What is a credit score?
A credit score is a number that is assigned to you based on how well you pay your loan and credit card payments. If you pay your payments on time, your score will be higher. If you make your payments late (over 30 days past the due date), your score will be lower. The bank or financing company uses this score to determine whether a loan applicant will be able to obtain a loan for a car, house, etc. Not only does it dictate whether you will qualify for a loan, but it can also determine what interest rate you will pay on a loan. Let me give you some examples of three individuals applying for a vehicle loan.
Applicant #1: He is constantly 30-60 days late on his credit card. He has an unpaid medical bill and it’s been turned over to a collection agency. He also has a collection notice showing up on his credit report because he didn’t pay his electric bill. His credit score is 465.
Applicant #2: She has been late only ONCE over 30 days on her credit card. She is making the minimum payment due consistently only forgetting about it this one time. Her credit score is 675.
Applicant #3: He has never been late on his credit card, and in fact, pays off his full balance every month. Doing this consistently afforded him the opportunity to get a small loan through his bank which he has paid every month, on time and never late. His credit score is 765.
Credit scores range from 300-850. You can easily achieve a good credit score with very little credit and consistent responsibility. As you can see in the above examples, it doesn’t take a lot to make or break your credit score. If you start out responsibly, your score will begin high and stay there as long as you make your payments on time. If you begin with the poor habit of making late payments, your score will start out low and continue to decline if this practice continues.
How you begin is of utmost importance because of how difficult it is to raise a low score. It’s easy to lose a good credit score and much more difficult to raise the score once it gets to a low point. Once you are “dinged” with a 30-day late notice on a loan or credit card, your credit score declines quickly. A 675 score could plunge to 600 with only one missed payment. However, it may take 12 months of consistent, on-time payments just to get your score back up to 675. I know it sounds unfair, but that is just the way the scoring system works.
All banks are different but still operate in basically the same way around the same numbers. The make or break point in qualifying for a loan is around 625. If your credit score is a 625 then you may qualify for credit and if you are below 625 credit score you may not qualify for credit. The higher above the 625 thresholds your credit score is the more options you have. Let’s take another look at our three applicants.
Applicant #1: He cannot borrow money at a bank because of his low 465 credit score. What are his options? He may have to go to a high-interest finance company where rates may be as high as 36%. He may have to buy a lesser vehicle at a “Buy-Here-Pay-Here” lot. The interest rates at these establishments are even higher than finance companies. In both of these scenarios, he is paying a high amount of interest to the business (the lender) and paying less on the principal balance of his loan. By paying less on the principal balance, it takes him longer to pay off the loan. What is happening to his vehicle? It is worthless and less every day because it is getting older. He eventually owes more money on the loan than the car is worth. This is a vicious cycle that many people fall into and can’t get out of and something you want to avoid. This scenario happened because he had late payments and a low credit score and therefore, did not have any other options.
Applicant #2: She can borrow money at a bank but only with someone else signing the note with her. Since her credit score is 675 and below 700 she has to pay a higher interest rate because she is deemed a higher risk than someone with a 700+ credit score. She still qualified but instead of paying 4.9% on a vehicle loan, she had to pay 7.9%. The difference in these two interest rates amounts to hundreds possibly thousands of dollars over the life of the loan depending on how much she borrows and for how long. Again, just like applicant #1, she is paying more interest and less is going toward the balance of her car loan.
Applicant #3: He can borrow money at his bank without anyone signing with him. Since his credit score is in the 700’s, he is able to get the loan at 4.9% which allows him to pay his loan off quicker since less money is going towards interest. The lower interest rate allows more money to be directed toward the principal balance of his loan. Banks want his business.
This is the position you want to be in. Only by protecting your credit score can you get into a bargaining position. When you have a good (700+) to excellent (750+) credit score, banks want your business. When banks compete for your business, you have options, and having options means getting the best rate available. Having options offers you the freedom to be selective and gives you the greatest opportunity to succeed in the world of personal finances.
Credit Score Action Plan
For everyone: It is a good idea for everyone to apply for a free credit report at www.annualcreditreport.com. You can obtain one free report per year per agency. There are three major agencies; Experian, Equifax and Transunion. Your FREE report won’t give you a credit score but will give you the history of all your accounts. Review to make sure all information is accurate. If not, call the agency and dispute the inaccurate information.
If your situation is similar to Applicant #1, find the accounts on which you have had late payments. Start with the smallest and pay it in full as quickly as possible. Go to the next one and do the same. Continue with this plan until all debts are paid in full or up to date. As you continue this process your credit score will increase. This can be a long process, but it is necessary and will be worth it in the long run. Other ways to protect your credit score are:
- Protect your sensitive information. Only apply for new credit when needed. Avoid signing up for the “20% off first purchase” deals. Every time you give out your personal information it increases the chance of identity theft.
- Don’t co-sign a loan with anyone. If you do, make sure the payments are being made. Don’t just ask the person you signed with, check with the institution that made the loan. If one payment is late it will lower the scores drastically of both you and the one you signed for.
- If you have several cards but don’t use them, consider keeping them open as closed accounts can lower your score. This is almost a “Catch-22” area so make sure your score is high enough to take a modest hit in case you want to close some of the accounts.
Above all, be aware and take care of your personal and financial information. Once your credit is damaged, it is very difficult to repair. I wish you the best in your quest of obtaining the highest credit score possible. It is a goal worth pursuing.