Here, once again, is the direction we are headed with the series:
- Getting Your Credit In Order
- What Is the Actual Rate of Return on a Card?
- The Different Types of Credit Cards: Cash Back, Fixed Value, and Flexible Point
- Why Signup Bonuses Are the Key to Free Travel
- What Are the Right Cards For Your Desired Trip?
- What Are App-o-Ramas?
My goal with this series as a whole is to educate and excite, but at times, I have to splash some cold water of reality on my audience. This first part of the series is one of those times. Fortunately, it is not a boring subject, though, and when you finish reading it, I think you will have a much better idea of what you need to do and where you want to be with your credit before you go out and apply for a new card or two. Think big picture: get your credit in good shape and then you are ready to start reaping big travel rewards.
“Financing” (through points and miles) a trip like the one I described to Greece required a lot of planning on my part. Which cards gave me the most points? Which of those cards gave me the “right” points? How long would it take to accrue those points? What did the seat availability look like, particularly in the much smaller business class section? All were major questions, but all of those questions were premature until I knew where I stood from a credit point of view. Today’s article is about getting your credit in order. Even if you think you are set here, I think you may learns a few things that can take your score higher. I thought I knew a lot when I started, but I was very wrong indeed.
2) Credit Utilization: This one counts 30% of your score, so it’s another big factor. Let me use an example to illustrate this one. Let’s suppose you have two credit cards with respective credit limits of $10,000 and $15,000. Now, let’s suppose that at the time FICO looks at your accounts, they see that those cards have respective balances of $4,000 and $3,000. FICO will look at that and say “you are using $7,000 of your available $25,000 credit”. That comes out to 28% credit utilization. Everything is relative here, e.g. 40% is better than 50% but 40% is not where you want to be. I actually keep my credit utilization at 2% or less by continually paying off my balances (multiple times per month) so that my credit utilization is as low as possible any time my score is calculated. My advice is to just do the best you can, and consider making payments more than once a month if you are wanting to apply for more cards. The reason for paying more than once a month is that when your score is calculated, it is based on snapshots of your current credit situation. If that snapshot is taken just before you make your monthly payment, then your balance will appear higher than if you are paying more than once a month.
3) Credit Age: This one is 15% of your score. Lenders hate one thing more than any other…risk. If you have not proven yourself to be responsible with your credit over a long period of time, then they are not going to break their necks trying to give you more credit. I liken this to what I tell my 13 year old son. The more I see you act like an adult, the more I will treat you like one. Banks are no different: the more you prove yourself to be smart with credit, the more they will extend you. So, what is my advice here? Simple. Keep your existing credit cards, particularly your oldest cards…period. They increase the average age of your various lines of credit, and that matters a lot to the lenders. If you have a card with an annual fee that you no longer use, call the issuer of the card and see if there is a no annual fee version of the card to which you can downgrade. That way you can preserve the credit while absolving yourself of the annual fee.
Before I move on to factor number 4, I want to take a second to look at factors 2 and 3 together. Why? Because what I am about to explain is extremely important. Two of the biggest myths out there are: “if you apply for lots of cards, you’ll ruin your credit” and “if you cancel a card, you’ll damage your credit.” Okay, if both of these statements were true, then why would anyone bother with cards at all? Anyone can wreck his credit if he does not understand how the score is calculated yet applies for ten cards and cancels them all shortly thereafter. So, how do these myths tie in with factors 2 and 3? Let’s extend my example from earlier, where I have $7,000 in debt across 2 cards whose combined limit is $25,000. Suppose I apply for and am approved for two new cards whose respective limits are $5,000 and $10,000. Then my new combined limit is $40,000. Now, if you are saying “that’s stupid, why would you increase your debt?”, then you are confusing debt and credit. Yes, I now have $40,000, but these cards are brand new and have nothing on them yet. If I assume that my balances on the original two cards are still $4,000 and $3,000, then my debt is still $7,000. Here is the best part: Factor 2 is now much stronger for me because my new credit utilization is $7,000 / $40,000, or 17.5%. In other words, I dropped my credit utilization by over 10%, which greatly strengthens that part of the formula.
Let me finish this important point, and then we will move on to factor 4. What do you think happens when you cancel a card? Exactly. It is going to increase your credit utilization because you have the same debt but less available credit. With regard to factor 3, canceling a card can have a positive or a negative effect. Canceling an older card will decrease the average age of your credit (which is a bad thing) while canceling a much newer card will actually increase the average age of your credit. In short, I only cancel cards if a) it has an annual fee I no longer want to pay and the bank will not downgrade it to a no annual fee card or b) the bank in question won’t issue a new card to me unless I offer to cancel an old one. Even in this case, I will fight to hang on to that credit line by moving it to another card from the same bank if possible. Chase, my favorite card issuer, is pretty stingy with how many of their cards they will let you have, so I often shift credit from an existing card to support a new card.
4) Account Mix: Before I begin this one, have you noticed that we have already accounted for 80% of the score with the first 3 factors? They are definitely the most important, so keep your focus on them. Account Mix is 10% of your score, and it is the hardest to explain. In short, lenders like to see that your credit history consists of a good mix of credit types. Mortgages, auto loans, student loans, and revolving credit (such as credit cards) are what they look at. Honestly, I don’t think there is much you can do here. If you bought a car, you probably needed a loan for it. If you went to college, you probably needed loans as well. I just use credit where I must and let the chips fall. Control what you can control, namely paying off those loans on time.
5) Credit inquiries: This one is only 10% of your score, but a lot of people mistakenly think it is the largest determinant of your score. Let me be fairly open with my personal situation here: Credit.com, which I will say more about in a moment, gives me a horrendous rating on this component, but my overall credit score is still extremely high because my scores on factors 1-3 are as high as they can get. So, what is this 5th factor all about? It is a measure of the number of hard credit inquiries in the last 12 months. I could try to explain hard vs. soft credit inquiries, but let me defer to a very well-written article about it instead. For our purposes, actually applying for credit (whether it is a mortgage, an auto loan, a student loan, or a credit card) will result in a hard credit inquiry. If a lender sees lots of hard inquiries in a short time, it raises a red flag to them: “why is this person applying for so much credit in such a short time?”
Ready for another myth? “If you apply for lots of cards, it hurts your credit score.” Okay, this is true…in the short term. In the long run, it actually is beneficial to your score. Here is the reason. If I apply for 4 credit cards in one day (which I have done by the way), then those 4 hard inquiries are going to be on my credit report (think factor 5 here) for the next 12 months. BUT. I also obtained a boatload of new credit, so my credit utilization goes down by a ton (think factor 2 here). Factor 2 counts 3.5x as much as factor 5. So, am I saying “go out and apply for tons of cards and consequences be damned? Not at all. I am simply saying that eventually hard inquiries come off the report (they stay on for two years but only count against you for one), but once you have the credit, it is yours to keep.
Now, let’s finish this by talking about real strategies to help you get your credit where it needs to be. Once you do that, then you can do what I do: decide where you want to go, watch for outstanding signup offers, and apply for the right card or cards. Even if you are not interested in travel rewards from your cards, you will be able to get better cards with good credit. And no matter what your situation, monitor your credit score fairly regularly.
1) Go to annualcreditreport.com and get your free report from the Big 3 (Equifax, Experion, and Transunion) credit reporting agencies. Look for any discrepancies, and if you find them, follow these instructions. I cannot personally attest for having used the information in that link because I have not (knock on wood) had to do so. Incidentally, as consumers, we are entitled to one free credit report per year, hence the name annualcreditreport.com.
2) Sign up with creditkarma.com and/or credit.com. These sites (both of which I use) will not provide your actual FICO scores, but they provide what some people call FAKO scores (as in fake scores). Don’t laugh, they are pretty strong indicators of the real thing. Better yet, they are free and provide ongoing information about your credit (as opposed to annualcreditreport.com, which is only free once per year). Once you sign up, you can see your FAKO scores and determine which factors I described above are ones in which you need improvement. If it is factor 1), then you simply must make every effort to pay every bill on time moving forward. You can’t undo missed payments. If it is factor 2), then try to pay off more of your balance and do it more often. Also, read the next tip below for more help with factor 2). If it is only some combination of factors 3), 4), or 5), then your score is probably pretty strong already.
3) If you are struggling to make your minimum payment or are dealing with high interest cards, forget rewards cards for now and focus on finding a card with a strong introductory balance transfer rate. Many of these cards offer 0% interest rates for 12 months, though they typically come with 2-3% transfer fees. Those fees, however, should be much less than the interest you are accumulating over time. Interest is a killer as it eats away at your monthly payment, thus reducing the amount by which you are paying off your balance. Getting a low interest (especially 0%) card allows you to focus on knocking down your debt more quickly, which then allows you to start using a card that gives more valuable rewards. I must reiterate, however, that rewards cards are only useful if you pay off your balance every month. Otherwise the interest destroys any value the rewards might give.
4) If you are in college, getting credit can be hard. Fortunately, Citi provides a very good card just for you. Check it out here.
5) If you are relatively young and have not had a chance to establish a lot of credit yet, focus on cards with low interest rates, even if those rates are only for a fixed period of time (6 to 12 months). This allows you to more easily make your payments while also knocking down any debt you may have. As your credit age and strong payment history become more established, your score will go up. After that, you can start exploring more rewarding cards.
6) I offer the following guidelines, though they are far from absolute: if your score is over 700, then you are ready to start applying for true rewards based cards (hotel, airline, etc.). If your score is over 750, then you should be able to get almost any card you want.
So, there you go. An intro to establishing good credit. If you are already there, congratulations, the world is potentially your oyster. If not, put some elbow grease into it, get that score up, and then tread carefully into the world of rewards based cards.
I’ll admit, this article is definitely an “eat your vegetables” article. If you got through it, congrats. There is MUCH more exciting stuff coming in the next few articles.
Do you know how to get your credit report and how to improve your score? Feel free to send in your comments and questions.
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