One day I was speaking to one of my mentors and she told me that when she was growing up, she was told that credit cards were just like layaway (putting your clothes aside and making payments on them until the balance is paid off and then you take them home) except better because you could take your stuff home immediately. She said that she noticed that the people who were taught that were in financial distress. That story made me start thinking about some of the things I have seen and some of the beliefs I had about credit that impacted my credit card management. For example, I remember one incident close to when I first got a credit card, and I always wanted to do what they do on television, fill a fitting room with clothes and then saying, “I will take it all!” When I got a credit card, I thought that it was my dream come true, and I did it. I looked at the $20/month bill and thought, “I can afford this!” That was until, over time, I ended up with 7 credit cards and $15,000 in credit card debt.
I think that some of the beliefs that we have about credit impact how we treat credit card debt and our views about what it means to buy with credit. Some of those beliefs involve thinking that, “this isn’t real money.” I remember when I used to have the cash in my checking account, but then I chose to charge it because the costs didn’t appear real to me. I thought that if I could afford the minimum payment, then I could afford the purchase, and I would eventually deal with the balance later. I believed that as long as I paid my minimum on time, then I was being financially responsible. However, that was only partially true, because although it is great that I paid my bills on time every month, it wasn’t good that I had maxed out credit cards, that took up so much of my monthly budget that I was only paying the minimum on. Besides, I didn’t realize at the time that even though I was paying the bills on time, I was still hurting my credit score because my balances were extremely high.
I think that some of the beliefs that we have about credit impact how we treat credit card debt and our views about what it means to buy with credit.
I didn’t fully understand or appreciate what credit was or how important it was in my life. Think about it this way: When you were in school, you had a report card and a transcript. A report card showed you where you were for that school year and your transcript included all of your grades, your attendance, and your entire school picture. Your report card was a part of your transcript. Then, based on everything on your transcript, your overall GPA was calculated. This is similar to your credit. Think of your report card as your individual credit accounts and your credit score is your transcript of the history of all of the accounts that impact your credit. Every time you manage your finances in a way that is good, it is included on your transcript. Conversely, every time you make a financial mistake, it is also included. The sum total of all of your accounts and your financial history is then calculated into a credit score. This credit score is then used to determine your creditworthiness, your ability to repay your debt.
Although there are many scoring systems, the most common is the FICO credit score. The FICO credit score is rated between 300 – 850. The breakdown of what this means is the following:
- 300 – 629 = Bad Credit
- 630 – 689 = Fair Credit (average credit)
- 690 – 719 = Good Credit
- 720 and Up = Excellent Credit
Based on your credit score, lenders and even potential employers will try to make value assessments about how responsible you are. This is why it is so important to understand and work on improving your credit score.
Based on your credit score, lenders and even potential employers will try to make value assessments about how responsible you are.
Your credit score can impact:
Your potential employer may run your credit to determine how you may behave as an employee. If you have great credit then they may assume that you will be a more responsible employee. Furthermore, if you work in the financial industry, they may want to understand how your personal finances may impact your trustworthiness. Therefore, poor credit can eliminate you as a prospect for potential jobs.
Interest rates on a car or home purchase
Your credit will determine the rate at which a bank will lend you the money. Therefore, the higher your credit, the lower the cost of your finances and thus your monthly payment will be lower. Conversely, if your credit is not good, then your payments will be higher. Therefore, one strategy to reduce some of your recurring payments is to improve your credit. For example, I have a friend who diligently worked to improve her credit. She was able to improve her credit so much that when she got a new car, she was able to get her dream car, a Mercedes-Benz, for less than what she had been paying for her Dodge. This was because her interest rate on her Dodge was so high, that it drastically increased her car note.
Did you know that your car insurance company may do a credit check? They are doing this because they are trying to assess how risky you may be as a customer. They are looking at your credit score to make a determination of how responsible you are and then are drawing conclusions of how you may operate or care for your vehicle.
Ability to rent an apartment
What if you were considering purchasing a home, but couldn’t because of your credit score? Then you think that you are going to lease an apartment. What if you were declined because of your credit? What would that mean for your household? I’m not trying to scare you, however, I was recently talking to a friend of mine and she told me how she has talked to numerous people who are trying to figure out what to do because their credit had impacted their ability to rent an apartment, and they were desperately trying to find somewhere to live.
The good news is that there are things you can start to do now to improve your credit. We will discuss 6 ways to improve your credit score in this post.
Pay bills on time
(35% of your credit score)
Did you know that missed payments can reduce your score by 70-90 points? The biggest impact is on those with great credit. Therefore, guard your credit by being diligent with paying your bills on time. If you cannot pay on time, then understand when the company reports to the credit bureau. Make sure you pay before that day because at least, it will avoid the negative impact on your credit. However, that still may not help you to avoid other penalties. For credit card companies, this could mean late payment fees, higher interest rates, or even Universal Default. Universal Default really sucks, because this means that a late payment on one account can affect all your accounts. Although you won’t be charged a late payment on all accounts, the company has a right to raise your interest rates because you are no longer considered trustworthy. They can also reduce your credit limit. This can be extremely damaging for a couple of reasons.
- This increases your interest rate, which increases your cost of borrowing. This is critical because less of your payment is going towards your “principal,” the amount that you borrow and instead more of your money is going to pay interest. This makes it harder to see a reduction in your balance and extends the amount of time and the money that it will take to pay off your balance. As an example, if you borrow $1,000 at an interest rate of 15% but then the interest rate skyrockets to 25%, then it will cost you $613 more over time and 24 months longer to repay the debt (At 15% interest rate you would pay $370.46 in interest and it would take 54 months to repay vs. $982.96 and 78 months at a 25% interest rate). This makes it harder to pay off your debt. This difference is even more pronounced as your balance grows.
- If your credit limit is cut, then your credit will be impacted even more since your utilization ratio (how much credit you owe vs. how much you use) increased. Depending on how much your credit limit is cut, you may end up over your limit. That has happened to me before. One day, my credit card company decided to cut my limit, and they cut it below the credit card’s balance. I didn’t have the money to immediately repay the money to bring it down below what I owed, so in order to avoid further penalties, I had to cancel and freeze the account and work to pay it off.
Pay down your balances
(30% of your credit score)
Although there is no magic number, conventional wisdom recommends that you keep your balances below 30% of your credit limit. Calculate the “utilization ratio” by dividing outstanding credit by the credit limit. The higher the utilization rate, the lower your credit score. I previously mentioned that I experienced a credit limit cut. The reason why is because my utilization rate was too high and the credit company was concerned that I would end up defaulting. As you pay down your balances, your utilization ratio will decrease, and over time your credit score will start to improve.
Limit the number of new accounts opened
(10% of your credit score)
Imagine this. You have a cart full of stuff and the friendly sales associate asks you, “Would you like to open an account and save 15%?” Although, it may be tempting to say yes, it is best to say “no” for a number of reasons.
- Store credit cards carry higher interest rates, which means that it costs more to borrow the money
- Every time there is a hard inquiry on your account (a new inquiry when a lender checks your credit, at your request, to make a lending decision) your credit score may drop by a few points.
This means that the savings that you think that you may be getting or the benefit of a new credit card can actually hurt your credit score. New accounts, especially those opened within a short period of time, can also cause the credit bureaus to wonder if you are experiencing a financial challenge that may prevent you from repaying your debt.
Don’t close paid off accounts
As you start to work towards paying off debt and improving your credit score, it may be tempting to close off the paid accounts. That can actually hurt you.
- The length of your credit history is 15% of your credit score. Therefore, if you close an older account, then your credit history appears newer. This hurts your credit, because, in the eyes of the scoring company, you have a shorter, continuous credit history. They view this as being more unpredictable because they have less time to evaluate your credit management history.
- This also impacts your utilization ratio. When you close a paid off account, you lose that money that would appear as a part of your total available credit limit. Therefore when you divide your outstanding credit by your credit limit, the percentage will be higher.
Stay on top of your credit score
In 2012, the FTC commissioned a study to evaluate errors on credit reports. The data showed that 1 in 5 Americans studied had a mistake in their credit report and 5% of those studied had an error so bad that they were being overcharged for items like credit card debt, auto loans, and other financial obligations. With the incidence of errors being 20%, it is essential that you stay vigilant to ensure that you are not being overcharged and to ensure that errors are not impacting your credit score. Annualcreditreport.com is a site where you can pull your credit for free. You get 1 report from each of the 3 credit bureaus (Experian, Equifax, TransUnion) annually. When you review your report:
- Make sure that paid off accounts are marked paid
- There are no accounts that aren’t yours
- All of your personal information is correct
- Evaluate whether there are accounts that you aren’t aware of
- Note any errors, and if you find errors take steps to correct them
Repay accounts that are in collections
Unfortunately, once accounts go into collections, they will impact your credit score. The most unfair seem to be medical debt because it is expensive and many people can’t avoid those costs if they need medical attention. However, if you have an account in collections, first understand if you truly owe it by asking for a detailed invoice about the payment. If you do not owe it, then dispute it. Also, when you speak to a debt collector never verbally acknowledge that this is your account. Always review the details. Also, when you are paying back what you owe, don’t agree to a payment that you cannot afford. Make sure that you review your budget and keep great records to make sure that you know what you owe and agree to pay and that you get the proper documentation and removal/update to your credit report once it is paid off.
Conclusion: A Word of Caution
I know that I just went through a lot of information about why your credit is important and why you should be diligent in improving your credit. If you start to improve your credit you will experience lower monthly payments and over time, create more room in your budget. However, I also want to give you a word of caution. If you are struggling to build up an emergency fund or are struggling to pay your monthly bills, then focus on doing that first. It is better to be current with your bills and know that you have your basic needs met. It is also better to have a cash reserve of at least $1,000 or more if you can because it will allow you to better weather tough times. Cash on hand is better because it helps you to avoid relying on credit cards as a strategy to manage through tough times. Remember, anytime, your credit card company can decide to cut your credit limit or close your card. This has happened to me multiple times. Therefore, focus on the things that impact your daily living first, if you are unable to do that, and aggressively repay your credit card debt at the same time.
Aisha Taylor is a single mom of twins, personal financial coach, work from home entrepreneur, and #1 Amazon Best Selling Author of the book “5+5 FNPhenomenal Ways to Save $100 This Week Without Killing Your Lifestyle.” Aisha has been featured in ESSENCE, Jet Magazine, and Black Enterprise. She is also the Founder of FNPhenomenal (Frugal –n- Phenomenal), a movement designed to help single moms create a vision for their lives, craft a financial strategy to support that vision, and show them that phenomenal living is possible. It’s time for you to be Financially Phenomenal!