Recently, we have seen a silver lining. Due to the COVID-19 pandemic, there is less spending. The debt in this previous quarter has actually declined. Credit card balances fell by $76 billion, the steepest decline in the history of the data. This is great news!
We must manage our finances in such a way as to minimize the effects of this financial storm. Most people are not aware of the full extent of their decisions when it comes to using credit. How you manage credit will have an impact on your credit score.
What is a credit score?
Your credit score is calculated using the information in your credit report. Your credit report comes from your history of how well you were able to repay your loans. Lenders, landlords, and utility companies look at your credit score to see if you’re an acceptable credit risk. A high credit score means you are an acceptable credit risk. And you may qualify for a lower interest rate on some credit facilities and loans.
A low credit score may disqualify you from getting loans. Keeping your credit clean is very important to ensuring good financial health, much like your doctor’s health report and history.
What makes up your credit score?
Credit scores range from 300 (just getting started) up to 900 points in Canada, which is the best score. According to TransUnion, 650 is the magic middle number – a score above 650 will likely qualify you for a standard loan while a score under 650 will likely bring difficulty in receiving new credit. Order your credit report from both credit reporting agencies – Equifax and TransUnion – at least once a year for free (when requested by mail, fax, telephone, or in-person).
What affects your credit score?
Numerous factors determine your credit score.
Pay all of your bills on time. While this seems obvious, about 1 in 4 adults in the US are late paying their bills. This is according to the NFCC’s 2015 Financial Literacy Survey, sponsored by NerdWallet. Being late on bill payments or having your account sent to a collection agency hurts your credit score. As much as possible, automate bill payments through your bank.
Serious delinquency happens when you often miss payment deadlines on various credit facilities. It can lead to your credit history being put on the public record of collections. The severity and frequency of derogatory credit information – bankruptcies, charge-offs, and collections will lower your credit score.
Avoid maxing out your credit. Try not to run your balances up to your credit limit. Balances above 50 percent of your credit limits will harm your credit. Aim for balances under 30 percent. So, if you are going to keep a balance, it is better to keep a balance of under 30% for two of your credit facilities instead of having one with no balance due and one with a balance of 60% of the credit limit.
When a lender or business checks your credit, it causes a hard inquiry to your credit file. Avoid applying for credit unless you have a genuine need for it. Too many inquiries in a short period of time can sometimes be interpreted as a sign that you are opening numerous credit accounts due to financial difficulties, or overextending yourself.
There are two types of Credit Bureau file inquires: “hard inquiries” such as an application for new credit, which will lower your score; and “soft inquiries” such as requesting your own credit report, and businesses checking your file for updates to your existing credit accounts for approving credit limit increases. These will not appear on your file or lower your credit score.
Too many inquiries may indicate financial difficulties. It could also be that you’re moving to a new city and will need to apply for a new mortgage, a new electric/gas account, cable, phone, and other utility accounts. These “inquiries” into your account will deduct points from your score, so you may take a rather large hit, points-wise on your credit rating for moving houses. Inquiries for non-credit purposes (such as utility companies and car rentals), will cause your credit score to drop without adding points for having credit in good standing, as with a credit card that you pay off every month. Be careful to only apply for credit you really need.
Length/history of Accounts
A longer history on your credit accounts earns you more points on your credit score. A longer history on your credit accounts earns you more points. Avoid closing your accounts if you may need them in the future. Good credit history is built over time. It is common practice for people to hop from one credit facility to another – whatever is on offer at a lower interest rate. Each time you open a new account affects your credit score. If done often, this practice of transferring balances from one financial company to another will affect your overall credit score adversely.
Variety of Credit Accounts
A healthy credit profile has a balanced mix of credit accounts and loans. Having a mix of credit products (credit card, retail store card, a line of credit, car loan, etc.) will mean more points on your file than having only one type of credit, such as only credit cards. For revolving credit, try to limit two credit cards (one for a back up) – use one for online purchases. You may want this at a low limit (limits the impact of online fraud) and the other for in-person purchases. And then also have a line of credit.
Too many accounts
We do need to have a few credit facilities. Keeping too many open will lower your score. Avoid taking up on the countless offers by credit card companies that come through the mail, online, and stores. They are enticing. From low-interest rates to Airmiles and Cashbacks, the credit market is highly competitive. Select one or two that meet your household needs and ignore then rest.
Credit Bureau Errors
Credit bureau reporting errors such as an incorrect date of birth or social insurance number do happen. And they hurt your score. Check your credit score regularly, about once every one to two years, to ensure no reporting errors. It does not cost anything to get a credit report once annually.
Identity theft is when someone uses your personal information such as your name, address, and social security number to seeks credit. According to The Federal Trade Commission, as many as 9 million Americans experience identity theft each year. Check your credit report annually to see that there has not been unexplained activity on your profile.
Changing your address too often
The length of time at your current address will affect your credit score. Moving frequently gives a sense of instability. The longer you remain at one address, the more points you receive.
Changing jobs/employers frequently
The longer you stay at a job, the higher points your credit score receives. Being perceived as having a secure job and, therefore less of a risk as defaulting on your loans.
Having no mortgage on your file
The Credit Bureaus assign certain points for those who have mortgages and those who rent and deduct points for those whose housing situation is unknown. As soon as you pay off the mortgage, the reporting account is removed from your file, which will actually remove points from your credit rating! Credit card and other credit account history will remain on your account even after being paid off and closed, but a paid mortgage does not benefit your credit rating. So although you own your own home outright, it does not benefit your rating.
Having no debt
This may be hard to believe, but not having any debt is bad for your credit score. Not having a history on your file for creditors to evaluate is seen as a risk.
How to avoid the debt trap
Live Within Your Means
It seems like a no-brainer but living within your means guarantees you don’t get into debt. Credit gives us the false sense that we have more money than we really have.
The reason for the decline in the level of debt during the pandemic was the decline in the level of spending. Quarantined for an extended period of time people were limited to online shopping. No morning Starbucks lattes on the way to work at $5.00 a cup. No wandering into stores and picking up ‘stuff’ you did not need on the way back from work. Most people are unaware of how much their habits cost them over time. It’s called the “latte factor.”
Keep to a Budget
Some tips on budgeting:
- Keep track of every expense, including the small ones.
- Update your budget continually – by the month.
- Plan for both fixed and variable expenses.
- Implement the 50/20/30 budget.
- Spend 50% of your income on essentials – housing, food & transportation. Use 30% on personal expenses like dining out, gym membership, and your cell phone bill. Save 20%.
Establish an Emergency Fund
Most people run into debt when they lose their job or are in between jobs. Build an emergency fund equivalent of 6 months of income to prepare for the unexpected. Events such as job loss, illness or disability, or the death of a spouse. When the unexpected happens, like a leaky roof, many people resort to using their credit card or line of credit. An emergency fund is the best to deal with unexpected expenses.
Getting out from under “bad” debt.
- Target one card at a time – the one with the highest interest.
- Ask your creditors for lower interest rates & transfer your balance (cautiously).
- Make two payments each month instead of one.
- Stop using your credit card.
- Seek credit counseling.
- Consolidate debt into one with a lower interest.
- Buy what you need, not what you want because what you want is to be free of the burden of debt.
- Trim one expense each day.
- Go back to your values.
What’s it costing you
Revolving debt that is not paid off can add up over time. As in the example below.
Credit Card Debt!
John and Jane both have $2,000 owing to their credit cards. Both cards require a minimum payment of 3% or $10, whichever is higher. Both are short on cash, but Jane manages to double her payment to $20 while John pays the minimum.
The interest rate on both cards is 20% on the outstanding balance. This means that part of the payment goes toward the balance, and part goes toward interest on that balance.
Here is the breakdown of the numbers for the first month of credit card debt:
- Principal: $2,000
- Interest: $33.33 ($2,000 x (1+20%/12))
- Payment: $60 (3% of remaining balance)
- Principal Repayment: $26.67
- Remaining Balance: $1,973.33 ($2,000 – $26.67)
Balance calculations are done every month until the credit card is paid off. In the end, John pays $4,240 in total over 15 years for the $2,000 in credit card debt. The interest portion over 15 years is $2,240.
Because Jane paid an extra $10 a month, she pays $3,276 over seven years for the $ 2,000 in credit card debt. Jane pays a total of $1,276 in interest. The extra $10 a month saves Jane almost $1,000 and cuts her repayment period by more than seven years! The lesson here is that paying twice your minimum or more can drastically cut down the time it takes to pay off the balance, which leads to lower interest charges.
Bringing It All Together
Your approach to your money starts with your mindset. What are your current beliefs about money? If you are deep in debt, you need to look at your subconscious beliefs around money. Your money story will change once you change your story about money. Listen to your inner dialogue around wealth and abundance.
Make the decision now to change your relationship with money. Decide that you do not want any debt. If you have been carrying debt for years, you may not even believe that there is a healthier alternative.
To get your free credit report from three credit bureaus, Equifax, Experian, and Transunion click here.
For help with your debt and your credit score, you may want to look at The Attorney’s Guide to Credit Repair.
This post contains affiliate links. For more information, see my disclosure here.
Through coaching, webinars and public speaking Jennifer helps people and businesses discover how to create success on their terms. She has written numerous books on money: Women and Money: 7 Principles Every Woman Needs to Know to Be Financially Prepared in Any Economy and Growing Up With Money: Raising Financially Resilient Kids in an Age of Uncertainty.
You can reach her at email@example.com