Financial Literacy & Independence for Teens - Step 5 - Credit Scores
KEY POINTS
Teenagers are at the perfect age to start building their credit history.
Your credit score will transcend your personal finances for a lifetime.
Learn more than 20 simple ways to improve your credit score.
You can increase your net worth by $200,000 with an improved credit score.
What is a Credit Score?
Understanding and managing your credit score is a key step along the way of achieving financial literacy.
A credit score provides creditors with a relatively standardized benchmark to assess your creditworthiness and credit risk. It is a three-digit number used by lenders, creditors, and financial institutions to determine the likelihood an individual will repay their debts in a responsible manner.
Why are Credit Scores Important?
Credit scores provide lenders with critical data in a comprehensive, efficient, and timely manner. The scores help lenders make informed decisions regarding extending credit related to credit cards, automobile loans, mortgages, and more.
The higher the score, the more likely that the lender will extend credit.
A higher score can also result in the lender offering lower interest rates. Lower financing rates improve the borrower’s cash flows and support long-term wealth accumulation.
Credit Score Model
The most utilized credit scoring model is the Fair Isaac Corporation (“FICO”) model. FICO developed a standardized method for calculating credit scores based on information collected by credit reporting agencies.
Credit scores generally range from 300-850 and fall into the following categories:
800-850 Excellent
740-799 Very Good
670-739 Good
580-669 Fair
300-579 Poor
Credit score ranges may vary between different credit bureaus and scoring models. Different lenders may have their own criteria for evaluating credit scores.
Who Calculates Your Credit Score?
The three industry leaders are Equifax, Experian, and TransUnion.
Individuals are entitled to one free credit report annually from each of these credit bureaus. Such can be obtained at AnnualCreditReport.com.
Individuals can also create an account with any of these providers to obtain a detailed copy of their credit score on a monthly basis.
Types of Debt Used for FICO Score
It is important to understand which types of debt are included in your credit score and which types of debt are not included in your FICO score.
Debt Included in FICO Score
Revolving (e.g., credit cards, lines of credit)
Installment (e.g., auto loan, student loan)
Mortgage
Retail (e.g., retail branded credit card)
Finance Company Accounts
Debt Excluded from FICO Score
Non-consumer debt (e.g., business loan)
Non-credit accounts (e.g., utility bills)
Medical debt
Non-credit accounts can negatively impact your credit score if they go unpaid and are sent to a collection agency. Medical debt is treated differently than other forms of credit and typically only has a negative impact on your credit score if it is unpaid, reported to a collection agency, and is greater than 1 year old.
Other Exclusions from FICO Score
FICO does not consider non-debt items such as savings or checking account balances, investments, or records of purchase transactions.
The following personal traits are also not factored into the model; sex, marital status, race, color, and religion.
FICO Score Components
A FICO score has the following 5 categories and associated category weightings,
Payment History – 35%
This is a critical category due to the 35% weighting. It assesses your debt and bills management history. It evaluates your track record of making payments on time. Any late or missed payments are recorded along with their severity and recency. Late payments have a negative impact on your score, while a history of making payments on time will increase your score.
You can take these steps to increase your payment history score,
Pay on Time – Every Time
The most important thing you can do is pay your bills on time and not miss any payments. A single late payment can negatively impact your score; therefore, remain focused on being successful in this crucial step.
Set Up Payment Reminders
It can be challenging to track the timing of all your payment commitments. We recommend setting up reminders through email, text, or mobile apps. Check with your bank and credit card companies as they may offer this service.
Create a Budget
A well-conceived budget that works for you will ensure you have sufficient funds to cover the payments required. The budget can incorporate due dates and highlight the related payments required. Interact with your budget regularly to ensure you stay on top of your financial commitments.
Pay More Than the Minimum
Credit card companies require a minimum monthly payment of any outstanding balance. As noted above, you must ensure you pay the minimum monthly amount to maintain your credit rating.
If possible, pay more than the minimum as it will demonstrate responsible credit behavior, increase your credit score, pay down your debt faster, and reduce your interest costs.
Resolve Past Due Accounts
Reach out to the creditor and try to negotiate new terms. Once paid, ensure the creditor reports such as paid in full.
Credit Utilization – 30%
At 30%, this category is nearly as important as payment history and refers to the percentage of available credit utilized.
Credit utilization related to a single credit card would be calculated as follows: $1,000 balance and a $5,000 limit would equate to 20% utilization (1,000 / 5,000 * 100).
A low utilization of below 30% is typically considered as positive for most credit scoring models.
You can take these steps to increase your credit utilization score,
Monitor Your Credit Utilization
Constantly review your credit balances and compare such to your credit limits. You can also access your credit report to see which accounts are impacting your score and how well you are managing their respective utilization.
Maintain a Low Credit Card Balance
Your primary goal should be to pay off your entire credit card balance every month. It will eliminate interest costs and have a positive impact on your payment history and credit utilization. If such is not possible, pay as much as possible while always making at least the minimum payment required.
Request a Credit Limit Increase
Contact your credit card company and request an increase. If granted, the increased credit limit will immediately lower your utilization rate. Only do this if you have the financial discipline to not increase your spending proportionately with such a credit increase.
Avoid Closing Older Unused Credit Cards
An older card that is unused simultaneously creates a low utilization score and increases your length of credit history score (see below). You may need to make minor purchases on an infrequent basis to keep the card active.
Length of Credit History – 15%
Your length of credit history refers to the amount of time your credit accounts have been open and active. A longer credit history generally indicates a more established credit history.
You can take these steps to increase your length of credit history score,
Start Early
It takes a long time to build a strong credit history. One of the easiest ways to start building your history is to obtain a credit card. Provided you exercise the necessary financial discipline, this initial step will demonstrate your ability to handle credit in a responsible manner.
Keep Accounts Open
Once you have a credit account open, it can be very beneficial to keep it open as long as possible. The age of all your accounts contributes to your score. Be sure to maintain financial discipline with respect to these accounts and ensure you understand any costs associated with maintaining such accounts.
Avoid Opening Too Many Accounts at Once
Additional new accounts will lower your length of credit history score. Such will also have a negative impact on your new credit inquiries score noted below.
Become an Authorized User
You may be able to become the authorized user of a friend or family member’s credit card account to build a credit history.
Beware that the credit activity of each party impacts the credit score of the other party. Therefore, both parties must fully understand the risks of such an arrangement.
Credit Mix – 10%
The credit mix category refers to the types of credit that make up your credit history. A diverse credit mix illustrates your ability to responsibly manage various types of credit.
The main types of credit that contribute to your credit risk score, as noted above, include revolving credit, installment loans, mortgages, retail accounts, finance company accounts.
You can take these steps to increase your credit mix score,
Understand Your Credit Mix
Obtain a copy of your credit report from one of the major credit bureaus noted above. Review your existing credit mix and identify areas where you can diversify.
Open Accounts Strategically
Consider opening new accounts to broaden the credit types utilized. Only take this step if you can maintain financial discipline. Also, avoid opening too many accounts in a short period of time as such may have a negative impact on your credit score.
Do not rush to open new accounts just for the sake of diversification. You should take a long-term view towards managing this part of your credit score and developing a diversified mix of credit.
New Credit Inquiries – 10%
This category specifically refers to recent inquiries made by lenders when you apply for new credit.
You can take these steps to increase your new credit inquiries score,
Limit New Credit Applications
A hard inquiry is recorded on your credit report every time you apply for credit. Too many inquiries in a short period may negatively impact your credit score. Such could indicate financial instability or a high credit risk. Try to limit credit applications to only when necessary.
Space Out Timing of Applications
If multiple new credit sources are required, try to space out the timing of submitting the related credit applications. This avoids multiple hard inquiries on your credit report within a short period time and reduces the potential for a negative impact on your credit score.
Avoid Being Denied Credit
Only apply for credit that you are likely to be approved for. Hard inquiries from lenders that eventually reject your request will create two negative impacts on your credit score. When in doubt, search for pre-approval credit offers that you will qualify for and apply accordingly.
Credit Score Contents
Your credit report will contain more than just your credit score. It will likely contain the following sections,
Personal Information
This will include your name, address, Social Security number or equivalent based on jurisdiction, date of birth, and employment details.
Credit Summary
The summary will provide a listing of all credit accounts and their status. It will include the number of accounts opened and closed as well as the credit available.
Accounts
Each credit account will be listed by name and include the type of credit facility, account status, current balance, credit limit, and payment history.
Public Records
This section will include all public records related to the individual. Such may include bankruptcies, tax liens, judgments, and other legal matters.
Credit Inquiries
All hard and soft credit inquiries made within a specified timeframe will be disclosed.
Credit Score and Key Factors
The individual’s credit score and key factors described above will be disclosed.
Disputes
The status of any disputes related to a previous report will be disclosed.
How Long Does History Stay on Your Report
Reporting practices may vary by country and credit bureau. Generally, the following items will remain on your credit report for 7 years; however, some may remain for 10 years,
Late payments
Collection accounts
Bankruptcies
Tax liens
Judgments
Hard inquiries typically remain on your report for 2 years.
Delete Incorrect Credit History
Your credit report may contain errors that have a negative impact on your credit score. You can take the following steps to ensure your credit report is error free,
Review Your Credit Report
The first step is to obtain a copy of your credit report from one of the credit bureaus referenced above and do a detailed review of all its disclosures. Errors may include accounts that do not belong to you, incorrect account information, late payments, collections, and more.
Dispute Inaccuracies
Contact the credit bureaus directly by phone, mail, or online and formally dispute any inaccuracies. You will need to provide your personal details (e.g., full name, address, date of birth, etc.) and supporting documentation to back up your dispute.
Contact Creditor / Vendor
In addition to contacting the credit bureaus, you should also consider contacting the creditor or vendor that supplied the inaccurate information to the credit bureau. They may be willing to correct the reporting once you prove your case to them. This step may expedite resolution of the issue.
Be Patient
The process of fixing errors on a credit report can be a very lengthy process that may take 1-2 months or more. Politely follow up with the credit bureaus for status updates and ensure they have all the information they require.
Use Your Credit Score to Your Advantage
Higher credit scores increase the likelihood of securing financing with third-party lenders. However, you can obtain the following benefits and more by maximizing the power of your credit report,
Lower Interest Rates
Your credit score has a direct impact on the interest rates lenders charge you for the credit they extend to you.
Our post How Can Your Credit Report Increase Your Net Worth? illustrates the relationship between your credit report and the interest rate you pay. The example provided shows how you can save $200,000 by diligently maintaining a high credit score.
Identity Theft
Identity theft is just one of the many types of scams you must constantly guard against. It occurs when someone utilizes your personal information without permission to commit fraud or other crimes.
A key method of detecting identity theft is to regularly review your credit report. Look for changes to your personal information, unexpected new accounts, unauthorized transactions, credit inquiries that you did not initiate, and more.
Early detection is critical to minimizing the impact. Once detected, contact the respective credit providers, and inform them of the fraudulent activity.
Rental Accommodations
Landlords may check your credit score when considering your rental application. A higher score will increase your chances of securing your desired accommodation.
Better Insurance Rates
Some insurance companies consider your credit score when determining the premiums that they charge you. A higher score may lower your insurance premiums.
Cell Phone Plans
Some carriers may offer favorable terms, discounts, or the latest smartphone model based on your credit score. You may be able to avoid prepaying or making a deposit.
Utilities
A higher credit score may allow you to avoid placing deposits with the various utility providers (e.g., hydro, water, gas) when signing up for a new account.
Employment Opportunities
Employers in some industries or when hiring for specific roles may review your credit score to assess financial responsibility and creditworthiness.
Business Financing
A high personal credit score may increase your ability to obtain business loans or credit lines.
Travel Perks
Elite credit cards are typically reserved for individuals with very high credit scores. Such cards may offer an array of travel perks and other benefits.
Negotiating Power
A high credit score will put you in a strong position to negotiate favorable lending terms.
Personal Relationships
You may consider sharing your credit score with a significant other to be transparent and build trust. Such decisions should be carefully considered as any negative credit activity from either party will impact the other’s credit score.
BOTTOM LINE
We recommend individuals start building a credit history as soon as possible. The journey requires financial education and discipline. Create a strategic plan regarding building your credit history and implement a tactical plan that will achieve your goals over the long-term.
The ability to obtain and maintain a high credit score will transcend your personal finances for your lifetime.
