The Real Deal With Credit Scores.

You’ve probably heard of credit scores. You know that banks use them to decide whether or not to give you a loan and what interest rate to charge. But what really is behind the credit score? What’s not in the credit score? Does it really matter? And should the bank even use it? These are the kinds of questions that I asked when I learned about the scores. I’ve been asked these questions a lot over the years as well. I’ve found a lot of inaccurate and downright wrong information on the internet. Well, here are the true answers.

 

What is a credit score?

Your credit score is an estimated value put on your credit history. The FICO score is the most well know. It goes from 300 to 850. The higher the score the better record you have of paying your bills and not charging up your debt. So if you don’t pay your bills then your score will go down. Banks use this score because it is an easy way to get a general idea of how well you manage your debt and other bills.

 

What is behind the credit score?

The formula varies a little bit between different companies. The formula for the FICO score consists of 5 basic categories: credit length, types of credit, credit inquiries, payment record and debt utilization.

Credit length

This is how long, in years, you’ve been using credit. This is why many people say to keep your oldest credit card forever. Really, as long as you have a solid record for 7 years you probably have a long enough record to get and maintain a high score. So don’t keep an account if you don’t like it or it costs too much money. This is also only of medium importance to the credit score.

Types of credit

This looks at the different types of credit that you have. It helps your score if you’ve had several different types of accounts like a mortgage, a credit card and a car payment. It shows that you can handle multiple accounts at once. This is one of the smallest factors in the score so don’t go out of your way to get different types of credit just to raise your score.

Credit inquiries

This is how many times banks have requested your credit record. Having a lot of requests can lower your score. However, banks know that when you’re shopping around for a loan that you may have several requests. Because of that, several within a month only count as one. The concern here is if you’re applying for a new credit card every month. That will hurt your score. Like types of credit, this has only a small effect on your score.

Payment Record

Your payment record has a very large effect on your credit score. This is how good you are at paying your credit bills on time. Every time you’re late your credit score will go down. The later you are the lower it will take your score. The formula looks at it in 30 day batches. So if you’re more than 30 days late it’ll lower it a bit, 60 a bit more, 90 or 120 days even more. The goal here is to always pay on time. This will have one of the biggest effects on your score. And this is where you can have the biggest impact when you want to raise your score.

Debt utilization

Debt utilization is the other big part of your credit score. Here’s how it works. Say you have a credit card with a $1000 credit limit. If you only owe the credit card company $100 then your credit score will be higher than if you owe the credit card company $900. Basically banks want to see that you have credit and don’t use it.

 

What’s not in the credit score?

You may notice that your credit score doesn’t include your income. It also doesn’t include your net worth. It doesn’t look at how much money you have. It only looks at how much you owe other people. This has led to some interesting situations. People in their prime earning years have found that their credit scores have gone down. This is because your credit score only looks at what you owe. Some people reach their fifties, are making more than they’ve ever made, have large savings accounts because they want to retire, but don’t owe any money. They have paid off their mortgages and their cars and don’t need credit cards much. This results in a low credit score since they won’t have a lot of recent loan payments. Less debt like this means a lower score.

 

Do credit scores really matter, and should banks even use them?

This is kind of a yes and no situation. Credit scores do matter. They give a good indication of how likely you are to pay your bills. Banks have found that if you haven’t paid your bills in the past then you aren’t likely to pay them in the future. They’ve learned this the hard way over and over. The subprime mortgage crisis is a recent example. The loans were called subprime because the people getting the mortgages had bad credit scores.

But the scores only tell half the story. You can have a bad credit score, but still not be a credit risk. People that pay all their bills, save up for their purchases instead of taking out loans and don’t use credit cards can still be good credit risks even though they’ll have lower scores. That is one word of warning. If you follow the advice on this website, advice like save up for your car instead of taking out a loan, pay your mortgage off early, don’t use a lot of credit cards and always pay off the full balance, you won’t maximize your credit score. But you will be able to buy anything you want.

Banks should look at more than just the score to determine whether or not to give you a loan. That’s why they look at your income. If you want to borrow a lot of money, like to buy a house, they’ll also look at your investments and savings.

 

The bottom line is that credit scores are not the end all be all that they may appear to be. They are just a gauge on how well a person has paid their debt bills on time in the past. That only tells half of the story since the other half is whether or not they have the money and income to pay their bills in the future.

 

myfico.com is good source for information on how the FICO score in particular and credit scores in general work.

How to Deal With Bills You Can’t Pay.

A lot of what I’m talking about on this site only works if you have more money coming in than going out. That’s really the only way finances can work successfully. Like I talk about in my post The Three Money Rules and How to Follow Them, you can’t become financially secure unless your income is more than what you’re spending. So what do you do when all of your bills for the month add up to more than what you make? Well, first there are some things that you shouldn’t do, then there are some things that you should do depending on how bad your situation is, finally there are some things you should do to dig yourself out of that hole forever.

 

This post is for when you’ve already canceled cable and other things you don’t need. This post is for when you’re trying to keep the lights on and food on the table.

 

What you shouldn’t do.

  1. You shouldn’t take out a payday loan.

This is one of the worst things you can do. Payday loans have ridiculously high interest rates. They really aren’t designed to be paid off. They’re designed to keep you in a cycle of paying more and more until you can’t afford to pay. Not all companies that offer payday loans are unscrupulous like that, but there are many that are.

  1. You shouldn’t charge more on your credit cards.

This can be difficult, but adding more to your pile won’t help you pay your bills in the long run. It might be a short term solution, but usually by this point that option has passed.

  1. Don’t pull money from your retirement accounts.

Many times people will pull money from retirement accounts to pay for debt. This can hurt you more in the long run than the bad credit from not paying your bills. The money in your retirement account will continue to grow. Money in your retirement account is usually untouchable by creditors even in bankruptcy. Make this a last resort.

 

What you should do.

  1. Look at your expenses.

Most likely by this point you’ve already done this, but it doesn’t hurt to repeat it. Cut out anything that is extra. You don’t need cable. You don’t need a gym membership. You need food to eat and a roof over your head.

  1. Pay the essentials first.

Pay the most important things first. Shelter and food. Always make your rent or mortgage payment if possible and put food on your table. It is very difficult to find new housing if you are evicted. And if you don’t eat you won’t be healthy enough to make things better. Being sick can also increase your costs.

  1. Prioritize your bills.

Some bills are more important than others. Look at your bills and determine what is most important. Make sure those get paid first. Pay the rest as you can. Here are a few suggestions to help you prioritize your bills. Pay for your needs, then your secured loans, then your unsecured loans with any money left over. Pay for your home first. Make sure you have money for food. Then make sure you can pay for utilities like electricity and water. Then pay for any secured loan on something you can’t live without. Secured loans are loans where the bank owns the item until you pay it off. This might include your home or a car. After that, pay your unsecured loans. These are the things like credit card bills, student loans and personal loans. The things where the creditor can’t take anything away from you for not paying.

 

If some of them are particularly old. For example, if you have a credit card loan that you haven’t paid on in several years. That should be put at the bottom of the list. Unpaid credit loans that haven’t been paid in 7 years are required to be removed from your credit report.

  1. Contact your creditors.

Creditors are businesses. They want to make back the money they loaned you. If you call them ahead of time and tell them that you can’t make the payments, but are willing to pay them back they may work with you. Most banks have departments dedicated to working with people that are having trouble paying their bills. When you call them tell them that you can’t pay the bill and tell them what you can pay and ask them what they can do. They may be willing to change the interest rate, change the payment schedule, temporarily suspend payments, or many other things to help you out. The key is to start talking to them early.

  1. Determine what’s not worth paying.

If you truly can’t pay all of your bills you may have to pick what you can give up on. Make sure you pay for things you can’t live without; home, car, food, utilities. Most anything else may hurt your credit, but won’t hurt you. Unsecured loans, like credit card debt, are easily the first to go. If you don’t pay them it will hurt your credit, but they can’t take your things away.

  1. Consider bankruptcy.

Bankruptcy can be a scary thought, but it can also solve a lot of problems. Bankruptcy can allow you to renegotiate payment schedules, adjust interest rates and even delete some debt. It is also cheaper and easier to do than most people think. You will need to talk to an attorney, but it can help you reorganize or completely eliminate much of your debt. It all depends on your situation.

 

How to dig yourself out.

  1. Create a budget.

The first step in digging yourself out and getting on the road to financial security is to set up a budget. No matter what brought you to this point, whether it was a job loss, medical emergency or some other event you will need to set up a new budget for your current situation.

 

Look at how much money you’re making. Then list all of your expenses. Write down how much each one is per month. If they aren’t the same each month then estimate what you think it will be. I recommend estimating high just in case. I also recommend having a line item for “Other” to cover all those little things that just come up. And be sure to add a line item for “Savings”.

  1. Develop a plan.

When setting up your budget start developing a plan to pay your bills and put money into savings. The savings will help prevent this type of situation in the future because it will give you a cushion. Look at things like how long it will take to pay off the debt with what you pay each month. As part of your plan, adjust the numbers in your budget to find something that works.

  1. Bring in more money.

There are a lot of ways that you can bring in more money. If a job loss caused the problem with paying the bills then a new job may be the priority. Until then there are a number of other ways you can start to bring in more money. Either temporarily or as a permanent side gig. Things like a second job, side work, or even doing online surveys can help. See my list Way Too Many Ways to Make More Money for some ideas.

 

Not being able to pay all of your bills in a month can be very stressful. It can be easy to let it get the best of you. It’s important to try and take a step back and look at your situation. Find comfort in education and planning. If you develop a plan then you can get the important bills paid and have a way to deal with the things that won’t get paid. Good luck.

 

Anything I missed? What other things are important when you can’t pay all of your bills?

The Problem of Debt and How to Get Rid of It.

Americans are being crushed under debt. We borrow money to buy the things we need. More often than not though, we borrow money to buy the things we want. According to NerdWallet the average American household has over $15,000 in credit card debt. That doesn’t even include a car loan or a mortgage. And credit card debt isn’t cheap. The average interest rate on a credit card is 18%. It can go even higher.

 

Now, what does that actually mean? First, let’s look at how credit cards work. We have to go back to high school math for this. Say you buy a new TV for 500 dollars. You put it on a credit card with 20% interest. Most store credit cards have even higher interest. And, for this example say you have a minimum payment of $25 per month. That would be about typical. How much will that TV actually cost you, and how long will you have to pay for it?

 

Just to make sure we’re clear on words. Interest is what the bank charges you to buy that TV for you and let you pay them back over time. The longer you tie up their money the more they charge you. Principal is the amount you actually borrowed. So in this example it’s the $500. In most loans you pay the interest and a little bit of the principal each time you make a payment.

 

If there was no interest the math would be easy. You would divide the 500 by 25 and you would get 20 months. Now with interest it will take a little longer. Generally interest is calculated every month. The bank will usually divide your interest rate by 12, since there are twelve months in the year and that’s how much interest you pay that month on whatever is still owed. So, if you owe $500 and your interest rate is 20% per year then the bank will divide 20%/12 and charge you 1.67% interest that month. 1.67% of 500 is $8.33. So before you can even pay towards the 500 you have to pay that interest of $8.33. Typically the bank doesn’t charge interest the month you make the charge, though. So you generally don’t start paying interest if you pay for all the charges you made that month.

 

Here’s a little table showing the month, payment that month, the amount owed before the payment is made, the amount owed after the payment is made, the interest added, and the amount that will be due next month.

 

Month Payment Total Owed Before the Payment Total Owed After the payment Interest Added For The Month Total Owed Next Month
1 $25.00 $500.00 $475.00 $7.92 $482.92
2 $25.00 $482.92 $457.92 $7.63 $465.55
3 $25.00 $465.55 $440.55 $7.34 $447.89
4 $25.00 $447.89 $422.89 $7.05 $429.94
5 $25.00 $429.94 $404.94 $6.75 $411.69
6 $25.00 $411.69 $386.69 $6.44 $393.13
7 $25.00 $393.13 $368.13 $6.14 $374.27
8 $25.00 $374.27 $349.27 $5.82 $355.09
9 $25.00 $355.09 $330.09 $5.50 $335.59
10 $25.00 $335.59 $310.59 $5.18 $315.77
11 $25.00 $315.77 $290.77 $4.85 $295.61
12 $25.00 $295.61 $270.61 $4.51 $275.12
13 $25.00 $275.12 $250.12 $4.17 $254.29
14 $25.00 $254.29 $229.29 $3.82 $233.11
15 $25.00 $233.11 $208.11 $3.47 $211.58
16 $25.00 $211.58 $186.58 $3.11 $189.69
17 $25.00 $189.69 $164.69 $2.74 $167.44
18 $25.00 $167.44 $142.44 $2.37 $144.81
19 $25.00 $144.81 $119.81 $2.00 $121.81
20 $25.00 $121.81 $96.81 $1.61 $98.42
21 $25.00 $98.42 $73.42 $1.22 $74.65
22 $25.00 $74.65 $49.65 $0.83 $50.47
23 $25.00 $50.47 $25.47 $0.42 $25.90
24 $25.00 $25.90 $0.90 $0.01 $0.91
25 $0.91 $0.91 $0.00 $0.00 $0.00

 

So by having the loan you end up paying more. You pay a total of $100 in interest. Your $500 TV ends up costing you a little over $600. That’s 20% more. The loan also ties up $25 of your money every month for 24 months. Even on months that you have something more important to pay for.

 

So, next time you want to buy something with a credit card think about how long it will take to pay it off, and the extra interest you will pay. Is it worth the extra money in interest?

 

So what can you do about it? Ideally plan ahead. If you know you are going to buy a $500 TV put $25 a month in a savings account every month. Then when the account reaches $500 you can buy the TV. This way you get it for cheaper. You can also skip a month when you’re tight on money, or if something else comes up. You can’t skip a month with the credit card.

 

But what do you do with the debt you already have? There are several strategies that you can use to get rid of it. The first step to each of them is don’t add anymore debt to the card. You can see more details in my post Strategies to Pay Off Debt. Below is a summary of what you can do.

 

Step 1. Don’t add any more debt to the card.

This is probably the most important step. If you stop adding to the debt you can pay it off. If you continue to add to it you may never pay the debt off. You will simply pay the bank more and more interest making the bank owners richer and yourself poorer.

Step 2. Always pay at least the minimum payment.

The minimum payment usually covers the interest and a little bit of the principal. It’s also the least amount that you can pay and keep the bank from getting upset. Paying this amount each month will keep your account current. Many credit cards will raise your interest rate if you don’t pay this. So missing it may cost you even more money.

Step 3. Pick one card and put your extra money to it.

This is how you start to get rid of the debt. Pick one card. This could be the card with the highest interest rate, or the card with the highest balance, or the card with the lowest balance, or even the card with the company you like the least. However you decide to do it, pick one card to pay off first. Put all your extra money to it and pay the minimum balance on your other cards. As soon as this card is paid off switch to the next card and do the same thing.

Step 4. Don’t add any more debt to the card.

Once a card is paid off don’t add more debt to it. That would only continue the debt cycle. Instead think of all the extra money you’ll have left over once you pay off the cards.

 

That’s the four, really only three steps to getting rid of the credit card debt. The hardest part is the discipline to stop using the cards and to pay extra each month. If it’s truly important to you to have a strong financial future then you can do it.

 

What strategies do you use to pay off your credit cards? Any strategies to keep yourself from using your cards?