What You Need to Know About Credit
by Eddie Johansson
Scott W. O'Brien is a partner and financial planner at WorthPointe in Austin. His experience working with divorced and widowed women led him to create From Surviving to Thriving - A Financial Resource for Divorcees and Widows. For this book, he enlisted experts from several fields. This is the chapter on credit by Credit Security Group President Eddie Johansson. It contains information of value to all and specific information to help women move forward after a major life transition.
Excerpted with permission from: From Surviving to Thriving by Scott W. O’Brien, CFP® Copyright © 2017 | Scott W. O’Brien | All rights reserved. Download the book free here…
What is good credit? What is bad credit? How important is your FICO® score? How can you enhance your credit? How can you ruin it? How can your credit score affect your life?
These are just a few questions you may occasionally ask yourself — but I hear them all the time. Even extremely intelligent people may be uninformed or misinformed about issues pertaining to credit, and that can pose significant challenges when a life event such as a divorce or death of a spouse occurs.
Just 14 years ago, in 2002, I was blissfully unaware that credit was about to play an important role in my life. I wanted to buy a house, and learned I couldn’t, because I didn’t have a strong enough credit score. I did my homework and ultimately rectified that situation so I could become a homeowner — and realized I wanted to help others who didn’t understand the importance of their credit score.
Every day, I meet with people who want expert analysis of their credit scores. I’ve participated in more than 6,500 structured consultations, where I don’t have the luxury of being wrong. With that as a preface, let’s move on to the meat of the matter, remembering that what you don’t know about credit can certainly hurt you.
The Big Three: Credit Bureaus
Your credit report is as unique as your thumbprint. It’s a record of your payment history — how you’ve managed credit since the first time you were granted it — including credit cards, all types of loans including mortgages, and public records from banks — as well as any collection activities that have occurred.
Data on your credit activity is reported monthly to the three major credit bureaus: Experian, Equifax and TransUnion. They are receptacles for storing the information.
Because they can determine what accounts are included in your file, they can play a significant role in your life. Your credit history on file at the credit bureaus is used to determine whether you’ll be able to buy a house or a car, or to make other large purchases you’d like to finance, and what interest rate you’ll be offered if you are extended credit.
But that’s not all. Your credit report may affect your insurance situation and even whether you will be able to get a job. Hiring decisions are not credit score-driven, but many employers don’t want to hire people who have a lot of debt.
You may notice that your history paying utility bills for electricity and water, as well as cell phone bills, does not appear on your credit report. And thus we come to our first credit tip, regarding which bills are most important to pay on time:
Credit Tip 1: If you only have enough money to pay either a credit card bill or an electricity bill, pay the former, as that delinquency will be reported to the credit bureaus.
Personally, I’d rather live with candlelight for a month to maintain my high credit score, rather than have it drop up to 70 points due to paying a credit card bill late. And here is our second credit tip:
Credit Tip 2: It’s very important to realize there are no “boo boos” on a credit report — only bombs and bigger bombs. A 30-day delinquency is a bomb.
What’s Your Number? FICO Scores
Your FICO score is based on your payment history, but you may not know that you have numerous FAKO scores, which are those provided by the credit bureaus; organizations like Credit Karma and FreeCreditReport.com; and even your credit card provider. You have only one true FICO score — the one lenders use — and it’s available for $60 at MyFICO.com.
How can this be? The data being used to calculate all scores is the same, but the scoring method applied can be dramatically different. Without getting too technical, the three models used by the credit bureaus are:
- Equifax Beacon 5.5: FICO 5
- Experian Fair Issac version 2: FICO 2
- TransUnion Classic 04: FICO 4
What this means is you need to be conscious of the scoring model used to determine a particular credit score — and you must understand that lenders don’t use FAKO scores, only your true FICO score.
FICO scoring is a future risk assessment tool, with scores that range from 300 to 850. The better your payment history, the higher your score will be. What scores are considered good or bad? From the FICO company’s illustration above we see that:
- 300-560: bad
- 560-660: not good
- 660-720: good
- Over 720: great
Your score will go up or down based on your payment activity as well as the number of inquiries into your credit. The key concept for maintaining good credit scores is “paid as agreed” - no late payments, ever. Inquiries make up less than 10% of your score, but it’s still best to keep them to a minimum, perhaps 1-4 per year. Here are a couple more tips:
Credit Tip 3: Small mistakes cost you big points. One 30-day late payment will lower a 680 credit score 40-80 points.
Credit Tip 4: Only apply for new credit when you’ve made the decision to move ahead; don’t just fish around .
If you are in the market for a home loan, it might give you peace of mind to know that all such inquiries within a 14-day period are counted as one.
What are some other things to keep in mind as you tend to your credit score?
Understand that time matters. You’ve probably heard the saying, “time heals all wounds.” That is certainly true when it comes to your credit score, as it will recover over time from something like a late payment if there are no new bad events.
Let’s say you have a 550 score. You can raise it to 600 within a year by having no more negative activity and charging a small purchase to one credit card every month and then paying the bill down to a small balance ($10 or less) each month... Which leads to our next tip:
Credit Tip 5: You can’t change the past, and you should never stand on principle.
Realize that timing matters. Because your score predicts the likelihood of a 90-day default over the next 24 months, anything recent has a lot more weight than something that happened many years ago. With that being said, it’s best to buy a home before a car, for instance, and eliminate as much credit card debt as possible before buying a home.
Credit Tip 6: Never open a new account within eight months of a major purchase.
Know that size doesn’t matter. A bad event is a bad event, regardless of whether it involves a debt of $37 or $10,000. The important concept is “paid as agreed.” Stay in the “black” and you’re golden; go in the “red” and you’ll be in trouble, even if the amount involved is small.
Consider the long-term consequences. When you open a new credit card account, your score will go down. Thus, when a store offers you a $50 savings if you open an account, don’t do it unless you won’t need to rely on your credit for 8-12 months. Otherwise, you could end up paying thousands of dollars more for a purchase like a car or home due to an increased interest rate based on your lowered score. It’s just not worth it.
Understand the value of keeping multiple accounts open. It’s a myth that closing a credit card account will increase your credit score. Say you have four credit cards and you close three of them; not only will that have no short-term effect on your score, it will bring down the average age of your accounts, which isn’t good. If you do choose to close an account, make it a newer one and keep the oldest. There’s great value in keeping some accounts open and active — with no late payments — to prove that even though you have the ability to spend above your means, you aren’t.
Understand how FICO looks at your credit card ratios. In the best-case scenario, if you carry any debt at all on credit cards, it’s best for it to make up no more than 2% to 3% of the balance available to you. The more money you owe to credit card companies, the higher risk FICO assigns you, and thus your score will go down.
Realize that FICO doesn’t crunch stories, but data. Underwriting is often automated, so your tale of woe is not going to make a difference in most credit decisions. Even if you get to share your story with a lender, 99% percent of the time that isn’t going to change what you get because the loan originator doesn’t make the decision and the underwriter, who does, is limited by a set of guidelines.
Seems like a good time for another tip:
Credit Tip 7: The key to recovering from a “bomb” on your credit is nothing else negative.
That doesn’t mean to stop using credit, but use what you have judiciously, at least one revolving account like a credit card and one installment account like a mortgage payment. But make sure you pay as agreed.
Life Events and Credit
When people get divorced, there can be some negative consequences when it comes to credit that can often be eliminated via knowledge. You should be aware that buying a home together is building debt, not credit. If both spouses are on the mortgage, divorce doesn’t change that obligation for the debt.
It’s not uncommon for the wife to remain in the home after divorce, with a settlement that may include her ex-husband continuing to pay the mortgage. What happens if he fails to do so? That will destroy her credit, since the debt is also her contractual obligation. A better option is to sell the house and split the equity, so each spouse can start anew.
Another scary scenario to consider involves an ex-husband who files bankruptcy and has his debts discharged — leaving his ex-spouse 100% responsible for their formerly joint debt.
Here comes a tip:
Credit Tip 8: When couples divorce, it’s very important for them to become “unjoined” on accounts.
Speaking of bankruptcy, it’s good to be aware that it’s not the end of the world. It can actually be a fantastic tool for a widow whose husband left her with debt at a level she can’t pay off. A Chapter 7 bankruptcy discharges in six months, and it’s possible to get an FHA loan to buy a home with just 31⁄2% down in just two years (or seven years for a conventional loan).
What does bankruptcy do to your credit score? You might be surprised. Let’s say you have a score of 700 and you’ve maxed out your credit cards. If you paid them off, your score would move to the upper 700s. If you file for bankruptcy and get rid of your secured debt — and have no other negative events — one year later your score would be back to 700, but it would never go higher.
The key to reestablishing credit is to be absolutely perfect after your bankruptcy discharges. As noted earlier with respect to recovering from credit score bombs, open one little installment loan and one credit card and follow the holy grail: paid as agreed.
Now back to the “ex” situation. What’s most important to remember is that just because your ex-spouse has debt, it doesn’t make it yours unless you are contractually liable. There’s no such thing as community debt, but bill collectors commonly go after exes because they might erroneously believe they’re responsible for anything their spouse bought while they were married. That’s only the case if it was a joint purchase.
It’s All About Risk
Lenders determine your suitability for credit based on the potential that you will repay the loan. While your FICO score is a significant indicator of that, it’s actually not #1; money is the biggest risk reducer.
Here are a couple examples:
If you want a conventional home loan and hope to only put 5% down, you’ll need to have a FICO score that’s more than 640. However, if you’re willing to put 20% down, you may be approved even if your FICO score is under 640.
If you’re buying a car, a FICO score of at least 700 will guarantee you the best interest rate. But let’s say your FICO score is just 640. You can still get a loan at a good rate if you put $1,000 down on the vehicle.
It’s tip time again:
Credit Tip 9: Don’t despair if your FICO score is lower than you would like when you want to finance a major purchase because money talks.
Focus on Accuracy/Fraud Protection
Many people routinely check their FICO score (or more likely their FAKO score), but it’s more important to check the data that’s being used to calculate it. It’s a good idea to get your credit report from annualcreditreport.com; I suggest staggering that task so you get a report from a different credit bureau every four months, i.e., Experian in January, Equifax in May, etc.
If you see something on your credit report that’s not accurate, don’t waste your time fighting with a credit bureau, but go directly to the data furnisher — and understand that the burden of proof is on you.
There are plenty of credit repair companies out there, but as is true in any industry, some are good and some sound too good to be true. A good way to determine a good credit repair company is to see if they can tell you which accounts in your file cause your score to be where it is and how your score will change if the corrections they propose are made. If a credit repair company doesn't understand how the contents of your credit file affect your score, how can you trust them to start changing those contents? And, always check the company out at the Better Business Bureau website.
A final thought here about identity theft, because it’s something people are often concerned about when it comes to their credit. You really shouldn’t lose any sleep over it, because your odds of being a victim of identity theft are a lot lower than commonly believed; you probably have a better chance of being struck by lightning or winning the lottery.
Be very careful with who has access to your personal information, because most identity theft is perpetrated by someone you know. And, if you’ve recently moved, it’s a good idea to visit optoutscreen.com to stop pre-approvals from being delivered to your old address, where someone could try to gain credit in your name.
To Sum It Up
How you have used credit in the past will go a long way toward determining what your future credit options will be. Even if you have bombs on your credit report, you can mitigate their potential to damage your creditworthiness by paying as agreed moving forward and putting down cash when making purchases you wish to finance.
If you are divorced or widowed, it’s important to understand which — if any — of your spouse’s debts are your responsibility. Unless there is joint liability, meaning you signed a contract to secure a loan or credit card, his personal debt doesn’t transfer to you, even if it was incurred while you were married.
And this brings us to the final tip:
Credit Tip 10: Educate yourself about your credit so you don’t face an unpleasant surprise when you try to finance a large purchase.
Eddie Johansson is the nation's leading expert on credit scores and FICO® scoring, and is the founding president of Credit Security Group. Credit Security Group offers credit score education, analysis and planning through their Credit Security Analysis service.