All you need to know about Credit Score

When apply for a loan or home mortgage, your lenders would refer to your credit score to determine the interest rate. The lower your credit score, higher will be your APR. A loan or mortgage on a lower credit score would usually be n the range of 0.5%-2% more than the best possible credit score. If the credit score is very low, the lender may decline your credit application. There are 5 parameters that are used to determine your credit score. Few of them have a low to medium impact and others have a high impact. We will examine each of these parameters and compare them with good personal finance habits:

Length of Credit History

The average duration for which the credit (like loan, mortgage, credit card) has been opened. If your length is 8 years or higher, you would score the highest marks for this parameter.

Do’s and Don’ts:

• Every new credit addition will reduce the average length of credit.
• Closing of old accounts don’t reduce the average time for calculating length of credit. They simply mark these accounts as closed.
• Revolving Credit or Mortgage also gets in the record for add-on family members even if they are not paying credit card dues.
• Add your spouse to a mortgage or a loan even if they are not going to pay an installment. This will help build their credit history.

Recommendations

• Add your child after their age of 15 years as an add-on member. This starts building their credit history and will improve their credit score so they can tap financial resources at a better rate when they are ready to access them. You may use your discretion and not hand over the card to your child to use it and keep it at a safe a secure place. Just having the card counts and spending at an add-on card member is not tracked separately.
• It is important for migrant workers that get their SSN number to start off with a credit card right away so they can build their credit score over time. You may want to consider a pre-paid credit card (strange as it may sound, such a card actually exists) initially if you are not being offered a regular credit card.

Total Accounts

This is the count of all accounts including active and closed accounts. More than 25 accounts is usually gives you full marks for this parameter. Note that when you refinance your mortgage with another lender, then it would count as a separate new account. Opening too many accounts just before you refinancing or apply for a loan or mortgage will negatively impact your credit score.

Recommendation

Open accounts as early as possible to get a good ageing for these accounts and thereby a better credit score. If you open several credit accounts in one go, it would reduce your credit score.

I recommend opening accounts every 6 months in the initial years. If possible, do not open an account at least 9 months prior to a loan or home mortgage application.

Credit Card Utilization

This is the ratio of sum of credit used to the sum of credit limits of all your active credit cards.

A credit utilization sweet spot is between 10-20% and is considered healthy. Anything outside this range (even if it is less than 10%) will raise red flags for the individual credit card. If you are using 30% limit on one card and less than 5% on another then they would average out to the sweet spot.

Recommendation

• Once you have owned a credit car for a reasonable amount of time (more than a year), request credit card companies to increase your credit limits. They would usually oblige if you have a good credit score. This doesn’t mean that you would have to increase your spending on credit cards. It’s just improves your credit card utilization and thereby your credit score.

Derogatory Marks

Derogatory marks are usually added after you have defaulted on any payments. These would also include payments to utility companies. They will send several reminders over snail mail, e-mail and, in some cases, from collection agencies. Actual marks get added if you have not made payments despite the reminders for more than 90 days.

Avoid getting into this category ever! Keep this number 0 at all times! Most of us are not willful defaulters here but can easily get into this trap that can severely impact our credit score if we are careless.

For all our credit accounts, we need to ensure that we keep our contact information updated. This is particularly important for cards we don’t use too often. Address, phone number and e-mail needs to be kept updated at all times.

Derogatory marks also apply to utility accounts. Few of the accounts get reported every month like Savings & Checking Accounts, Mortgages, Credit Card, Loans (Personal, Auto, Line of Credit). There are other accounts that are reported only in case of default like HOA Dues, Utility Bills, Rent, Property Taxes, Insurance Payments).

Recommendations

• You should setup direct debit from your bank account to the credit card company on the credit card company website and not on the bank website. The reason is that if there is an issue with the bank processing your payment then the credit card company will still consider your account as overdue, but if issues with credit card systems results in delayed payments then they will not take any action as its their issue.
• For non-credit card accounts, like term insurance, property taxes, utilities, HOA payments, home rent, personal loan you will have an option to pay by credit cards or bank account. Few of them may charge you additional fees if you pay by credit card, I would suggest you pay with credit card if they do not charge any fees as this will help with better cash flow. Like what I mentioned in my earlier bullet, setup autopay directly with the provider rather than through your bank website.
• Be on the lookout for the final payments due if you discontinue or switch services. They may be debited after a full and final settlement is processed by the service provider or utility company and would usually take more time than the usual payments. If you have cancelled your auto pay for the utility and have changed your address and other contact details (but not updated it on their website), then you will be unaware that you owe them money and your account gets delinquent.
• Irrespective of the payment that you are trying to schedule – credit card monthly payments or utility/ mortgage/ insurance payments, you need to set the autopay on the bill due date. This will help you with cash flow. They won’t come hunting for you till due date so there shouldn’t be any urgency from your side either.
• Another important aspect is that for such payments never use the financing offered by them as they are usually at higher rates compared to the sources that you can avail. Also, they may offer you financing at 0% but will charge you one time upfront fees. This may look attractive at the first glance but is actually a mechanism by these companies to charge you all interest that you would have otherwise paid upfront and then offer you 0% financing.

Hard Inquiries

Sometimes the lender would have to check your credit score even when they need to pre-qualify you for a loan or a home mortgage. These appear as hard credit inquiries in your credit report. The lender perform the credit check to determine the interest that they would charge you on the mortgage or loans.

Too many such inquiries will reduce your score. When you are shopping for a loan or mortgage, ensure that you will get pre-qualification and quotes only with a shortlisted set of lenders and not with every lender that approaches you.

As your credit score goes up with sound financial habits, you will be able to avail the best rates that lenders have to offer. (Refer to the blog: Can sound financial habits adversely impact your credit score? – Myfinancejournal)

Recommendation

• Once you have got quotes from the shortlisted lenders you need to select only one lender that you would use for closing your loan. This habit will reduce multiple hard inquiries to your credit score. Hard inquiries usually stay on your account (and impact your score) for a period of 2 years from the date they were initiated.
• If you have hard inquiries from several lenders on a loan or mortgage application, they will be considered as a single hard inquiry so long as they are within 30 calendar days from the first hard inquiry. It is advisable not to have more than 4 hard inquiries on your account.

Where is Credit Score Used?

• Home Mortgage
• Car Loan
• Determine Credit Limit for Credit Card
• Determine deposit amount to start service with a utility company