How Can Your Credit Report Increase Your Net Worth?
KEY POINTS
Your credit report and related FICO credit score has a direct impact on the interest rate you pay
Credit reports can be checked, at not cost, and steadily improved over time: let us show you how
Higher FICO scores can translate to significant increases in net worth and generational wealth transfers
“… nothing is certain except death and taxes.”
Benjamin Franklin
I would humbly add one other virtual certainty:
DEBT
When harnessed correctly, debt can be instrumental in building your legacy. In this post, we will focus on reducing the cost of debt as opposed to the use of debt.
Debt can be daunting. So, let’s break it down into three basic components:
Amount borrowed
Financing period
Interest rate
You dictate the amount borrowed and the desired financing period. The bank dictates the interest rate you pay.
Or do they?
There are a lot of factors that go into the final interest rate you pay.
First, there are several macro factors that you do not control. The overwhelming factor impacting the interest rate you pay will be the Central Bank’s discount rate/interest rate. Your financial institution will use this rate as the foundation for determining the interest rate you are charged.
Second, there are several micro factors that you control. They can have a major impact on the ultimate interest rate you pay. To some degree, you control the following factors (mortgage example utilized):
Credit score Home location
Loan amount Down payment
Loan type Interest rate type (e.g., fixed, variable)
Loan term
We will focus on a single factor and illustrate how to save hundreds of thousands of dollars by taking a disciplined approach to managing your legacy.
How is this possible?
Credit Ratings
Welcome to the world of credit ratings.
For some, this will be the first time you have read about credit ratings. Others may have a vague awareness of credit ratings but may lack the ability to harness their financial value.
Let’s change that now and get your legacy plan back on track.
We have all watched the news headlines chronicling various world governments struggling with their national debt and annual deficits. Debt defaults and related currency crises are always preceded by credit rating downgrades. These downgrades are issued by independent financial institutions. The lower / riskier the credit rating, the higher the interest rate costs incurred by the government.
Just as governments have their credit rated, so to do individuals. A personal credit rating downgrade can be devastating to your legacy over the long-term.
Credit Reports
From a personal rating perspective, the U.S. and U.K. are dominated by three national credit bureaus: Equifax, Experian, and TransUnion. These entities extract your personal financial information from your creditors. They will also obtain your personal information from public records (e.g., court documents). The credit bureaus will analyze, summarize, monitor, and sell your personal data to financial institutions that you conduct business with.
At a high-level the credit bureaus will assign you a monthly FICO score based on your cumulative data. Approximately 90% of top lenders utilize FICO scores when assessing credit applications. As the scores are calculated monthly, your score may experience timely delays when reflecting your debt servicing activity. For example, you may make a substantial credit card payment just after the credit bureau pulled your data: such will not be reflected until the following month.
Sample FICO score ranges:
How can an improved FICO score and credit report save you money?
So, how do the FICO score ranges translate to dollars and how do we improve our credit rating?
First, let’s look at the prize: money saved.
The following table illustrates the financial impact of your credit score on a $400,000 30-year mortgage. At first glance, the 1.6% interest rate differential between the highest and lowest credit ratings may not seem substantial.
However, the superior credit rating translates to approximately $150,000 in interest savings. If you invested the monthly interest saved, an Excellent credit rating can translate to over $200,000 in savings based on a 2% reinvestment rate. The spread in rates can be even wider on other types of loans (e.g., automobiles).
What impacts your credit report and FICO score?
Now, let’s look at what variables impact your FICO score and how to use them to your advantage.
The credit bureaus collect all sorts of pertinent data that is grouped into 5 main categories:
Payment History – 35%
It is critical that you pay your bills / financing obligations on time. Every bill. Every time.
This includes payments related to credit cards, personal lines of credit, home equity lines of credit, mortgages, student loans, automobile loans, merchant loans, etc. If your landlord reports to a national credit bureau a late rental payment may also be captured in your score.
Utility bills and cellphone bills are not typically included in your payment history unless such accounts are delinquent and have been turned over to a credit collection agency.
Any late payments or underpayments reported will be recorded and will negatively impact your credit score. The late payments will typically remain on your credit report for 7 years; however, their impact will lessen over time.
Your ability to create and stick to a budget will be crucial to maintaining a positive payment history. Our post How to Make a Budget That Works For You provides the tools to create a customized budget.
If you have a poor payment history, consider automated payments. If you find a payment history error on your credit report, you should contact your lender and request they amend their records.
Available Credit Utilized – 30%
Available credit only includes revolving credit. Such credit does not have a pre-determined end date. Therefore, credit cards and lines of credit are included. Whereas your fixed term mortgage and auto loans are not included.
Your available credit utilized is simply the amount of revolving credit you are using divided by the total amount of revolving credit available. Such will be calculated on a per account basis as well as a cumulative basis. Your credit report will disclose each of your accounts and the amount of credit utilized for each account.
It is generally recommended you keep your utilization rate below 30% (e.g., $3,000 credit utilization on a credit card with a $10,000 credit limit). This can be achieved by making regular timely payments and maintaining credit cards with nil balances (presumably you would want these cards to have no annual fees). You may also request an increase in your credit limits or apply for new credit accounts; however, the extra credit room may be too tempting for some individuals and opening too many new accounts in short period will adversely impact your credit score (see New Credit below).
Length of Credit History – 15%
This score considers an average of how long your accounts have been open, how long specific credit accounts have been open, and how long has it been since an account has been used.
An account must be open for a minimum of 6 months for it to be included in your FICO score. The longer the history, the less risky the account is perceived to be, and the higher resulting credit score. Younger individuals are inherently limited when it comes to length of credit history. Therefore, it can be wise to start responsibly building a credit history as soon as possible.
Couples should carefully manage which individual opens each respective account. We have spoken with couples that put most of their accounts in one person’s name. Although such did not impact their ability to service the debt, the other spouse was surprised to learn their credit score was negatively impacted.
New Credit
Your credit report captures ever instance when you apply for new credit. Credit approval is not important, the simple act of applying for new credit is captured. Such inquiries will remain on your report for 2 years; however, only inquiries from the last 12 months impact your FICO score.
As alluded to above, the FICO categories are often inter-dependent. For instance, applying for a new credit card may reduce your FICO score in the short-term. However, over time it will benefit your Length of Credit History and if managed wisely it could also benefit your Available Credit Utilized and Payment History.
Credit Mix
Lenders and creditors prefer to see a history of managing the different types of credit accounts discussed throughout this post. It may not be wise to open credit accounts solely to maximize your Credit Mix rating.
However, you may want to consider deferring the closing of a fully paid off credit card (assuming such card does not attract annual fees). As noted under New Credit above, maintaining a credit card can positively impact other areas of your credit score.
The 5 categories above are explored in more depth in our post Financial Literacy - Credit Scores. Credit scores form a crucial part of an overall financial plan as explained in Financial Literacy - A Definitive Guide.
Final Thoughts
We recommend you obtain a copy of your credit report from one of the credit bureaus on a regular basis. Such will not impact your credit score as it is not considered an inquiry about new credit. Review the report carefully and report any discrepancies to the respective credit bureau.
Your ability to prudently maintain a healthy credit score may be the easiest way to add hundreds of thousands of dollars to your legacy. Such impact can be amplified when applied to multiple members of your family.
Get that FICO score under control and watch your legacy plan grow.
