This is the tenth day in our 31-Day Money Challenge. Over 31 days we’ll publish 31 podcasts, each designed to help you move closer to financial freedom. Yesterday I answered reader questions on everything from timeshares to social security. In today’s podcast, we look at the importance of credit scores and how they are calculated.
Sponsors: The 31-Day Money Podcast is sponsored by Betterment and Personal Capital. Betterment and Personal Capital are two tools you can use to make investing easier, less expensive, and more effective.
Listen to this podcast episode:
- How important is your credit score?
- Learn how a good credit score can save you $90,000 or more over the life of a mortgage.
- How are credit scores calculated?
- Payment history (35%)
- Credit utilization (30%)
- Inquiries (10%)
- Length of credit history (15%)
- Types of credit used (10%)
- Why your income doesn't affect your score.
- How can you monitor your score for free?
In this episode I mention the following resources:
- myFICO Mortgage Calculator
- Interview of FICO credit expert Tom Quinn
- myFICO Score Watch
- Credit Sesame
- Credit Karma
Transcript of Podcast
Now today we're going to be turning to credit scores. I'm going to cover three basic questions about credit.
One, how important is your credit score. Two, how are credit scores calculated. Three, how you can monitor your score for free. Tomorrow we’re going to have on the show Maxine Sweet who is the credit expert at Experian, one of the three major credit bureaus. Kind of a one-two punch here in two days we’re going to knock out credit scores. In some ways I almost hate to have to talk about credit scores, with all the things in the world, all the things going on in our lives it’s one more thing we have to worry about. I can remember back in the day when we didn’t worry about credit scores because we didn’t know what they were. My wife and I bought our first home in 1993. There was no way to access your credit score like there is today. I had no idea what my credit score was, we just applied for the loan. Today things I guess have changed, the reality is your credit score can have a huge impact on your finances. We’ll cover credit scores today and tomorrow.
The other thing we are going to do today, a little bit different than in past podcasts. I’m going to answer a reader question and I’m going to cover a news item. I’m kind of experimenting a bit with this approach but I’m thinking rather than holding reader questions and perhaps having an entire show just on Q&A’s. I’m going to answer a reader question if not every episode, almost every episode of the podcast. Then if there’s a news item that I think is interesting, I’m going to cover that at the beginning of each show as well. Today we have one of each, so we’ll do that at the start of the show before we turn the credit scores.
Before we do all of that though, a quick shout-out to our sponsors. Personal Capital is a free online tool that allows you to aggregate all of your investments into one place. You can see their performance very easily. You can look at your asset allocation across all of your accounts, retirement and non-retirement. You can also see how much your investments are costing you. You can check it out at personalcapital.com.
Our second sponsor for this 31-Day Money Challenge is Betterment. Betterment is an online platform that invests your money for you. You just pick the percentage of stocks and the percentage of bonds that you want and Betterment does the rest investing your funds in a series of low cost ETF’s. They rebalance your investments for you and they also automatically reinvest your dividends. You can check out Betterment at betterment.com.
Our reader question today and actually the news item go hand and hand. Let me start with the reader question it comes from Julianne. She writes, "So blessed I found your site, love the podcast. Short, concise and so educational. What about single income households, limited money coming in, can we still put these and other tips in place?"
What a great question. It really underscores a challenge for me as I write for the blog Doughroller and I produce these podcasts. So many people reading and listening come from varying backgrounds and varying financial situations. Some folks are just starting out while others are in the middle of retirement. Some are perhaps making a modest income while others are making hundreds of thousands of dollars a year. We each have different struggles we're each in different situations. So how do you create podcasts and blog posts and whatnot that can help a wide range of people? I try to do that a couple of ways. One is by obviously covering a lot of different topics. Everything from investing, to mortgages, to debt, to budgeting. Really, at the heart of Julianne's question I think is this. The basic principles of personal finance and investing, do not change based on your income. The way in which someone should invest their money in my view, is the same whether you make $25,000 a year or two $250,000 a year. Whether you should budget is the same regardless of how much you make. Some might think, "Oh, golly if I make $250,000 a year I don't need to budget." I don't agree with that. I think everyone needs to spend their money consciously. The only way you can do that is in some form of budgeting.
If you listened to the budgeting podcast of 31-Day Money Challenge you know my belief that there is no one right way to budget. There are a lot of different ways and they can be effective for you but regardless of your income you should know where your money is going. Even today’s podcast about credit scores, credit scores don’t depend on income. Someone making $25,000 a year could have a higher credit score than someone making $250,000 a year. Answer to Julianne’s question, yes, I think and I hope that the tips and resources that I mention in this podcast or on my blog can help you regardless of where you are with your finances.
That kind of dovetails into the news item that I want to talk about today before we get to credit scores. It’s an article I saw on CNN written by Emily Jane Fox. The title of the article is, Millennials Turn Up Heat Against Low Wages. There’s a picture of folks protesting low wages. I guess they make minimum wage at fast food restaurants. If you follow the news on this item or this issue you know that there’ve been a lot of protests. But what caught my attention was actually the first two sentences of the article where the reporter writes the following... “Stuck in low wage or part time jobs with mountains of student loans to pay off. The generation that came of age in the new millennium finds itself in a hopeless situation. Despite being better educated than previous generations, many young people are shut out of the middle class with no roadmap of how to get there.”
I started thinking about that, well it's one thing to feel stuck and it's one thing to feel hopeless. But do you really believe you are? I think just about all of us at one time or another have felt hopeless and stuck in some situation, whether it's trying to improve your job and your income. Or saving an emergency fund, or buying your first home, or maxing out your 401k. Or heck, just even saving it all for your retirement.
We may have felt stuck and hopeless in other situations beyond finance too, whether it's in relation to our health or perhaps relationships. It's one thing to feel stuck or helpless though. It's another thing to truly believe that you are. I think this is more than just a semantic difference. It really matters, because if you really believe you're stuck and hopeless I think you'll act one way. If you say, "I may feel stuck or hopeless but I know deep down I'm not." I think you'll behave a different way. When I think about this article, just the fact that these folks are protesting tells me that while they may feel stuck and hopeless, they may be frustrated and even angry. I think they don't really believe that they are, otherwise why protest? If your situation is hopeless what's the point of protesting? I think they're protesting because they think it'll help their situation.
My point here isn't about minimum wage and the debate there should it be raised or not. It goes much further than that. It's about our own attitudes towards our situation. I think if we can see ourselves as able to improve our situation, we may feel hopeless but if we don't actually believe we're hopeless, I think it will motivate us to start asking questions, "What can I do to improve my situation? Do I need to improve my education or my training? I'm going to spend more time looking for a better job, even if it takes me weeks or months. I'm not going to give up." You'll take that attitude if you don't truly believe you're hopeless or your situation is hopeless. But if you do believe that, well then why bother?
It actually brought to my memory another article by the same reporter. I’ll leave links to both to these articles in the show notes. This was back in December, it was an article titled, I Work Four Jobs But I’m Still Struggling. It’s about a young man named Bobby Bingham. He has a college education. From the article I think he’s single and shares an apartment with a roommate. And it says he barely gets by. Not unlike the article about the millennials turning up heat against low wages, this article starts out in the similar vein. Bingham is 37- years-old and has a college degree but like many Americans is stuck working many hours in low wage part time jobs. When I read that I thought, “Well does he really think he’s stuck? He’s no doubt frustrated but he’s got a college degree. He’s 37! Does he really believe he’s stuck? As I read through the article and I got to the very end of it, he’s quoted. He says, “The only choice I have is go into work and do this. Looking around and seeing all these other people I work with. They don’t see any other choices either.” Well, I guess he really does views himself as stuck. The quote is, it’s his only choice and if that’s what he truly believes then he’s going to keep doing the same thing. I guess the question for you today is, how do you view your situation? It may feel miserable. It may feel hopeless and you may feel stuck but do you truly believe you are? I hope the answer is no. As difficult as the situation may be that you’re going through right now I hope you don’t see yourself as truly stuck and truly hopeless. Because, if you see yourself that way it’ll affect the choices you make and the things that you try to do to improve your situation. But if don’t see yourself as hopeless and stuck, you’ll start looking for ways to improve your situation. I think for many people that makes all the difference. That’s my view on these news items. If you have a different view or just want to share your opinion you can do so. Just go to speakpipe.com/doughroller leave your first name and let me know what you think.
As I mentioned we’re going to cover three basic questions today about credit scores. The first one is, how important really is your credit score. That’s question one that we’re going to tackle. Then we’re going to tackle how credit scores are calculated, then finally we’re going to talk about some tools you can use to monitor your credit score for free.
Let’s begin with the first question, how important is your credit score? For me by far the most important aspect of a credit score is when you apply for a mortgage, whether you’re buying a new home or you are refinancing your existing mortgage. I want to give you a sense as just how important a credit score is. MyFICO, for those who don’t know FICO is sort of the standard credit scoring formula that at least most creditors use. Not all creditors, but most creditors use it. The folks at FICO started a site called myFICO that includes an excellent forum where you can get questions answered about credit and credit scores. It had some interesting calculators. The one I’m looking at now is a loan savings calculator. I’ll link to it in the show notes but basically what you do, you pick the type of mortgage you want to get. I’ve selected 30-year fixed and the amount of your loan, and I’ve put in $250,000. What it does is it calculates what your monthly payment will be, depending what your FICO credit score is. The top FICO score is 850. To qualify for a mortgage you generally need a credit score of at least 620. The way the calculator works is it breaks downLets see here, six different FICO score ranges. For example it goes from 620 to 639, then from 640 to 659 and on up. The top range is from 760 to 850.
As your credit score moves up the interest rate that you can qualify for goes down. Of course as your interest rate goes down your monthly payment goes down. The thing is, the numbers get really big. On a $250,000 mortgage if you have a 620 FICO score (which would be the lowest you could have to qualify for a loan) at today’s rates you’re going pay according to MyFICO about 5.844 percent. That’ll give you a monthly payment, this is principal and interest of $1,474. Now if we move up to the top range, that’s 760 and higher, your interest rate drops to 4.255. That’s about one and a half percent drop. Your monthly payment goes down to $1,231, which is about $200...Trying to do the math here, about $240 a month’s savings. That’s a lot of money, remember that’s your monthly savings. When you multiply that over a 30-year mortgage, the numbers get really big. The only difference is your credit score. One of the things that the calculator shows you is your total interest paid. The numbers are really eye-opening. If you have the 620 credit score your total interest paid on this mortgage over 30 years will be $280,602. Let me try that again, your total interest paid will be $280,602. If you have the highest range in credit score that is 760 or higher. Total interest would be $193,000. So we’re talking a difference of about $90,000 in interest over the life of a loan. All because of your credit score. Credit scores are really important. They have a big impact on your finances.
That's mortgages, you may be saying "I don't have a mortgage," or, "I don't want to buy a home," for example. Well, if you're going to rent an apartment or a home, most landlords and property management companies check your credit report. In fact I know folks who have been denied an apartment because they have bad credit. Credit will affect you even if you're renting. It also has other effects, we're going to be talking about getting out of debt and one of the best way to get out of debt or the first step is to reduce your interest rates. We talked about that when we talked about the one-and-done method of saving money, which was podcast 13. Lowering your interest rates is an easy way to save money if you have high interest credit card debt the easiest way to do that is to balance transfer offers. But you can only get those if you have a good credit score, I'll leave a link in the show notes to this but I'm looking at a list of zero percent cards on a website called allcards.com.
One of the things this website does is it lists the average and lowest credit scores that were approved for each card. For example, I'm looking at the CiTi simplicity card on this page which offers a zero percent APR balance transfer for eighteen months. The average credit score approved for this card was 720. The lowest credit score approved was 641. You need a reasonably good credit score to qualify for this and virtually all of the other zero percent credit cards. That's just another way your credit score matters. As I've mentioned in the past it also can affect your car insurance premiums. The higher your score the lower your premium, it can also affect your ability to get jobs in certain industries. For example in finance or if your job requires a security clearance. Your credit score matters for a lot of different reasons, I think again its biggest impact is when you get a mortgage, refinance a mortgage. But it has a significant impact well beyond that as well. Again this is one of the reasons I'm spending two days in this 31-Day Money Challenge talking about credit scores. Like it or not, they really matter.
Alright now, question two for today is how are credit scores calculated. I want to reiterate something I said earlier and that is that income doesn’t matter, which is a surprise I think to a lot of people. But your income, not only is not a factor in credit scoring formulas, but the credit reporting agencies don’t know what your income is. It can be an indirect factor if you, say lose a job and you’re out of work for a while and as a result you can’t pay your credit cards, or your mortgage or your car loan on time. That’s going to of course hurt your credit score. But your actual income, whether you make twenty-five or fifty thousand dollars a year or maybe as much as half a million dollars a year doesn’t directly affect your credit score. If it’s not based on income, what’s it based on? Fortunately, folks at FICO have given us a good bit of information on how the FICO formula works. You’ll learn tomorrow with Maxine Sweet from Experian that there are different types of credit scores. But I think they generally follow these factors, so what are they? There are five of them. There’s your payment history, do you pay our bills on time? Credit utilization of your revolving credit like credit cards. How much of your credit limit have you used up, are you almost maxed out on your cards or do you have a lot of available credit, that’s a factor. What are called enquires, that’s when you apply for a new loan and the credit, the lender checks your credit report. That’s known as an inquiry and it can affect your score. The length of your credit history, how long have you had credit? The fifth factor is the types of credit that you have. Say for example, a revolving credit like a credit card versus installment loans like a car loan or a school loan. Those are the five factors, now the important thing to realize is that they’re not all equal. Some of these factors weigh more heavily into your score than others. The most important factor is payment history, do you pay your bills on time? That factor according to FICO accounts for about thirty-five percent of the score. It’s the single most important factor that the FICO formula considers. Paying your debts on time is very important, a late payment, for example even if you’re just one month late it stays on your credit report for seven years. The good news is, it doesn’t affect your credit the same over those seven years. As a late payment gets older and older on your credit file it hurts your score less and less but it’s still there for seven years. Paying your bills on time is a must in order to have a good credit score. That’s 35 percent of the overall score.
The second most important factor accounting for 30 percent of the formula is credit utilization. To have a good score you want to try to keep your credit utilization at about 20 percent or lower. For example, if you had $10,000 in available credit on your credit card, you want to keep your actual balance at $2,000 or less. Of course, the goal is to pay off your credit cards on full every month. Once you start to get above, say 50 percent of your available credit that you’ve used. Your credit score really starts to take a hit and of course if you’re maxed out on your cards that’s going to have a significant effect on your credit score. Those two factors make up 65 percent of the formula. They are together by far the most important aspects of your credit file, when it comes to calculating your score. Do you pay your bills on time, your debts on time and what is your credit utilization for your revolving accounts?
The other three inquires, length of credit history and types of credit account for between ten and fifteen percent each. They are not insignificant but they're not the real drivers of your credit score. A lot of folks get focused on how applying for credit can affect your score. In extreme cases if you're applying for lots and lots of credit cards all at once it might have a bigger impact. If you're about ready to apply for a mortgage or refinance I would avoid applying for a new credit because as we looked at earlier in the show, even small changes in your credit score can have a big impact on your interest rate that you qualify for.
But while these are certainly important to be mindful of, your inquiries, length of credit history and types of credit used are not the more significant drivers of your credit score. One thing that I would mention about length of credit, it’s not just about how long you’ve had any credit. They also look at average time on file. For all of your different accounts, what’s the average time they’ve all been open. That’s something that was new to me, I learned that with my interview with Tom Quinn. He’s the credit expert at FICO, he came on the show for a podcast number two. If you haven’t listened to that podcast and you want to improve your score or you’re getting ready for a mortgage I highly recommend that you listen to that interview. Again you can just find it by going to doughroller.net/podcast2. That’s podcast followed by the number two and that will redirect you to that interview with Tom. I learned a lot in that interview, I thought I knew a fair amount about credit scores and Tom taught me a lot. As I guess you’d expect from the expert from FICO. That is generally how your credit score is calculated. Or I should say the factors that go into it. One thing I’d say too is that, how things hurt your score will vary depending on your specific situation. In other words, a late payment doesn’t affect everybody the exact same way. If you have thirty-five years of credit history and you’ve had mortgages, credit cards, car loans, school loans and you’ve paid everything on time for a very long period of time. Having a single 30-day late payment because maybe you just forgot to pay a credit card is not going to affect you the same way as it might someone who’s brand new to credit.
The same thing is true with credit utilization. Really all of the factors, so there's no hard and fast rule as to how each of these will affect everybody. It is very specific to each individual but the takeaway for me on all of this, and we're going to talk more about improving your score tomorrow, but the two key elements are pay your bills on time and keep your credit utilization as low as possible.
The third question for today is “How can you monitor your score?” There are a couple of ways and I’ve used all of these. First thing I would say is you absolutely have to get you free credit report from anualcreditreport.com. You can get your report from each of the three credit bureaus for free each year, from that website. That doesn’t give you your credit score but it gives you a free copy of your credit report. The importance for that is you can check for errors, you want to do that particularly if you are really focused on keeping your score up. Maybe you are going to apply for a mortgage or whatever, you really want to know what’s on your credit report. It’s free, I’ve got my report from anualcreditreport.com. You get it for free online, it just takes a couple of minutes and that’s the first thing. In terms of actually getting your score and monitoring it, I would recommend three resources. First is MyFico. By the way, I’ll leave links to all of this in the show notes. MyFico has a, what they call score watch. It’s one of those deals where you have you to put in your credit card and you get a free 10-day trial. If you don’t cancel they start charging you a monthly fee and that’s important to know. If you want to keep that credit monitoring service that’s fantastic. If you don’t you want to, cancel it before the 10-day period ends. That’s just something important to remember. But you do get your FICO score through that process and then again can continue to monitor your score if you want to.
The other two tools I use and I've talked about these in the past. Credit Sesame and Credit Karma. What I like about each of these is that you don't have to give them a credit card. They are free. I signed up for both, again they're free. They're very informative. I'm looking at my Credit Sesame report now and it looks like my score is 793 according to Credit Sesame. I can see the history of it. I can see how it moved up and down throughout 2013. Really more importantly, you can dive down into the tools that they offer to see what's keeping your score up, what's helping your score but also what's hurting your score. That can be a big benefit when it comes to improving your score in advance if, again, maybe a mortgage or a refinance. Again, that's Credit Sesame and Credit Karma. As I said, I use them both. I'll leave links to both. I found them both to be very helpful and understanding credit scores and again what can help your score and what can hurt your score. I hope you found today's podcast helpful. As I said tomorrow we're going to talk to the credit expert from Experian to get more information about credit scores and how to improve them. Just to get her perspective on credit reports and credit scores. Just given how important they are to our finances.
That brings the show to a close. You can find the show notes where I'll include links to all the resources I mentioned today. Just go to doughroller.net/podcast17, that's podcast followed by the number 17. You can leave a voicemail with a question or comment, just go to speakpipe.com/dougroller. Leave your name and your question or comment. You can also email me firstname.lastname@example.org. I read every email and respond to every email. You can subscribe to this podcast, just go to doughroller.net/itunes. You'll be redirected to the iTunes page where this podcast resides. If you haven't already, please subscribe to our weekly newsletter. That's at doughroller.net/newsletter to free newsletter ice and out every Saturday packed with resources and tips to help you make the most of your money.
Day 11: How to improve your credit score (interview with Maxine Sweet of Experian)