Credit (and credit cards – which I will tackle with the next post) related questions are rather popular in the military.  Many people that enlist or even commission never get told the details about credit scores and why it is better to have a good score.  We all know or at least heard of someone that buys a car out of tech school with 15-20% interest rate and is always short on cash.  Well, to prevent that from happening, having a good credit score is essential.   Hopefully this post sheds some light on the various basic questions about it.

So what is a credit score?

A credit score is a number that is based on a combination of various financial factors.  It is the most important thing when it comes to interest rates on auto, home, personal and any other kind of loans.  The most common credit score that is used is known as the “FICO” score (http://www.myfico.com/).  While this will be geared towards that particular score, you can apply the same fundamentals towards any other credit score aggregates.  Essentially, a credit score rates your “trustworthiness” to pay off debts.  The higher the score, the more you have demonstrated to not be a liability to lenders.  The FICO score ranges from 300-850.

Think of it this way – if two of your friends or coworkers came by and asked you for some money and you know that one is very responsible with finances, but he just had an emergency while the other is constantly asking people to borrow funds for daily expenses, cancels various plans because he can’t afford them, or even gets his car repossessed for missing payments, who would you rather loan that money to?  My guess is that you would pick person #1.  This is exactly what the credit score figures out.

Why is a credit score important?

A credit score ultimately governs most things in our adult lives that have to do with money.  You want car insurance?  Having a good credit score can (and usually will) decrease your premiums.  You want a loan on that cool new car?  A better credit score will lower your interest and save you money.  Home loan?  Credit score will determine your interest rate there as well – which will have an impact on the overall amount that you can borrow.  If you want a “premium” credit card for perks, the company will check your credit score for eligibility.  For the military specifically, not only can having a bad credit score prevent you from joining the military in the first place, but it can also jeopardize your clearance (if you have one).  It can also have an effect on renting a place, or even getting civilian employment after the military.

What affects my credit score?

While many financial situations affect your credit score, some are more important than others.  The most important thing in a credit score is your ability to pay your bills ON TIME.  This includes credit cards, loans, and even your phone bill or rent!  With credit cards or anything else you finance, it is important to note that paying the total amount is not as critical as making sure you at least make the minimum payments on all of your debts.

That does not mean, however, that paying things off in full is NOT important.  The second most critical thing to your score is the total amount you owe across all of your loans / lines of credit vs your available credit (also known as your utilization ratio).  The lower your utilization ratio is, the higher your score will be.  Because your utilization changes every time you pay on your loan or credit card balance, only the past month is used to calculate the score.  

After those two big ticket items, things like how long your line of credit has been open, the various types of credit that you hold and how many “credit pulls” (when banks formally check your credit) you have in the recent history as well as how many new accounts you recently opened.  

***IMPORTANT NOTE***

There have been multiple reports of credit cards not disclosing your balance to reporting agencies if you paid it off in full before it posts every month.  To clarify – if you make a purchase of $10 on the 2nd and pay it off completely on the 3rd, when your card closes out on the 5th, it will show you had no balance all month.  While you can pay off a little bit off during the monthly period, make sure you have a little left over for the time of the statement posting to ensure it gets reported.  Essentially, do not pay the CURRENT balance in full, but rather focus on paying the STATEMENT balance in full.

Misconceptions about increasing your credit score.

There are a lot of “armchair” experts about money matters, and credit is no different.  Some people will advocate for you to keep a balance on your loans to establish a “history”.  Others will tell you to get a loan just to “build credit” when you can pay off the item in cash.  Some will swear their credit score is (near) perfect and they just do not believe in a credit card… While these things will certainly impact your credit score, and as long as you pay at least the minimum balance every month will give even increase it, these statements are crap and your friend that may be advocating these things is a moron.

Let us start with keeping a balance.  This is a TERRIBLE idea if you can pay off the total amount.  Never carry a balance “just because”.  Since the average Credit Card APR is upwards of 15% and even having the SCRA caps it at a whopping 6% limit, you end up GIVING THAT MONEY AWAY FOR NOTHING!  While it is true that your credit score will go up by doing this, it is not because you are paying interest, but strictly because you are paying every month.  The bank does not count how much interest you have paid for the month, but rather just your balance and if you paid on time or not.  Thus, if you paid attention to the post above, paying off the card in full will still show that you are paying every month and will also lower your utilization due to having less debt to your name.

Getting a loan will do the same exact thing as above.  You are paying someone interest for no good reason and decreasing your total net worth (and thus worsening your utilization).  Do not do this unless you are getting a 0% APR loan as that is essentially free money due to inflation.

Lastly, we have credit cards.  Not getting a credit card can be advantageous if you have poor self-control and will feel the urge to max it out.  However, credit cards will give you the best “bang for the buck” towards your credit score due to having that extra utilization available.  i.e. if you have a CC that has a limit of $20,000 and you have nothing on it, you have an extra $20,000 you COULD be borrowing.  In addition, most cards will have some kind of “cash-back” or “bonus points” programs where you will make some of your money back.  I will address this more in depth in my next credit-card focused post.  Lastly, many credit card companies now give you a free credit score based on their available information.  While this will likely not be exactly the same number that a bank might get while doing an official inquiry, it is usually within 20-30 points.

If you have any additional questions or would like clarifications, feel free to give me a shout!