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how use of credit impacts your financial well-being

Nurse Your Wealth: Use of Credit

Credit plays a huge role in your financial health

  • Your use of credit has a direct impact on your credit score.
  • Your credit score is a 3 digit number lenders use to decide how likely it is that you will repay them on time if they grant you a credit card or loan.
  • The higher your score, the more likely it is that you will receive the best terms for your loans and credit cards.
  • Maintaining a high credit score has multiple benefits, the largest being that you can experience significant savings on interest rates on big ticket items such as a home purchase, or get you the best rates for your private student loans.
  • There is no uniform algorithm that is used by all lenders to calculate your score, but the most common ones, such as your FICO score, use 3 digit numbers that ranges from 300 to 850, with 850 being the best.

FICO credit score ranges

An excellent credit score can potentially save you tens of thousands of dollars

  • Take a look at the chart below.  For a 30 year fixed rate mortgage of $200,000, an excellent credit score could save you over $60,000 over the life of the loan.   The larger the loan the higher the savings.

How credit scores reduce mortgage costs

So what is considered to be an excellent credit score?

  • As mentioned before, there are countless scoring models in the marketplace.
  • FICO considers a score above 800 to be exceptional.
  • But in reality, most lenders don't require a perfect score to get their best rates.
  • According to a study by Informa Research, which tracks interest rates by credit scores on a daily basis, the lowest rates offered on various mortgage related loans are being offered to people with scores at or higher than 760. 
  • And, the lowest rates offered on various auto loans are being offered to people with scores at or higher than 720.  
  • So as you can see you don't have to drive yourself crazy trying to strive for a perfect 850 credit score.

How your credit score is calculated:

  • Each lender's proprietary scoring model gives different weights to the factors that affect your score, but there are usually seven factors that go into it:

how your credit score is calculated

  1. Payment History: This is typically the most important factor.  Late or missed payments bring your credit score down.  Conversely, if you have a long history of paying your bills on time, your score will generally be higher.  The most important thing you can do to boost your credit scores is to pay all your bills on time every month.  If you establish a pattern of doing this early on, for example with your student loan debt, you credit scores will improve.
  2. Credit utilization ratio: This is the amount of revolving credit you're actively using compared with the amount of credit available to you, based on your credit card limits.  For example if you have 3 credit cards providing you a total allowable limit of $15,000, and put $3000 total a month on those 3 credit cards, your ratio is 20% (3,000/15,000).  For the best scores you'll want to keep it under 10%.
  3. Number of accounts: Credit scoring models also look at how many credit accounts you have open and on how many you carry balances.  It's better to have more accounts that don't have a balance than ones on which you do carry a balance.  It's generally a good idea not to close credit card accounts that don't charge annual fees because those cards that you don't use will improve your utilization ratio and your credit history.  A best practice is to simply make one purchase on those cards every six months or so and immediately pay it off so the credit card company doesn't automatically close it for inactivity.
  4. Credit history: Most scoring models also look at how long you have actively used credit. They typically look at the average age of all your open accounts. The longer your credit history, the better it is for your score.  Student loan debt does count towards your history and for a lot of people, it is the first use of credit in their history that a lender will see.  *TIP: You don't need to carry a monthly credit card balance to build your credit history.  You can pay off your credit card bills every month and positively affect your credit standing.
  5. Credit Mix: This part of your score is determined by how many different types of installment and revolving credit you have.   Installment credit has a fixed end date with a series of payments due every month. Installment loans include mortgages, student loans, auto loans, and personal loans.  Revolving credit doesn't have a specific end date or set balance. Instead of spacing out the balance equally over a certain length of time, a minimum payment is due each month.  Consumers can choose to pay more than the minimum but are not required to.  Credit cards are the most common type of revolving credit.  Ideally your mix will contain a combination of both types. 
  6. Hard Inquiries: A hard inquiry shows creditors that you applied to get credit somewhere else, whether that’s a car loan, mortgage, student loan or credit card.  Having too many in a short period of time may reduce your score.  *Checking your own credit score is not considered a hard inquiry.  Neither is getting a loan pre approval since only a soft inquiry is used for this.
  7. Negative Information:  Negative information on your credit report can lower your scores.  That information remains on your credit report for a set period of time.  For example, late payments appear for seven years from the date you first missed a payment.  Paying off a collection account won't immediately remove it from your credit report.  Bankruptcies can remain on your report for seven to ten years, depending on the type of bankruptcy.  The good news is, all negative information will eventually cycle off your credit report.  Until it does, focus on the things you can positively influence, including paying all your bills on time.  *TIP: If you accidentally miss a credit card payment, call your credit card company as soon as you notice it and ask that they don't report it.  If you have a history of paying on time they will generally agree not to.

You should regularly check your credit report and scores

  • Think of credit reports like a medical record, which lists facts such as symptoms and test results, and credit scores as the resulting diagnosis.
  • You should check both periodically.  As mentioned previously, doing so will not have a negative impact on your scores.  Checking your credit report allows you to detect and dispute errors.  It also helps you identify and stop identity theft early on. 
  • You have the federally mandated right to view your credit reports from each of the three major credit bureaus for free once every 12 months at www.annualcreditreport.com
  • There are many free ways to pull your credit scores from the major credit reporting agencies.  In addition to various websites, a lot of credit card companies including Chase and Discover now offer this service.  Knowing your score means that if its good, you can use this as leverage when negotiating with lenders, and if it's not as high as you want it to be, you can focus on making it better.

freezing your credit

Freezing your credit

  • As of 2018, a new law was passed that allows you to freeze your credit for free.
  • When you freeze your credit, the credit reporting bureaus can’t give any information to anyone who makes an inquiry about you.  Typically, businesses inquire about your credit when you (or someone posing as you) attempts to, for instance, open a new credit card, buy a car or rent an apartment.
  • When your credit is frozen and the business can’t get any information about you, it typically stops the process — which means a fraudster will be unable to open an account while using your identity.
  • Freezing your credit can be a good line of defense against identity theft, but you have to remember that you will first have to remove the freeze if you wish to apply for a loan or line of credit in the future.  For this reason, if you know you will be needing a mortgage or car loan in the near future, you may want to hold off.
  • If you want to freeze your credit, you need to do it at each of the three major credit bureaus: Equifax (1-800-349-9960), TransUnion (1-888-909-8872) and Experian (1-888-397-3742). 
  • When you freeze your credit you are issued a PIN that you need to store safely as this is what you will use when you call or go back online to unfreeze your credit.
  • Once you request to remove the freeze, it only takes about an hour for the process to be complete.

How to maximize credit card rewards

maximizing credit card rewards

  • This strategy assumes you don't have existing credit card debt and you are paying your balances off in full each month.
  • The idea here is to carry one card that pays 2% cash back on everyday spending, and a few additional cards that pay oversized rewards on specific categories that you spend the most on.
  • Nerdwallet is a good resource for finding the best cards for various spending categories.  They keep an updated list of recommendations here.
  • An example of a combination you may want to use is as follows: 

A) The Citi Double Cash Card for 2% back on every day purchases (no annual fee).  

B) The American Express Blue Cash Preferred Card for Groceries ($95 annual fee but still one of the best for groceries if you spend $6,000 per year on them).  

C)  The Capital One Savor Cash Rewards Card for dining out (no annual fee and 4% back on dining and entertainment).  

D)  The Wells Fargo Propel American Express Card for travel (3% back and no annual fee).

E) If you are already an Amazon Prime member and make a lot of purchases on Amazon, you may also want to explore the Amazon Prime Rewards Visa Card which provides 5% back on Amazon purchases.

Disclaimer- We have no affiliation with Nerdwallet or any of the credit card companies mentioned.  we receive ZERO compensation in any way, shape, or form for recommending them.  Our suggestions are simply based on personal research and experience.  Keep in mind these companies are constantly changing their rewards programs, so always do the research on the most up to date offers if you plan on signing up for a card.

  • As you can see, this strategy involves carrying about 4 separate cards and being cognizant about using the right one for the right purchase.  It's actually easier than you would think to put into practice and it could save you a ton of money each year if you stick with it.   One tip is to label each card with a tiny piece of duct tape that states what category of spending it should be used for.  This way you can easily pick it out of your wallet when you need to. 
  • Now there are some self proclaimed credit card ninjas out there who could very well provide a strategy that could save you more than what we have outlined here.  But it would also probably require a much more complicated strategy that includes using cards with rotating rewards categories, and we personally just don't think the extra rewards would be worth the effort.  If you do, then by all means go for it.  
  • Remember to be careful about opening multiple cards in a short span of time, as they do require a hard credit check and that may have a negative impact on your score.
  • When considering cards with annual fees,  make sure you do the math and compare the net amount in rewards you would receive from them versus a zero-fee card that offers a lower rewards rate for the same spending category.  In some cases the card with the annual fee is still better.  In other cases it is not.  

Key Takeaways

  • Being diligent with your use of credit can payoff in more ways than one.
  • You could save substantial amounts of interest on big ticket purchases that require financing.
  • You can reduce your private student loan interest rates and therefore your monthly payments.
  • Once you have a credit card strategy in place, you can maximize the amount of rewards you receive each year without having to put forth much additional effort.  
  • Combining your cash flow optimization strategy with your credit strategy is one of the smartest things you can do to enhance your financial wellness.  Unlike the future returns of your investments, it is something you have 100% control over.  

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