Financial fitness depends in large part on the strategic use of credit, according to experts who advocate responsible borrowing habits to build strong credit scores.
A good credit score can help investors quickly obtain loans on favorable terms, while a low score can be used by banks, mortgage lenders, credit card companies, auto makers and others to charge higher interest rates or deny credit altogether. Late payments and bankruptcies, the proportion of debt to available credit, the time since an account was opened, the time since an account was used and the number of recently opened accounts can all adversely affect a credit score, so it’s important for investors seeking financial fitness to understand how opening and using credit cards affects credit scores.
The most widely used credit score - FICO - can be broken into five components, according to myFICO, the educational arm of the company. The weightiest category is a borrower’s payment history, which generally makes up 35 percent of the score. The amount of credit owed accounts for 30 percent of a FICO score, while the length of credit history - or “credit age” of a borrower - makes up 15 percent. Types of credit and new credit each makes up 10 percent of a FICO score. The importance of the categories may be somewhat different for investors new to credit, according to myFICO.
Financial fitness can be improved by paying bills “on time every time,” according to the blog Free from Broke. First in line to be paid is a home mortgage, next are high interest credit cards. “This is probably the most important thing you can do to improve a credit score,” according to the blog. “If you haven’t been keeping up with your payments, it’s likely that you credit score has dropped substantially.”
Financial fitness can also be improved by actively using one or two credit cards, and occasionally spending on any other cards a borrower may have. “The reason for keeping those additional cards open is for maintaining a higher utilization limit,” said Free from Broke. (Credit utilization is the combined credit limit from all cards compared to balances on those cards. A utilization rate near 100 percent means the cards are maxed out. Free from Broke recommends a utilization rate of 30 percent or lower, even for borrowers who pay off balances in full each month. )
At the same time, financial fitness can be undermined by applying for too many credit cards. Applying for a new credit card can have the positive effect of lowering a borrower’s credit utilization rate, but it can have other adverse effects. “Each time your credit score is checked by a credit or loan company, you could potentially lose points from your FICO score,” said Free from Broke. A new credit card can also lower your “credit age” or the length of your credit history, which can also subtract points from your credit score.
The credit rating agency Experian recommends, “Apply for and open new credit accounts only as needed. Don’t open accounts just to have a better credit mix. It probably won’t improve your credit score.”
In a bit of counterintuitive wisdom, the website Credit Karma tells us that never using your credit cards can actually hurt your credit score. Some credit card companies will designate a card as inactive and stop reporting it to credit bureaus. “This could shorten your age of accounts and increase your credit utilization rate, since the card’s credit limit will no longer appear as ‘available credit,’” said Credit Karma. Alternatively, a borrower who never uses any of their credit cards could end up with a utilization rate of 0 percent, another red flag on a credit score.
“Never using your credit cards could reflect poorly on you because creditors want to see that you’re currently using the credit you have – and using it responsibly – in order to assess you as a good credit risk,” according to Credit Karma. “If you don’t have any current activity, they won’t be able to accurately judge your creditworthiness.”
For more tips on financial fitness for the beginning investor see our related articles on managing debt and saving for retirement.