the card active.
One area that I haven’t called out until now is that of what is known as Inquiries. Whenever someone wants to look at your credit report/score, they have to make an inquiry. There are two kinds of inquiries that could occur – hard and soft.
When you apply for credit of any form, there will be a hard inquiry into your credit report. The inquiry is associated to a specific request for credit and will remain on your credit report for somewhere around two years. The older they are, the less they will impact your credit score.
Soft inquiries are NOT associated to a specific request for credit and have no impact on your score. You can not dispute them and really only show up for your own awareness. An employer may request a copy of your credit report before offering you a job – this would show up as a soft inquiry.
Suggestion: Apply for credit ONLY when you need it and keep the number of hard inquiries to an absolute minimum. Store credit cards are seldom worth having, so don’t fall into the trap of impacting your credit score to “Save 10%” on a current purchase.
Subscribe to the blog so you know when upcoming articles are published!
Good writeup on credit, Mark. Especially on never closing cards since it’s not obvious that you’ll lose that credit history, that’s something I wish I knew earlier, but fortunately, I made only made that mistake once. Now I do as you suggest and keep every card forever but make sure I make a small charge every couple of months to keep them open.
There really is a lot to know and understand about all of this stuff. I am by no means a financial expert, but I have learned a lot about all of this over the decade (especially in the last few years) and am sharing bits of it in the hopes that others will find it helpful as well.