I recently listened to Earn Your Leisure’s podcast episode 84 on Jamila Davis. Jamila was working her ass off as a young woman and had a goal of buying a Lexus GS 300. Once she did, she had a lot of people asking her to help them get expensive cars. She began making money by helping other people get their dream cars, and she quickly realized she could make even more money with real estate. After a short time, she was helping some of the top rappers get their hands on their dream homes.
Many of her rapper clients had a problem when they tried to buy their first mansion though. They had no credit history. They would get famous, start making millions, but not be able to get loans to buy homes due to their lack of credit history. When I heard this, I thought this was an insane problem! The banks knew the rappers had the income, but since they were newly rich, they wouldn’t lend to them. (We won’t get into the racial discrimination involved with this problem, but just know that it isn’t lost on me.) It showed me that it isn’t only about the journey to get the money in the bank, but that you need to be building trust on the back end to be able to buy the things you want in life. The way you do that is by building credit.
Your credit score impacts your life in so many ways. Some of the ways you’re probably familiar with your credit score being used are to determine the interest rate on your loans, to check your ability to pay your rent when you submit your rental application, to get approved for credit cards, things like that. What you may not be aware of is that your credit score is also used to determine your insurance premiums, your cell phone plan rates, and your utilities deposits. If you have a good credit score, you will get better rates on ALL of these things. A bad or mediocre credit score, on the other hand, can cost you an excess of $100K over your lifetime. That is A LOT of your hard-earned cash. For many of you, this exceeds your annual salary. That means you would need to work several years just to pay the higher payments caused by your poor credit score.
So How Do They Come Up with Your Credit Score?
Your credit score is a number ranging from 300-850. The higher the number, the better your score. This number is used to help a lender determine the probability the borrower will repay their loan on time. The higher your credit score, the less risky you are to lend to. There are several credit scoring systems, but the most commonly used is the FICO score.
Your credit score is based on your payment history, credit utilization, length of credit history, types of credit, and new credit. Your payment history makes up 35% of your credit score and tells the lender whether or not you pay your debts on time. 30% of the score comes from your credit utilization. You want to have a low utilization percentage. For example, if you have a credit card limit of $10K and have used $2K of that, your credit utilization will be better than someone who has used $6K of their $10K limit. Length of credit history accounts for 15%. If you opened a credit card when you were 18 and never use it, still leave the account open. All of your history with that credit card will add to your length of credit history. The longer your history, the better. 10% of your score comes from the types of credit you have like your credit cards, mortgage, car loans, etc. This factors in if you have installment credit such as mortgages and car loans, as well as revolving credit such as credit cards. The final 10% looks at any new lines of credit you’ve opened, and inquiries into your credit score. Having a lot of credit inquiries will damage your credit score.
What Makes a Credit Score Good?
In the previous section, you learned that credit scores range from 300 to 850. Borrowers with scores under 640 are considered subprime. These borrowers are often offered subprime loans. Subprime loans have higher interest rates because the borrowers are deemed riskier. (Credit scores are not the only factor considered when deciding to offer subprime loans. Read our post on the racial wealth gap to learn how race also plays a factor.) These higher interest rates can end up costing you a lot of money over the term of the loan. A person with a credit score near 620 will end up paying $65K more on a $200K mortgage than a person with a credit score over 760.
A credit score of 700 or higher is considered good and borrowers can be offered better interest rates at this level. Scores of 800 or above are considered excellent. A more comprehensive FICO score range is shown below.
- Excellent: 800 – 850
- Very Good: 740 – 799
- Good: 670 – 739
- Fair: 580 – 669
- Poor: 300 – 579
How Can You Improve Your Credit Score?
If you have a low credit score or no credit score, there are three ways you can improve it. Since your payment history makes up the largest portion of your credit score, this is where you should start. If you are trying to repair your credit score, start by taking a debt inventory. In an excel spreadsheet, Word doc, or notebook, log every open credit card and loan you have and the current balance and due date for each. Also log the credit limit and minimum monthly payment for all of your credit cards. If possible, set up automatic monthly payments. This will ensure that you never miss a payment. If your income is sporadic and automatic payments won’t work for you, set up due date alerts for all of your payments. If your payment due dates are all over the place, you can call the lenders and see if they can change the due dates. If you get everything due at the same time, it will be much easier to make sure everything gets paid on time. After about 6 months of consistently making all of your payments on time, you should see an improvement in your credit score.
If you are trying to establish credit, I would suggest opening a credit card. Do your research to make sure you’re getting one that will suit your lifestyle. If you love to travel, the Capital One Venture card gives you a lot of points that you can use later to cover travel purchases. The American Express Blue Cash Preferred card offers great returns for gas, groceries, parking, and subscription purchases. Nerd Wallet allows you to compare a lot of credit cards, so you can start there. The key to your success with your credit card will be to pay off the entire balance every month. I purchase everything on my credit card and pay it off in full every month. This allows me to get all of the benefits of using the card, build a great payment history, and not pay any interest on my purchases. Interest is only charged on balances you keep for over a month on your credit card. If you’re worried about overspending on your credit card, start by just buying a few things, like groceries or gas, and paying those purchases off every month. This will still allow you to get the same benefits I listed above, and you can build your comfort level with using your credit card and add purchases over time.
After you’ve set up your payment plan, the next way to improve your score is to improve your credit utilization. This makes up the second-largest portion of your credit score, and it is simple to improve. If your credit limit is $10K and you’re purchasing everything on your credit card each month for a total of $6K, your credit utilization rate will be high because you are using 60% of the credit you have available. To improve your credit utilization rate all you need to do is increase the credit available to you. You can do that two ways. The first is to call your current credit card company and request to increase your credit line on your current credit card. The second is to open a new credit card. Pretty simple.
The last way to improve your credit score is to never close an account. Closing a credit card account affects both your credit history and your credit utilization. Even if you’re no longer using a credit card, keep the account open. All of your previous payment history with this card and your credit limit will help keep your credit score up.
Negotiating Interest Rates
Many people aren’t aware that you can negotiate the interest rate on your credit card. If you are currently maintaining a balance on your credit cards, you can call your credit card company and try to negotiate a lower rate. It will be important to show that you are making all of your payments on time, so make sure to first follow the steps above to improve your payment history if it isn’t great right now. After you’ve established your payment plan, call and ask for a lower rate. A lower rate will decrease any of the future interest you are charged on your current balance until you can pay it off. If you currently have a $10K credit card balance and an annual percentage rate (APR) of 25%, you will accumulate $2,500 in interest this year. If you call your credit card company and can reduce your rate from 25% to 15%, you will only accumulate $1,500 in interest this year. That is a savings of $1,000 for a 20-minute phone call!
Credit cards are amazing tools for building credit, but they can easily end up costing you a lot of money. Whether you’re building credit or repairing it, following these rules will make sure that you always maintain a high credit score and save money.
1. Never carry a credit card balance. Credit card companies charge extremely high-interest rates. You carrying a balance allows the credit card company to makes returns of double or triple what the stock market returns.
2. Always make at least your minimum payment on time on all of your debts. Your payment history makes up the largest percentage of your FICO score, so make it a priority to have a good payment history.