Your credit score is your key to getting a loan when you need it, and you want your score to be as high as it can.
In this installment of Industry Focus: Financials, Motley Fool analyst Gaby Lapera talks with Dan Caplinger, The Fool's director of investment planning, about how your credit score gets determined and what you can do to improve it. With tips on how to handle older credit accounts, making sure you know the terms of your debt, and being aware of common mistakes, you'll be in a better position to get as high a credit score as you can.
A full transcript follows the video.
This podcast was recorded on Jan. 30, 2017.
Gaby Lapera: We talked a little bit about credit card debt, how you might get there. Let's talk about something that's related to that, which is credit scores. Dan, why are credit scores important?
Dan Caplinger: Credit scores have become increasingly important because, basically, if you ever need to get financing for something, whether at the house, a car, or even basic consumer loans, it's important to have a good credit score so that you can have any chance of getting that loan in the first place. In addition, even once you climb above the barrier for getting the loan at all -- the higher your credit score is, the better your terms are likely to be. If you have a really good credit score, not only would you maybe be able to get offers and take advantage of offers that other people wouldn't even receive, but your interest rate might be lower, you might be eligible for bigger credit card rewards, the terms of the repayment might be easier for you. You get some rewards, you get some benefits, from doing the work to get your credit score as strong as it can be.
Lapera: Right. You might be wondering who comes up with the credit scores and how are they calculated? There's three credit bureaus, which is Equifax, TransUnion, and Experian. They all use the same basic factors to get your credit score. Some of them weight some more or less. But, by working on those credit factors you can improve your credit score. The one that, in general, holds the most weight is how on time you are with your payments.
Editor's note: Credit scores range from 300 to 850. Higher credit scores are better.
Caplinger: Yeah. Having a good payment history is really important. That's where you get back into those terms. You need to understand when those payments are due. You have to make sure that you give enough lead time so that when you make that payment it's going to credit on time, so you're not charged with a late payment. That way, you won't have to pay that fee, but you also won't get that ding on the credit report that hurts this amount, because your payment history makes up about 35% of what your credit score is. So, getting in the habit of being on time with those payments, it can be a really big boost if you've had bad payment history in the past. Getting that fixed will see that score bump up a really large amount.
Lapera: Yeah, even if it's just a minimum payment, it's a really important thing to be on time. The next most important thing, probably -- because they don't actually release exactly how they figure out the formula, but in general, people have figured this is about what it is -- is the percentage of the utilized credit limit. This is the combination of every line of credit that you have, how much you're using it. Say you have two credit cards and one has a limit of $1,000 and one has a limit of $2,500, so the total is $3,500. It's how much you use out of that entire amount.
Caplinger: Yeah. You hear people talking about, "I'm almost maxed out on my credit cards," and usually that's a bad sign in terms of this part of the scoring. If you have most of the credit that you have been extended, if you're using all of that up, and you already have debt of that amount, it means you really don't have that much left to borrow, and the credit scoring bureaus are going to say, "Boy, that seems risky. That means you don't have that much more capacity to borrow, and you owe a lot compared to what credit card companies and other lenders are willing to give you in the first place." That adds up to a more troubling situation than somebody who has a couple hundred dollars on their credit cards, but they have thousands of dollars of credit limit. For them, they're not very concerned, because they haven't really used up much of their credit at all.
Lapera: Yeah. So, there's two ways to attack this. One is to spend less. The other is to get your lines of credit increased, which can be tempting fruit for some people, because they're like, "Oh, I have a bigger credit limit, that means I can spend more money." But, the idea is, if you increase your credit limit, then the amount that you spend regularly will be a smaller percentage of that. So, one of the ways you can do this is, if you do have a good record with your credit card company -- so, again, if you already have a good credit score, sometimes it gets in a self-perpetuating loop -- you can ask your bank to bump up your limit. I know, some banks, you can ask for that online, you don't even have to go into a branch anymore.
Caplinger: Yeah. Or, the customer service lines, you can call in on the phone and they can sometimes be helpful as well.
Lapera: Yeah. And sometimes they just raise your credit limit just because you have been a good customer for a long time. That happens on occasion. They'll just send you a letter saying, "Hey, it's more."
Caplinger: But be careful. A lot of times, when a bank makes that decision, it's based on the expectation that you're the sort of person who is going to take advantage of that by spending up toward that higher credit limit. So, really, the most important thing about managing your credit cards is knowing yourself, and knowing what your predilections are. If you're going to be tempted, if that temptation is going to be too much to resist, then you have to think about that, and you have to manage things accordingly.
Lapera: Yeah, definitely. I've heard multiple people, also my age, say that they don't trust themselves with a credit card, so they don't have one. It's one of those things that, when I hear that, I'm like, "Ugh, you're shooting yourself in the foot for if you ever want a loan!" But, I mean, that is a deep knowledge of oneself that a lot of people don't have. So, I don't know how to feel about it.
Caplinger: It's hard. You're better off having a credit card than not having it in terms of building up a healthy credit history. But like you say, if it's a potential addiction, you might be better off staying totally clear, rather than having it and misusing it.
Lapera: Yeah. I want to make a little side note here. The easiest way to build credit is via a credit card, because it's easier to get them something like a home loan or an auto loan. You can build credit on those things, but generally you're going to have to have someone co-sign on a loan with you. So, it'll go on your credit score, it'll also go on the other person's credit score. So, keep that in mind, if you were thinking about co-signing a loan with someone to help them out, to help them start building credit, that debt also goes in your name. So, it can impact your credit score as well. So, in general, credit cards are the easiest way to build up. But I think, Dan, you were saying that student loans also go toward credit scores, right?
Caplinger: Yeah. A lot of people, their first exposure to debt is when they go to college and they need to borrow money in order to pay their tuition and their room and board and that kind of thing. With most student loans, they're in the student's name, versus the ones that are in the parent's names. Student loans for the student use that student's social security number, goes on the student's credit history. Some of those loans, like you said, even if they're co-signed by parents, if it's in a student's name, it's the student that's on the hook for it. If you're in that situation, take those student loan payments seriously, because they might be the foundation on which you're building up a healthy credit score, if you manage your debt well.
Lapera: Yeah, which brings us back to our next metric, which is how many lines of credit you have. That includes auto loans, mortgages, student loans, and credit cards. The more different types you have, and the greater in number they are, the better your credit score.
Caplinger: That's right. That's generally right. What lenders want to see it's like you're able to handle different kinds of debt. Whether that's a fixed-payment kind of debt like a car loan, where you have a set amount that you pay every month, or a home mortgage, a fixed mortgage where you pay that set amount every month, as well as the variable amounts you would pay on credit cards, that gives a more complete picture of how credit-worthy you are.
Lapera: Yeah. Again, this is kind of the double edged sword. Because you could take out a bunch of different kinds of credit. But of course, that means you'll have a bunch of different ways to get into debt. And that's part of the thing they're measuring -- your capacity to be in debt, because that makes you a good customer, because they know you will be paying at least the principal and probably interest payments, if you're the average American, as well, and that's how banks and credit card companies make money. Number four is the length of your credit history. There is no way to game the system on this one. You just have to have a line of credit for as long as possible. The longer you have credit, the better your credit score. The only way, if you really want to try and to help someone else, if you have kids, you can open a credit card in their name and your name and pay money to pay off the bill every month, and that will help them. That's actually what my parents did for me. Thanks Mom and Dad!
Caplinger: Yeah, the one strategy you can use here, it comes up when people are thinking about closing out a credit card. A lot of time, you might have a credit card and you don't really use it that much anymore, and you think, "I have a better card," maybe the old card is just a plain old vanilla credit card where is the new credit card you have gives you mileage, air miles, or points or cash back or something like that. Before you cancel that old card, consider what effect it's going to have on the length of your credit history. If it's your oldest card, if you've had it forever, then sometimes it makes sense to hang on to it and to use it every once in awhile in order to make sure that you maintain that length of credit history and boost up your score a little bit.
Lapera: Yeah. You can do that. Other than that, like I said, it's pretty much parents putting the kid's name on their debt, which is a double-edged sword, because if the parents don't pay off the debt, then the kid's credit score gets trashed before they even have a chance to start. Then, the last metric that the credit unions check is hard checks. It's a hard pull on your credit score. This is, for example, if you go to a car dealership and you're going to buy a car, they always check your credit before they offer you the loans, so they know what terms to give you. If you have a lot of those hard pulls on your credit, you're going to be dinged at least a few points, because that means, for whatever reason, you're opening up a lot of debt at the same time.
Caplinger: That's really what they're looking for. If you're going out and trying to open three or four new credit card accounts all at the same time, most of the credit card bureaus are going to assume that the reason you're doing that is, you got yourself in trouble and you need a big inflow of credit right now. That's the kind of risk that those bureau want to take a look at closely and flag their customers on so that whoever the last person is to give that new credit card understands, when they're doing it, that this person already just opened up a whole bunch of other things, and to take that into account in making the decision about whether or not to give you that card.