Building credit and having a strong credit score can have a major impact on your finances long-term.
A higher credit score = a lower interest rate on loans and mortgages because to a lender, you are a more reliable borrower with a higher credit score, so they will offer you a lower rate. This might not feel like a big impact but let’s look at an example from Bankrate.com. http://www.bankrate.com/finance/credit-debt/tips-for-boosting-your-credit-score-1.aspx “On a $165,000 30-year fixed-rate mortgage, that difference could cost you more than $13,378 in interest charges, assuming a 4.5 percent interest rate with a 700 credit score and a 4.875 percent rate on a 698 score. Fall below a 660 and the rate goes up even more, if you can even get approved for a mortgage at all.” $13,378 is a significant amount of money for only 2 FICO score points.
This demonstrates the importance of a strong credit score and why you should start building your credit now. Also, notice that 4.875% – 4.5% = 0.375%, that means a difference of less than 0.40% can cost you over $13,000 over a 30-year period. This should make it clear that it is critical to find the lowest interest rate possible!
Let’s understand how to get a FICO score. In order to obtain a FICO score, you need to have a loan, credit card, or form of credit for at least 6 months. How is the FICO scored? Leveraging myfico.com, the chart below displays how Fico scores are calculated, broken down into 5 major components, Amounts Owed, New Credit, Length of Credit History, Credit Mix, and Payment History.
To summarize this chart, let’s start with Length of Credit History. The longer your credit history the better, because it provides the credit bureaus a longer track record to justify lending you money. Second, Payment History. Notice that your payment history is the most important part when it comes to calculating your score (roughly 35%). It is critical that you do not miss a payment as it can have a huge impact on your score. A useful tool to help avoid missing payments is leveraging tool like mint (https://www.mint.com/) that consolidates all accounts into one to help you monitor your finances. You should also try to automate your payments so you will never miss one. If you do happen to miss a credit card payment you can usually call the credit card company and explain the reason you didn’t make the payment, if the reason was that you simply forgot, they will usually waive the penalty fee and not report it to the credit bureau if you call and ask (it happened to me once)! Third, Amounts Owed, makes up 30% of your score. This looks at your credit limit compared to how much credit card debt you owe also known as your credit ratio. Ideally you want to keep this below 30% to have a positive impact on your score (such as, if your credit limit is $2,000 you should try to keep your credit card debt within $600). Fourth, Credit Bureaus are looking for a mix of credit, like credit cards, utility bills (don’t miss a utility bill payment), loans, mortgage, which makes up roughly 10%. A good mix of credit will help this part of the FICO score. And lastly, new credit also has an impact on your credit score. For example, if you just applied for 3 new credit cards, your FICO score will take a small hit because it will raise questions about why you are applying for multiple lines of credit in such a short period of time. To learn more about what makes up your FICO score, visit http://www.myfico.com/crediteducation/whatsinyourscore.aspx.
Now you know what makes up your credit score, use it to your advantage to help build your credit. As mentioned above this is critical when applying for loans as higher FICO scores results in the lower interest rates which will save you a lot of money over the life of your loan or mortgage. A quick solution to help build your credit when applying for a mortgage is to completely pay off your credit card debt to keep your credit ratio as low as possible (remember Amounts Owed = 30%).