Certain personal finance gurus such as Dave Ramsey argue that you can (and should) ignore your FICO credit score. Others, like Suze Orman, advocate taking control of your score. So who is right?
Given how often credit scores are talked about in various books and on TV, I wanted to dig deeper and see how much impact your credit score can have on your life.
What is a FICO credit score?
Fair Isaac and Company (FICO) has developed a system to help creditors determine a person’s credit risk based on their credit history. Lenders rely on these scores when determining whether or not they should lend to a prospective borrower.
You may be surprised to learn that you actually have three scores instead of just one. That’s because each credit bureau can generate their own score for you based on the information that they have. What is my credit score?
How is your FICO credit score calculated?
Your FICO score is determined by what’s in your credit report. While the exact formula is a secret, here are the factors that affect your credit score and approximately how much weight is given to each.
- Payment history – 35%
- Amounts owed – 30%
- Length of credit history – 15%
- New credit – 10%
- Types of credit used – 10%
What’s frustrating with this formula is that your credit score can actually decrease if you make a financially sound decision, like paying off debt.
For example, Nickel discovered his credit score went down when he paid off his mortgage. I also saw my score drop by seven points when we paid off my car loan.
While there are various opinions on what constitutes a good FICO score, a score of 760 or above is generally enough for you to get approved for a loan at a favorable rate.
Who uses FICO scores?
So when does your credit score actually come into play? If you’re applying a loan, your credit score will almost certainly play a role in your approval. Your score can also play a role in determining the interest rate you’re offered.
While some mortgage lenders do “manual underwriting,” they are in the minority. That being said, Dave Ramsey advocates using this sort of lender in his Total Money Makeover program.
Aside from lenders, it’s important to know that other companies are starting to look at your credit scores. They include:
- Car insurance – Did you know that your score can affect your car insurance premiums?
- Landlords – Depending on where you’re looking to live, some landlords are running credit checks to protect themselves from bad tenants.
- Potential employers – Like landlords, some employers see credit scores as an indication of a candidate’s reliability.
- Utilities – Some companies use your credit score to determine if you need to put down a security deposit.
- Banks – Many banks, both online and local, will check your score before opening an account – especially if you are applying for overdraft protection.
While you may not be crazy about the many ways in which your credit score can influence your personal finance, it definitely pays to stay on top of it. Check what you can do to help your credit score.
Maintaining a good score without debt
Dave Ramsey has commented that if you avoid debt, then your score will go down to zero. While Dave may not care about his credit score, the fact is that your credit score can impact various facets of your life. But is it necessary to carry debt to maintain a decent credit score? Not necessarily.
You should never borrow money just to build your credit score. Likewise, you shouldn’t carry a balance on your credit card in hopes that it will boost your score. To maintain a decent score, simply keep an eye on your limits and always make your payments on time.
Credit scores are really just a snapshot of your financial life, and much of the information is drawn from recent statements. If you max out a credit line shortly before applying for a loan, that can negatively impact your credit score even if you intend to pay it off in full.
That’s one of the big problems with credit scores – they don’t necessarily reflect your long-term financial health.
Thoughts on credit scores
It surprises me a bit to see how much your credit score can affect your daily life. We’re not doing anything special to manage our scores, but they are important to us.
My husband and I have a single credit account that we use occasionally, but we pay it off in full every month. We also have a mortgage that we’ll probably have for another 15 years based on current payments.
How important is your credit score to you? Have you done anything special to improve or maintain your credit score? Have you ever had any problems getting a loan or in other areas due to a low score?