Are Your Credit Scores Hurting You?

Article by Jordan Crouter

Don’t believe anyone who tells you that credit scores are irrelevant to your financial health. But you also should not believe that credit scores are any reliable indication of your financial health. You can be a multi-millionaire with no credit score or someone with excellent scores who’s on the brink of a financial meltdown. Indeed, economists currently are worried about a steep rise in foreclosures among “prime” customers, those who had good credit when they got their mortgages but who took on too much debt or lost their jobs in the recession. The confusion over what credit scores are, and what they do, leads to some unfortunate attitudes:

– Some people dismiss credit scores entirely, either believing scores have no effect on their finances or out of a general disdain for credit and debt.

– Others understand that scores are important but believe that if they handle their money well, their scores automatically will be good.

– Still others are positively obsessed with their scores, focused on boosting them as fast as possible without considering how their actions might affect the rest of their financial lives.

All of these folks are misguided and could be risking some serious fiscal fallout. Let’s take these myths one at a time.

Myth No. 1: Credit scores don’t matter.

Here’s the truth: Credit scores are increasingly critical to the financial lives of most people.
In today’s credit crunch, only people with good scores are snagging the best rates and terms on mortgages, credit cards and other loans. They can effectively fight back against the credit card rates increases and limit cuts so prevalent today. Meanwhile, many people with bad scores are paying far more for credit or being turned away entirely.

Even if you’ve paid off your home and never plan to borrow another cent, you may still need to be concerned about your numbers. Credit scores are used by insurance companies to determine premiums and by landlords to evaluate applicants. (Employers often review credit information as well, although they tend to look at your entire credit report, rather than just a three-digit credit score.)

Furthermore, you can have great scores without being in debt.
While having installment accounts such as mortgages and auto loans can boost a score, they’re not essential.

You can achieve a score of 750 or above over time just from credit card accounts that you pay off in full every month, according to FICO, the company formerly known as Fair Isaac that created the leading credit scoring formula. In other words, you don’t have to pay a dime of interest to get and keep good FICO scores.

Myth No. 2: Great finances make great credit scores

I wish.
Credit scores were designed to help lenders gauge a borrower’s risk of default. That’s it. The only information used is what’s in your credit report. The formula is particularly affected by:
– Whether you pay your bills on time.
– How much of your available credit you’re using.
– How long you’ve had credit.
– How recently you’ve opened a new account.
– The mix of credit you use.

Here’s what does not go into a score:

– Your income or how much of it goes to pay debt.
– Your net worth.
– Your retirement account balances.
– Your investment returns.
– Your employment history or prospects.
– Whether you live within your means.
– Whether you pay your credit card bills in full each month or carry a balance.

The bottom line: If you don’t have and regularly use credit, the scoring formula will have a tough time assessing your creditworthiness. That’s how folks who’ve paid for everything with cash wind up with low scores or no scores.

It’s also how people who don’t carry balances can score lower than they deserve. If they use up most of their available credit each month, that can ding their scores even if they pay their bills in full. Savvy credit users continue to pay their balances, but make sure they use only a fraction of their available credit at any given time: 30% is good, under 10% is better.

Score creators — and lenders — don’t particularly care that the credit scoring system isn’t fair to the unwitting or the credit-averse. What they care about is that the formula works in general to help separate the good risks from the bad. If you get unfairly lumped in as a bad risk because you don’t use credit “right,” it’s no skin off their noses, but it could ultimately cost you a bundle.

Myth No. 3: Great credit scores make great finances

Look again at that list of what isn’t included in your score. Some of the most important gauges of your financial well-being are missing from the credit-scoring algorithm.

That’s because credit scores were never designed to be an indicator of your overall financial well-being. They do not measure your worth, monetary or otherwise.

You can take pride in a good score, of course, but you shouldn’t assume it means your finances are sound. In fact, some of the things people do to boost their scores can come back to bite them.

One of the quickest ways to increase your score, for instance, is to pay down credit card bills. Some people do this by taking out 401k loans to pay off debts. The debts effectively disappear from their credit reports, because 401k loans aren’t reported to the credit bureaus, and as a result borrowers may see a substantial increase in their scores.

But if these borrowers later lose their jobs, they could be in a world of hurt. In most cases, the loans become due shortly after employment ends, and any unpaid balances become inadvertent withdrawals, triggering big tax bills. The money can’t ever be put back into the 401k, so these borrowers lose out on future tax-deferred returns as well.

Other people use their great scores to pile on cheap debt. People with excellent scores still get 0% balance-transfer offers on credit cards, low rates on auto loans and below-prime rates on home equity lines of credit.

But at some point, that debt load can topple them. Even a small setback — a higher interest rate, a cut in hours at work, a lowered credit limit — can be a crisis when you’ve borrowed too much. People who resisted the urge to load up on debt are likely to do better in this recession than those who didn’t. As with everything else in the personal finance world, you have to look at the big picture — and your credit score is just one of the factors you need to manage.

Are Your Credit Scores Hurting You?
Jordan Crouter
cell: 949-310-6998
www.jordancrouter.com

About the Author

I am on a personal MISSION to empower all of you frustrated stuck entrepreneurs & give you the strength, courage & support to finally turn all of your dreams into reality!