In a perfect world, we’d pay for everything we buy with cash so that we won’t be in debt. And to the extent that you can do this, I’m in favor of it. The reality for a lot of us, however, is that our largest purchases are usually made with credit. For instance, buying a home, buying a car, or paying for a wedding may require some form of credit.
People with good credit save tens of thousands of dollars on these purchases. That’s why credit has a huge impact on our finances.
Let’s look at why good credit is important, and how to improve your credit score. First, let’s talk about one of the key factors of credit: your credit score.
What is a Credit Score?
A credit score is a number between 300 and 850 that shows your risk to lenders, and the higher your score, the better.
Here’s what your credit score is based on:
- 35% – Payment history (paying on time helps you, but paying late hurts you)
- 30% – Amounts owed (how much you owe versus how much total credit you have)
- 15% – Length of history (how long you’ve had credit)
- 10% – New credit (older accounts are better, showing that you’re reliable)
- 10% – Types of credit (varied types, such as credit cards and student loans, are better)
Why Is a Good Credit Score Important?
If you have good credit, you’ll get a better interest rate on loans. If you have poor credit, your loans will have a higher rate, which means that you’ll be paying more in the long run. So when will you actually need a loan?
Do you dream about buying a nice house one day? Could your car possibly break down in a few years, requiring you to buy a new one? If the answer to these questions is “yes,” you’ll probably end up paying for these items with a loan – unless you have thousands of dollars in an savings account.
Here’s how a loan’s interest rate makes a huge difference. Assume you borrow $200,000 for a 30-year mortgage. These are the differences in what you’d pay based on your credit score.
If your score is between 760-850 (the best range), you can get a loan with 3.51% interest (rate as of April 2012, via myFICO). At this rate, you’d pay a total of just under $324,000 ($323,875.11), which includes the original loan and interest.However, if your score is between 620-640 (the worst range), your loan would come with a 5.1% interest rate – a 45% increase. At this rate, you’d pay a total of over $391,000 ($391,056.57 ) for your home.
In this case, a high score can save you almost $70,000. What could you do with an extra $70,000?
Not improving your credit score is like taking a $20 bill and putting it in the paper shredder – every day. But improving your score over time is like taking that same $20 bill – and depositing it into your bank account every day.
How Do You Improve Your Credit Score?
The easiest way to improve your credit score is through the responsible use of credit cards, which most people have.
The three best things you can do are:
- Pay off your card regularly. Your payment history makes up the largest part of your score. Paying your bills on time is the best thing you can do for your credit.
- Keep your cards open for a long time. Lenders like to see a long history of credit, and the longer you hold an account, the better your score will be. If you have a current card, and decide to get a new card, don’t close the old one.
- Improve Your Credit Utilization Rate. Your credit utilization rate is the amount you owe on all credit lines divided by the credit limit available to you. Credit issuers want to see your credit utilization rate below 35%, so if you’re maxing out your credit card each month, you could be hurting your credit score – even if you pay off your balance each month. You can lower your credit utilization rate by increasing the credit available to you or by using your credit card less.
Over time, these steps have helped launch my credit score into the best range, and I hope they help you too.
Do you know your credit score? What are you doing to improve your credit score?