Why a High Credit Score Doesn’t Always Mean You’re Financially Healthy
There are more numbers that can make you proud of your money management skills than a high credit score. And for good reason: lenders use credit ratings to determine everything from mortgage interest rates to whether you qualify for the best credit card rewards.
This post was originally published on LearnVest .
So, if you worked hard to score 700 or higher (usually considered to be in the “good” range), that means you are doing something right — and you will likely be rewarded for your financial diligence.
“Your credit rating is the number that represents you to the world,” says April Lewis-Parks, director of education and public relations at Consolidated Credit. “So the financial impact of a good credit rating is enormous.” This means that you are attractive to lenders who can then offer you loan conditions that those with a lower score will not apply.
However, it is important to remember that your credit rating is not critical to your financial health . It’s possible to have decent results and still struggle with debt – or at least make decisions that won’t necessarily benefit your money in the long run.
To understand how this could have happened, we asked credit and finance professionals to share some scenarios that illustrate how you can have high scores while still making some less stellar money moves.
You are never late with payments, and only pay at least every month
Meeting the payment deadline on time is one of the most important ways to maintain a high credit rating – after all, payment history accounts for a hefty 35% of your FICO rating (one of the most common credit ratings used by lenders and the one we’ll focus on here).
However, if you just pay the minimum amount and have a balance every month, you are digging yourself into a hole of debt that can take years, especially if you have high interest rates, explains Katy Ross, manager. Education and Development at American Consumer Credit Counseling, a nonprofit credit consulting agency.
Ross offers the following hypothetical example: some credit card issuers set minimum payments at 2% of the total balance. So if you owe $ 5,000 on an account with an annual rate of 18% and only pay a minimum of 2% each month, it will take over 44 years to clear your account. Plus, you’ll pay more than $ 12,400 in interest – money that you could use to fund things like your emergency fund or retirement fund.
On top of that, even if you don’t face late payments, paying only the minimum means you are potentially increasing your loan utilization rate – a separate factor in calculating your credit rating (more on that below).
You have a low level of loan utilization, but this is because you continue to apply for a new loan
The amount of your debt on credit accounts is 30% of your FICO score, and the key factor in this calculation is your credit utilization rate, that is, the total amount of your debt divided by the total credit limit available to you. “If your utilization rate is higher than the recommended 30-35%, it can be bad for your financial stability,” says Ross.
One of the ways to improve your loan utilization rate is to increase the total amount of the loan issued in your name. This strategy, however, can backfire because it can: 1) discourage you from being more aggressive in paying what you owe; and 2) entice you to keep spending because you have more credit to spend on.
“Just because a credit card company wants to lend you more money or increase your credit limit doesn’t mean you can afford [spending more],” says Lauren Zangardi Haynes, CFP®, Evolution Advisers in Midlothian , Virginia. “If you already have a credit card and ask [the company] to increase your limit and they do, great if you’re not going to maximize it.”
Indeed, one of the times when you might be tempted to open a new credit card is if you are already close to making the most of your existing one. Lewis Parks illustrates this scenario: Suppose you have a credit card with a balance of $ 4,000 and that card has a credit limit of $ 5,000; your utilization rate on this account is a whopping 80%. You will then receive an offer in the mail for a new $ 12,000 limit card that will allow you to transfer your balances for a limited period of 0% per annum. After you transfer that $ 4,000, your loan utilization rate is much more favorable – 33%.
But here’s the catch: “People are consolidating their debts, but they still have another line of credit, so they end up writing off both cards,” says Lewis-Parks. Plus, once your 0% teaser rate expires, the annual interest rate on whatever debt you have is likely to jump, which could put you in worse shape than when you started, she adds.
The increase in available credit boils down to this: “If you know that credit cards will be very attractive to you, then you should not open multiple credit cards,” says Haynes. Also, remember that every time you apply for a new loan or loan, a hard request is triggered in your account, which can lower your score by a few points, especially if you are applying for multiple lines of credit in a short amount of time.
Your high credit rating gives you the right to receive a large loan amount, and you are engaged in the maximum amount
As we mentioned earlier, the better your credit rating, the more likely you will receive favorable terms from lenders, such as lower interest rates and higher loan limits. But it’s important to reiterate: just because you can borrow a large amount of money doesn’t mean you really have to.
Haynes says she sees this spring a lot when it comes to getting the right to mortgages. Home buyers often borrow the largest amount they are approved for because they really want to convert into their dream home or a larger home to house their future family. Unfortunately, this can lead to the fact that you are “poor” – spend on housing such a large percentage of your income that it makes it difficult for your cash flow.
“This huge mortgage payment really makes it difficult for [people] to save more for retirement, vacation, or emergency,” Haynes says. “You [also] need a bigger contingency fund because you need to have more money to cover these huge mortgage payments, so this becomes a round-robin problem.”
Ultimately, if you manage your money in a way that improves your overall financial picture, it will help you maintain a good credit rating, says Lewis-Parks. “It’s much more important to make sure you are financially healthy, have emergency savings, have a retirement plan, and know what you’re spending on.” she adds. “[Then] you will naturally have an excellent credit rating; this is usually the case. “
Why a high credit rating does not always mean financial well-being | LearnVest