Credit Scores: Playing the game

If you’ve been following my posts, you probably realize I’m not very excited about debt.  Like most things I’ve ever wanted in life, a great credit score is something that I wanted for years and today don’t care to use very often.  I used to be all about getting the best interest rates, but today it’s about saving as much as I can to build wealth and realize my next big dream of owning a house I designed, on a good sized lot, away from people.  Well, far enough away that my Great Danes barking near the house won’t both my neighbors. 

Image from wsj.com

I learned a long time ago, building credit is a like a game.  It’s you against your creditors.  If you minimize your balances and carry almost no credit card debt, don’t open new accounts often and always pay on time, you will build a great score after several years with minimal interest paid, and you win.  If you’re impatient, run up your cards near or over their limits, and pay late, you’ll suffer financially and you lose on interest and fees and your score is lower. My advice is to never open a card account if you don’t have self-control.  I do admit having self-control with credit and the self-control to stick to a budget is pretty much the same thing. 

Throughout the years, I have found it much easier to spend on credit.  Every automobile I have purchased was on credit, although through each car acquisition, I had more down and a priority to pay off the load as fast as possible.  Now that I have enough saved to go out and buy a car with cash, I wouldn’t dream of parting with my hard-earned cash.  I’ll continue to enjoy my paid-for truck for years to come. 

What makes up your credit score?

Generally, there are five attributes that are counted in your credit score (listed in order of importance):

  • Payment history:  Do you pay on time? (35%)
  • Amounts owed:  How much of your credit lines are utilized? (30%)
  • Length of credit history:  How old is your oldest account and the average age accounts? (15%)
  • New credit:  How many new accounts do you have and can you manage them? Inquires? (10%)
  • Types of credit used:  What is the mix of cards, installment loans, and mortgages? (10%)

For more detail on what makes up the average credit score, check out this old CNBC post as it is still relevant today!

Each attribute is weighted more than the other because paying on time is more important than your credit mix, but it all adds up.  This is why you can build a decent score in as little as two years, but it will take seven or more, and take multiple loan types, to show you really know how to handle your debt load.

To have the best scores, you should rarely apply for new credit.  Once you find a great credit card, if you use one, stick with it.  Don’t try to open up new cards in search of better rewards.  Also, if you do open a new credit card, do not close the old one unless it has an annual fee.  Try to keep the card active by charging something every few months and paying it off before interest accrues.  I have a lot of good card accounts that I have obtained over the last 20 years, and keep open just because of age and the high limits help me ensure that even if I have a balance of $5,000 or so one month, my utilization is only around 2-3% of my total credit lines.  Always keep your purchases well below your limits.  If you keep getting close to the limit but pay it off before interest is due, apply for a credit line increase to help keep your score high.  Remember the credit is like having money.  The more you have, the less you need, and the more attractive you are as a borrower (until you borrow too much!).

As far as credit mix, having auto loans, student loans, and mortgages will all help your score.  Mortgages are considered “good debt”, which is debt that shows you are really responsible and making sound financial choices.  Also, it usually means you have equity and assets, which means if you don’t pay your creditors, they can try and put a claim towards your assets and gives them a little more assurance you will pay them back.  Most people who own homes are responsible and want to keep their home, therefore why credit card companies love homeowners.  If you have not assets, besides retirement assets, you are judgment proof and if you default, creditors will have no asset to try and claim, so all they get to do is put a bad mark on your credit and make it impossible for you to borrow until you clean up the mess or it ages off your report in a decade.

Earlier, I mentioned that I don’t strive to have the best credit cards or brag about my credit score.  As I’ve learned through the years, showing how much you can borrow through flaunting lavish houses and flashy cars is not the best use of credit.  Instead, build credit to get the best mortgage rate and know that insurance companies look at credit scores when setting auto premiums.  When you do borrow, do it strategically.  For instance, I really am tempted to pay down my mortgage, but my interest rate is so low, that I feel good having a beefy emergency fund and plunking a large amount of my paycheck into retirement.  Based on historical, long-term returns, I will come out ahead having my cash compounding at 8-12%, rather than at 3%, which is what I get while I pay off my mortgage. 

I do agree with Dave Ramsey that you can pay your house off quickly and then shove boat loads of cash into investments afterward, and probably come out about the same, and there is more risk involved with holding a mortgage, but I do insure against potential chaos with a large emergency fund. If I had kids depending on me, I might change my strategy, but being single, I feel pretty good about my risk levels. 

How do you feel about the use of credit scores in consumer lending?  Is it a fair practice?  Do you think that creditors should look at other factors besides a score? Leave me a comment! I’d love to hear from you.

I paid that balance off! Why do they keep charging me interest?

Recently, I went to pay off one of my older, higher-interest rate student loans, and was excited to finally have it at $0.  I paid the amount shown in the “balance” field on the FedLoan Serving website, so I thought the loan was history.  Wrong!  I went back the next week to see my beautiful $0 balance, and the site said I still owed $1.05.  I know, not very much, but still annoying!  If I would had left that $1.05 there and not paid attention, I could have seen interest or late fees and have it grow again.  That would be frustrating!

Photo credit: Alamy.com

The same can happen with your credit cards.  You might think you are paying off the balance every month, and you might be, but not within the contractual time period, known as the “grace period”.  The grace period is the time you have to pay your balance before interest accrues.  If you only pay the minimum by the due date, and then pay the remaining balance off before your statement cycle closes, you will suddenly have a balance applicable to interest.  This means you will be subject to an average daily balance interest rate computation.  So if you owed $1,000, paid $100 on the due date, and then the remainder on Day 29 of 30, your average daily balance would be closer to $1,000 and you would pay interest on that amount.

What’s worse is that if you keep paying your card off by the due date, you will still have average daily interest calculated and accrued on each statement.  Why?  Not paying your balance by the due date one time puts you into perpetual interest calculation.  To stop this from occurring, you need to pay your card off and not use it until the next statement cycle.  This will reset your grace period.

Also, be wary of offers to transfer a balance at a low rate on a card you are using for daily purchases and intend to pay off each month to avoid any fees.  If you do this, your payments will go towards the promotional balance and you could end up paying interest on all purchases until you pay it down to $0.  I suggest shopping for a card with a great balance transfer rate, at a site such as Bankrate or join Credit Karma, which can recommend the best cards based on your credit profile.  Keep your everyday spending card, which hopefully gives you rewards of some kind, separate from balance transfers that you are using to reduce interest and have a plan to pay off before the introductory period expires.  Strategize your balance transfers with the intention of fully eliminating revolving debt and not just to move it around.  With any kind of debt, you should always have a plan with an endgame designed with payoff as the goal.

On a related note, I found a great post on creditcardinsider.com in case you are interested in learning more about how credit card terms work.

Have you ever been frustrated with interest charges that you thought should be paid off and done?  Briefly share your story in the comments section on the blog page.  As always, thank you for reading!