Originally posted by Vickie An at LearnVe$t
There are few numbers that can make you feel prouder about your money-management skills than a strong credit score. And for good reason: Lenders use credit scores to determine everything from the interest rate on your mortgage to whether you qualify for the juiciest credit card rewards. So if you’ve worked hard to reach a score of 700 or higher (generally considered entering the “good” range), that means you’ve been doing something right—and are likely to be rewarded for your financial diligence.
“Your credit score is a number that is representing you to the world,” says April Lewis-Parks, director of education and public relations at credit counseling organization Consolidated Credit. “So the impact, financially, of having a good credit score is huge.” It means you’re attractive to lenders, who may then offer you loan terms that those with a lower score wouldn’t qualify for.
That said, it’s important to remember that your credit score isn’t the be-all and end-all of your financial health. It’s entirely possible to have a decent score and still struggle with debt—or at the very least, make decisions that aren’t necessarily good for your money in the long run.
To understand how this could happen, we asked credit and financial pros to share some scenarios that illustrate how it’s possible to have a strong score but still be making some less-than-stellar money moves.
You’re never late on your payments … but only pay the minimum each month.
Meeting that payment-due deadline on time is one of the most important ways to keep your credit score strong—after all, payment history makes up a hefty 35% of your FICO score (one of the most common credit scores used by lenders, and the one we’ll be focusing on here).
However, if you’re just paying the minimum amount due and carrying a balance every month, you’re digging yourself into a debt hole that could take years to dig out from—especially if your interest rates are high, explains Katie Ross, manager of education and development at American Consumer Credit Counseling, a nonprofit credit counseling agency.
Ross offers up this hypothetical example: Some credit card issuers set their minimum payments at just 2% of the total balance. So if you owe $5,000 on an account with an 18% APR and only pay the minimum of 2% each month, it will take more than 44 years to pay off your account. Plus, you’ll have paid more than $12,400 in interest—money you could be allocating toward goals like your emergency or retirement fund.
On top of that, even if you’re not getting dinged for late payments, paying only the minimum means you’re potentially increasing your credit utilization rate—a separate factor in calculating your credit score (more on that below).
You have a low credit utilization rate … but it’s because you keep applying for new credit.
The amount you owe on your credit accounts makes up 30% of your FICO score, and a key factor in this calculation is your credit utilization rate—that is, the total amount of debt you owe divided by the overall credit limit available to you. “If your utilization ratio is higher than the recommended 30% to 35%, it may not reflect well on your financial stability,” says Ross.
One way people may try to improve their credit utilization rate is to increase the total amount of credit they have to their name. That strategy, however, has the potential to backfire because it could 1) discourage you from being more aggressive about paying down what you owe; and 2) tempt you to keep spending, because you have more credit to spend against.
“Just because a credit card company wants to lend you more money or increases your credit limit does not mean you can afford to [spend more],” says Lauren Zangardi Haynes, CFP®, of Evolution Advisers in Midlothian, Virginia. “If you already have a credit card and you ask [the company] to increase your limit, and they do, great—as long as you’re not going to max it out.”
Indeed, one instance in which it might be tempting to open a new credit card is if you’re already close to maxing out one that you have. Lewis-Parks illustrates this scenario: Say you have a credit card with a $4,000 balance, and that card has a $5,000 credit limit; your credit utilization rate on that account is a whopping 80%. Then you receive an offer in the mail for a new card with a $12,000 limit, which will let you transfer your balances for a limited-time 0% APR. Once you transfer that $4,000 over, your credit utilization ratio is a much more favorable 33%.
But here’s the rub: “People consolidate their debt and still have the other line of credit open, so they end up charging up both cards,” Lewis-Parks says. Plus, once your 0% teaser rate expires, the APR on any debt you have will likely shoot up—potentially putting you in worse shape than when you started, she adds.
Increasing your available credit boils down to this: “If you know that credit cards are going to be very tempting to you, then you should not open a bunch of credit cards,” Haynes says. Plus, remember that every time you apply for new credit or a loan, it triggers a hard inquiry on your account, which could ding your score by a few points—particularly if you apply for multiple lines of credit in a short amount of time.
Your strong credit score qualifies you for a large loan amount … and you borrow to the max.
As we mentioned earlier, the better your credit score, the more likely you’ll be to receive favorable terms from lenders, like lower interest rates and higher borrowing limits. But it’s important to reiterate: Just because you can borrow a large amount of money doesn’t mean that you actually should.
Haynes says she sees this spring up often when it comes to getting qualified for a mortgage. Homebuyers will often borrow the largest amount they are approved for because they really want to upsize to their dream home or a larger home that will accommodate their future family. Unfortunately, this can lead to being “house poor”—spending such a large percentage of your income on housing that it hinders your cash flow.
“Having that huge mortgage payment really hamstrings [people] from being able to save more for retirement or vacations or an emergency,” Haynes says. “You [would also] need a bigger emergency fund because you need to have more money to cover those huge mortgage payments, so it kind of becomes a circular problem.”
Ultimately, if you’re managing your money in a way that improves your whole financial picture, that will help you maintain a good credit score, says Lewis-Parks. “It’s much more important to make sure you are financially healthy, that you have emergency savings, that you have a retirement plan in place, and that you’re aware of what you’re spending,” she adds. “[Then] you’ll naturally have a great credit score; it usually falls in line that way.”
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design), and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.