It’s a valid question. Your credit score is one of many metrics that is used to define your financial health, so it’s important to know how it’s calculated and the impact of a low score.
When I was working as a mortgage underwriter, there was a minimum credit score that the applicant(s) had to have in order to obtain a mortgage.
Applicants would begin the mortgage underwriting process, provide all the necessary documentation, and lock in their interest rate only to find that there was an issue when their credit report was pulled.
Even though everything else was in order, their credit score was too low to be able to purchase the home and take out a mortgage. Often times, this would come as a complete shock to the person or couple.
A recent article by cnbc.com points out the importance of checking your credit report annually, and that many consumers don’t understand how their credit scores are determined and impacted.
What Impacts My Credit Score?
High Impact:
- Credit Utilization: This can be determined by dividing the amount of debt you have outstanding by the amount of credit you have available to you. For example, if your current credit card balance is $1,500 and your credit limit is $5,000 – your credit utilization stands at 30%. The lower the utilization ratio the better, but a good rule of thumb is to keep this below 20%. Note that only consumer credit accounts are taken into consideration, so items such as mortgages and home equity loans are not included in this ratio.
- Negative Marks: Items such as liens or declaring bankruptcy can have a detrimental impact on your credit score. As the number of negative marks increase, your credit score will move in the opposite direction. That being said, the statute of limitations on negative marks is 7 years (10 years for declaring bankruptcy) so while it may take some time, recovering from such events is possible.
- Payment History: Showing a creditor that you are able to pay your monthly payments on time can help increase their confidence that you will continue to do so into the future.
Medium Impact:
- Age of Credit History: This can be determined by taking the average age of all your credit accounts. For younger people, this factor can often limit your credit score, but you will notice that as your accounts age, your credit score will gradually increase as well. It’s important to remember that a good credit history is not built overnight, so just as with saving for retirement, starting early can help immensely.
Low Impact:
- Number of Accounts: Having numerous debt accounts can actually help to increase your credit score. That is not to say go out and apply for 25 credit cards, as creditors also like to see a diversified credit portfolio. Having a mix of credit cards, retail loans, mortgage loans, etc. can help improve your score as well.
- Credit Inquiries: These can often be difficult to avoid. As you apply for new loans, creditors will usually inquire about your creditworthiness. By doing so, they will increase the number of credit inquiries, thus negatively impacting your credit score.
Maintaining a high credit score can play a vital role in many aspects of our lives.
Showing creditors that you are credit worthy can pay off substantially over the life of a loan. If a creditor can see that you have a good credit history, they will feel much more comfortable offering a loan to you – which often translates to better loan terms, i.e. lower interest rates.
Checking your credit report is a great first step to knowing where your creditworthiness currently stands.
Maintaining a high credit score can play a vital role in your ability to access credit and increase flexibility when making large purchases. This, in turn, can have a positive impact on your overall financial health. Utilizing credit can, at times, be even more beneficial than paying cash.
If you are considering making a major purchase or paying off debt, contact us to evaluate the impact on your financial plan.
