I don’t remember how I learned to use credit properly, and it wasn’t until I worked in the mortgage industry that I really understood how it worked.
So much of our lives revolves around money; how to get it, how to get more, how to borrow it and how to pay it back. Why in the world is this not taught to our kids in high school? They need to know how to get a loan, how to use a credit card responsibly, how to build credit when you don’t have any, and how to fix your credit if you slip up.
How many people actually understand the complex formula credit companies use to determine your credit score? Wouldn’t it be great if it became common knowledge? Well, during my interviews with Taralyn Rose at California Coast Credit Union, I was able to pick her brain to find out the answers to these questions.
LL: What are some of the things you wish people knew about credit?
TL: If you don’t use it you lose it! People think they can get a card and not use it and still have a good score. Or they can avoid debt altogether and be able to borrow money when they really need it. Lenders use this to determine your risk, so, for most people, 3-4 years ago is going to look a lot different from where you are now. Recent history is very important because it gives a better idea of your current situation and current risk.
What most people don’t understand is that 35% of your score is based on payment history. So, if you haven’t used it in two years you are not going to have a good score. Your first card, or your first card after a bankruptcy, may have a high interest rate but that doesn’t matter. Use it to buy small things and pay off immediately so you don’t overspend and still get credit for current payment history.
LL: Ok, so if 35% is payment history, where does the rest of the score come from?
TR: Another 30% of your score is balance availability, meaning having a total balance below 30% of your total available credit limit. The best way to maximize this part of your credit score is to pay the charges in full as you use the card, not even waiting for the due date. What a lot of people don’t realize is that the credit card companies report your account balance information at a different time than your due date. So, even if you pay your card off every month, it is likely that your credit report will show a balance because of the time difference between when they report and when you pay your bill. Again, be sure to use your credit! Whether you charge $2 or $2000 it doesn’t matter. What matters is whether or not you made your payment on time in order to fulfill your contract.
Another 15% is how long you have had credit, so don’t close the card you’ve had the longest!! Don’t close a card just because you’ve paid it off, or because you don’t use it too often, especially if you’ve had it awhile.
The next 10% is based on the number of inquiries and new accounts. Every inquiry costs you 3-5 points (with the exception of shopping for car insurance, raising your current card limits, preapprovals and other soft hits). If you have more than 3 hard inquiries in 6 months or 6 hard inquiries in 12 months you will lose 10% of your score, which can greatly affect your ability to get a loan.
The key to this is not to apply for more than one new account every six months because any new loan will drop your score a little due to the fact the account has no payment history. After six months of payments, the new account will show more favorably because you’ve shown you can handle the debt.
The final 10% is based on the variety of debt and the type of debtors you have. This means how diverse is your credit, and how do you handle the different types of debts. If you only have a car loan, there is no proof you can handle a credit card. It also means that who you borrow from matters: if you borrow from a high-risk lender then you must be at high risk to default, so you may not see your score rise as much as if you borrowed from a reputable lender.
During financial counseling we often focus on cleaning up credit: liens, charge offs, bankruptcies, and collections. We go through each one and determine if any action is necessary.
1st step: Any open collection account we request proof of debt through a certified letter. The company must comply within 30 days, and if they don’t it can be disputed and requested to be removed. By law, if they don’t give you proof then they can’t report it to the credit bureaus. If they do respond, then you write them a settle and delete letter and they will usually accept 30-40% of what you owe. So, get it in writing, pay it off, and it should go away. Even if they don’t agree to anything, the best way to handle it is to just pay it off. The new FICO rules state it will stop affecting your score as soon as it’s paid off.
2nd step: Charge offs that are still with the original lender. Either pay them off (and your score will slowly get better over 2 years) or request to settle the debt (it will show as settled instead of paid off, so it’s not as good but better than nothing) or let it go (will stay on 7 years from the date it first went delinquent) or set up a payment plan (they can’t report payments because they wrote it off so until you have paid the final amount your credit score won’t change).
3rd step: Bankruptcies stay on your report for 7 years for chapter 13 and 10 years for chapter 7. There is nothing you can do about it, except be sure to keep all other accounts current while your credit score recovers.
Now, I think we just need to get this information into our schools so our kids can go out into the world with a solid foundation for how to lead financially responsible lives!