How Understanding Your Credit Score Can Save You $100,000

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If you want to really want to get a handle on your money situation, look no further that improving your credit score.

Easily the most overlooked aspect of one’s finances, your credit score is the number that tells lenders how trustful you for credit cards, mortgages, and other loans. This one number affects whether or not you get a loan, the interest rate of the loan, and your credit limit for the loan.

The biggest purchases of your life – a house, cars , a  business, etc. – are effected by the size of your credit score and if it’s low, you’ll end up paying hundreds of thousands of dollars more in your lifetime just because you’re more risky to lenders.

Last week I had a guest post run over at the Digerati Life about the importance of getting your money in order in your twenties. In the post I included an example of how much poor credit can cost you.

Now let’s take a specific example that shows good credit at work: when you decide to buy a house and you’ve got great credit, your interest rate could be around 5.5%; but if you have horrible credit it could very well be pegged at 6.5%. A few percentage points don’t seem like a huge deal, but over the life of a thirty year mortgage, it’s a GIGANTIC deal.

So say you buy a $300,000 house. If you have a 30-year mortgage of $250,000 at a 6.5% interest rate, the house will end up costing you $700,111. That’s $333,548 just in interest! If you buy the same house with a loan sporting a 5.5% interest rate, the house will end up costing $642,260, with the interest totaling $276,322. A 1% change in the interest rate will cost you $57,226!

Having good credit is vital to being good with your money, but luckily you can turn around bad credit by learning how it works.

The Specifics of Your Credit Score

Your credit score is often referred to as your FICO score, which was the first credit scoring company. Lenders contact FICO when you apply for a loan to determine how much they should lend you and at what interest rate. Your FICO credit score can be between 300 and 850, but 60% of scores are between 650 and 799.

So where does your credit score come from? Your credit score is based on your credit report – a giant report card of your credit history. Included are any loans, credit cards, or mortgages you’ve had; and the specifics behind the accounts including dates, delinquencies, balances, etc.

Fortunately, for consumers you’re allowed to get a FREE copy of your credit report from each of the three major credit bureaus: Experian, TransUnion, and Equifax once every 12 months. This means you can get all 3 at one time or you can spread them out and get 1 every 4 months.

Visit AnnualCreditReport.com to get a copy of your credit report. They’re all similar and it doesn’t matter which one you choose first.

Your credit report doesn’t tell you your credit score number. The credit score costs money and the credit bureaus will probably try to get you to purchase a credit score on top of your free credit report.

Make sure to check for special promotions. For example, I went to get my credit report from Experian and they were offering a special deal where I could get my report and score for free if I signed up for a 30 day free trial of a special program they were offering. I had to give them my credit card, but I’ll cancel soon and not have to pay anything.

A credit score by itself will cost around $10-15. It can be a good investment to see how you’re doing with your credit and if you need to make any big improvements.  Once again, this is the number lenders see and it shows how credit worthy you are. Banks, credit cards, landlords, employers, and insurance companies will look at your score to see how risky you are if they should lend money or hire you.

The 5 Parts of Your Credit Score

In order to improve your credit score, it’s important to know the five parts that it’s made of:

35% – payment history: Have you paid your bills on time? Any late payments will hurt you in this category.

30% – card utilization: How much of your credit limit you’ve used. To improve this number, keep accounts with high credit limits open and also request higher limits every 1-2 years for each card you own. Also, avoid using 100% of your credit every month because it will seem odd to lenders if you’re maxing out your credit cards every month. To be safe use less than 50% of your credit limit and spread it across 2-3 credit cards if needed.

15% – length of credit history: This is usually the one that hurts young people just because they don’t have an extensive history. If you’ve only had accounts for a couple years, this will be low, but you have some time to get a credit card and grow your history before you apply for any big loans in your life.

10% – types of credit used: Credit cards, mortgages, student loans, auto loans, or business loans are all different types of credit you may have in your life. The more diversified you are the better you are in this category. This is one positive of student loans because it diversifies your credit used.

10% – recent credit pulls: Every time you apply for a loan, the lender must do a credit pull which goes on your credit report. If you’ve applied for 5 credit cards and an auto loan in the last couple of months this will hurt you because lenders will think you’re risky. If you’re going to be purchasing a house or a car soon and it requires a loan, avoid applying for credit cards or any loans within 6 months to allow your score to be at its highest when you apply for the loan.

Now’s the Time – Improve Your Credit

It’s important to start taking positive steps to improve your credit today. Pay your loans on time, limit the amount of credit you use every month, and diversify the type of credit you have over the next couple of years. These steps will all pay huge dividends when you go to buy a house in 5 years and you end up saving $50,000 just because you started using your credit card the right way.

Good luck!

How has good or bad credit effected your financial life? Leave a comment with your story below!

Photo by: dyobmit

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