Why Credit Matters And The Best Advice That Will Make Credit Work For You

My first exposure to credit was in college. Each week, I got offers in the mail to open a credit card. I didn’t understand the importance of credit then, so I didn’t accept any offers. Fast forward to renting my first apartment after graduation. Every apartment building asked for my credit history. I had nothing to show. They were not convinced by my declaration that I would pay my rent. 

I had to get a co-signer for my lease. That same week, I applied for a credit card and was rejected. I was crushed. I applied for a secured credit card, was approved, and was finally on my way to making credit work for me. Since then, I have maintained a credit score of 750 to 829. I have raised my credit limit to $70K across 3 credit cards and bought a house. I pay for vacations using credit card points and use benefits like rental car insurance and fraud protection. In this article, I share my best advice to make credit work for you. Before that, let’s talk about why credit matters and how credit scores at calculated.

Related article: The Truth About Credit And 17 Things To Do Now That Will Actually Improve Your Credit Score

 

Why credit matters

Credit affects most aspects of life in the US. Your credit history affects the options available for significant life moments such as:

• Paying for school – Federal student loan programs with no credit checks target undergrads and often have annual or lifetime limits. If you are a grad student, an international student, or need more than the public loan limits, you will need a private loan. Most private loans require credit checks. Some private loans are available if you have bad credit or no credit. But these loans come with higher interest rates and less desirable terms. With a good credit score, you expand your options for paying for school.
• Renting an apartment – Apartment buildings and most landlords require a credit check. It is not enough to have money to pay rent and your security deposit. Landlords want information about whether you pay back money over time. A good credit score builds confidence that you will honor your lease terms.
• Leasing or buying a car – Your credit score affects your options for buying or leasing a car. Leasing means you rent the car by paying a monthly fee – you will not own it unless you pick a “lease to own” option. Buying a car means you will own the car outright once you complete all your monthly payments. Your credit score will affect the interest rates and monthly lease or car loan payments.
• Buying a home – Are you ready to buy a home? This is often the most significant financial purchase for most Americans. You can put yourself in the best position possible by improving your credit score before going house shopping. Your credit score is one of the most important factors for determining your mortgage eligibility and interest rate.
• Applying for a personal loan – Do you need a loan to consolidate debt or to cover an unexpected expense? Your credit score will affect the options available to you and your interest rate.

 

What is a credit score, and how is it calculated

Your credit score is a numerical representation of your creditworthiness. It usually ranges from 300 to 850. Financial institutions use credit scores to determine how likely you are to repay a loan based on your history.

Your score is based on credit reports from credit bureaus such as Experian, TransUnion, and Equifax. 

There are many credit scores, but your FICO credit score is the most widely used one. Most people mean FICO when they say credit score. Some financial institutions also use VantageScore, created by the three major credit bureaus.

Both scoring systems update their models or create specialized scores for different types of loans (e.g., car loan vs. mortgage). This means you have more than one credit score. You will see different credit scores across financial institutions based on which scoring model they use.

Don’t worry about this. You will have good credit across scoring models if you have good financial habits. As you’ll see shortly, paying your bills on time, keeping credit use low, and having a long credit history matter most in calculating your credit score. These 3 criteria account for ~80% of your credit score, whether FICO or VantageScore.

How is your FICO credit score calculated

Your FICO credit score ranges from 300 to 850 as follows:

• Poor: 300-579
• Fair: 580-669
• Good: 670-739
• Very good: 740-799
• Excellent: 800-850

The most widely used FICO scoring model is FICO 8 (although some mortgage lenders prefer FICO 5). Your FICO 8 credit score is calculated based on the following factors:

1. Payment history (35%) – The most important factor in your FICO score is your payment history. How often have you paid your bills on time? How late were you if you missed a payment? Do you have unpaid bills that have been sent to collections? Have you declared bankruptcy, had a car repossessed, or had a house foreclosed? Lenders believe your past behavior, especially your recent past, is a good predictor of how you will act in the future.
2. Amount owed (30%) – Lenders like to see that you do not use all the credit available to you. This factor monitors your credit utilization ratio – how much you use out of your available credit. The lower the ratio, the better. You want to keep your credit utilization ratio below 30% and, ideally, under 10%. For example, if you have a credit card with a $10,000 limit, spend less than $1,000 (10%) and, at most, $3,000 (30% utilization ratio).
3. Age of credit (15%) – How long is your credit history? Your oldest account, newest account, and the average of all your accounts matter for this factor. The older your credit history, the higher your credit score.
4. New credit (10%) – Lenders don’t like to see many new applications for credit in a short time. The exception to this is if you are rate shopping. For instance, if you compare rates across multiple financial institutions for a car loan or mortgage, lenders will treat the multiple applications within the same segment as one.
5. Type of credit (10%) – This factor looks at the different types of credit you have, e.g., credit card, mortgage, car loan, etc. Having experience with different types of credit helps your score. That said, do not feel the need to get a variety of credit if you do not need it. You can have a high credit score even with only one type of credit in your report.

How is your VantageScore calculated

Your VantageScore ranges from 300 to 850 as follows:

• Subprime: 300-600
• Near prime: 601-660
• Prime: 661-780
• Superprime: 781-850

The best-known VantageScore model is VantageScore 3. It is calculated based on the following factors:

1. Payment history (40%) – Similar to FICO, the most important factor in your VantageScore is whether you pay your bills on time. If you miss a payment, pay as soon as possible, even if you only pay the minimum. Taking a long time to make a late payment and having many late payments lowers your score more.
2. Age and type of credit (21%) – This factor tracks how long you have been using credit and the different types of credit you use. Similar to FICO, the longer you use credit and the more types of credit you use, the better your score. VantageScore thinks of credit types as either (1) revolving debt, where you have a limit (e.g., credit cards), or (2) installment debt, where you make a fixed or variable monthly payment (e.g., mortgage and car loans).
3. Credit utilization (20%) – This factor matches your FICO score’s “Amount owed.” Keep your credit utilization ratio at most at 30% and, ideally, below 10%. Using too much of your available credit makes financial institutions think you spend more than you can afford. If you need to spend more than 30% of your limit in any billing cycle, pay off your balance early – before your billing cycle ends. Most credit cards report your balance once a month to the credit bureaus, and it’s usually reported after your monthly billing cycle ends.  
4. Total balances (11%) – This factor looks at the total balance across all your accounts. It includes current as well as delinquent accounts.
5. Recent credit (5%) – This corresponds to the “New credit” factor in your FICO score. Applying for too many new credit accounts in a short time outside of rate shopping is a red flag.
6. Available credit (3%) – This factor looks at how much credit you have available on your revolving credit accounts – typically credit card accounts.

 

 

10 Of The Best Pieces Of Advice To Make Credit Work For You

We live in a credit-based society. If credit will be a part of your life, why not use it to your advantage. Here are some ways you can use credit to benefit you:

1) Reframe how you think about credit

Only borrow what you can afford, especially with credit cards. Credit card debt is one of the most expensive kinds of debt. When the government borrows money, it pays 1-5% annually to borrow money. Credit cards charge 16% to 25% annually when you borrow money. 

2) Use credit to buy vs. rent

Most people can’t afford to pay for a car or a house in one go. As such, we use credit. This is great as long you stay within your means and only buy a car or home you can afford. You can use credit to pay over time while enjoying the house or car before it’s fully paid for. 

3) Get rewards when you spend

You can pay for travel, shopping, and entertainment with credit card points. Some credit cards offer other benefits like preferential access, discounts, and fraud protection. Figure out what you spend on and choose the card that gives you the most benefits when you spend. For example, you can get a cash-back credit card with 5x points on groceries if you cook a lot or get one with 5x points on restaurants if you eat out often. I use credit cards for all my spending to get as many points as possible while ensuring I only spend on what I can afford to pay off in full at the end of the month.

4) Take advantage of protections

Credit cards offer many protections, such as fraud protection and rental car insurance. For example, suppose you buy a concert ticket, and get to the venue but are not let in (this happened to me just last year). You can dispute the transaction, and your credit card company will refund you the amount while they investigate the dispute. I use my credit card for all transactions, so I quickly get my money back if something goes wrong. Check out the benefits section of your credit card to see what other protections you get.

5) Keep debt manageable

If you need a loan to buy a car or a house, decide how much you can afford and stick to it. Even if you get approved for more than you expected, stay within your means to keep up with monthly payments and unexpected expenses.

Although some experts advise spending less than 30% of your gross monthly salary (your salary before tax) on housing and less than 10-15% on car payments, these are general guidelines and don’t take into account your situation. If you can spend 10% of your gross monthly salary on housing, do so. If you live in an expensive city and it’s impossible to find an apartment that costs 30% of your gross monthly pay, then don’t beat yourself up for not sticking to this rule.

Remember our maxim, “Pay yourself first”. This means save first before you spend. If you keep debt manageable, you can reduce your spending and save money to deal with unexpected emergencies. For example, imagine you bought your car in 2018 and have just finished paying it off. You can keep using that car for as long as it works. Now, you can save the 10-15% you were spending on car payments instead of upgrading to a newer model and restarting car payments. You can use the 10-15% to create or shore up your emergency savings fund.

Decide how much you can afford and stick to it. Don’t blindly follow general guidelines. If you can spend less on debt, do so. It frees up money to save and invest.

6) Automate your payments

Making payments on time is the most significant contributor to your credit score. Automate your payments so you never miss a payment. If you don’t feel comfortable automating your payment, set a monthly reminder instead. Set a calendar reminder or an alarm on your phone for several days before your payment is due. Make your payment once you see your reminder – you may forget if you put it off.

7) Compare rates from 3-5 financial institutions 

You want to minimize how much you pay in interest. Get rate quotes from 3 to 5 institutions before settling on a mortgage. Credit bureaus understand this and will not penalize you if you apply for a mortgage from multiple financial institutions within 14 to 45 days. The number of days depends on the credit scoring model used. Since you don’t always know your financial institution’s credit scoring model, finish your rate shopping within 14 days. 

8) Get a travel credit card and pay zero fees on foreign transactions

I travel a lot. When I used my debit card abroad, I returned to a long list of foreign transaction fees on my bank statement. Now I use a travel credit card with zero foreign transaction fees. Plus, the currency conversion rate on my card is usually better than what I see offered in airports. Some travel credit cards also come with Priority Pass, which gives you free access to select airport lounges. This is my favorite credit card perk. I would never pay for lounge access, but I love having it free from my credit card. I can leave my luggage by my seat in the lounge, grab food, or nap in a comfortable chair.

9) Check what discounts or offers are available each month

Some credit cards vary the monthly offers or cash-back rewards you can get. At least once a month, scan the available offers and see what you can use. For example, one of my credit cards offers a free annual subscription to Lyft Plus. Another offers limited-time discounts on online shopping from popular stores such as Macy’s and Overstock.com. Scroll through your credit card offers – you may be surprised by the discounts available. You can also get priority access to buying concert tickets or special dining offers.

10) If you have multiple credit cards, use each for what it does best

Credit cards have different rewards. If you want to maximize your benefits from credit cards, you can match your spending to the rewards offered. For example, I have one credit card that I always use to pay for travel because I get 10x points on travel, zero foreign transaction fees, and free trip cancellation and interruption insurance. I have another card I always use to pay for groceries, as I get 6% cash back at supermarkets.