Do you care about your credit score? Most people do. You want a good credit score so you can get a credit card or qualify for a loan to buy a car or a house. Makes sense.
However, the steps you take to improve your credit score may not be sound financial decisions if all you look at is the credit score number.
Why? The credit scoring system is designed to help the banks, credit card companies and other lenders. It was not designed to help you.
In theory, a credit score is a measure of risk. By looking at several factors, the lender wants to know how likely it will be that you will default on your loan payments. It’s not a measure of how hard or easy it will be for you to keep up with those payments or whether or not you can afford the loan. Your lender just wants to know if you will default on the payments.
A credit score is based on five main factors (in order of importance):
- Payment history 35%
- Amount owed and utilization 30%
- Length of credit history 15%
- New credit 10%
- Types of credit used 10%
Payment history is the most important factor, accounting for more than a third of your total score. According to the model, you will have a higher score if you make all required payments on time. However:
- Not all payments are tracked;
- You don’t receive any benefit from paying your balance in full each month, or making extra payments on your term loan;
- The term of the loan isn’t factored into your credit score.
All this translates into a scenario where someone behind on their rent, paying only the minimum on their credit cards with a seven year car loan and close to bankruptcy could have better credit score than someone with a single credit card paying the balances in full each month.
Credit models can only tell if you are a delinquency risk if you use credit. Most credit scoring models suggest keeping balances on revolving credit accounts below 30% of the credit limit. Let’s look at why this is bad for you:
- If your only credit is a credit card, you need to carry a balance to increase your credit score.
- You can lower your utilization rate by increasing your credit limit.
- Debt levels are not tied to income.
So, someone who earns $50,000 per year and has three credit cards, each with a $10,000 limit and a $3,000 outstanding balance, may have a better credit score than someone with a $600 balance on one $1,000 card earning the same income. Does that make sense?
New Credit and Types of Credit
Another problem with the credit scoring system is that your credit score increases if you have multiple sources of credit. That means someone with a credit card, a bank loan, a car loan and a mortgage will have a better credit score than someone with only one loan or someone who has paid off their loans in the past. Is more debt in your best interest? I think not.
The problem is that the bank’s goals (make money) are different than your objectives (stay out of debt), and the credit scoring system often encourages higher bank profits:
- Increasing the length of time your loan will be outstanding and reported in your credit score may increase your credit score, but it maximizes the interest you will pay, and that maximizes the bank’s profits, but costs you more in interest.
- Keeping your utilization rate at around 30% increases the interest you pay, and maximizes the bank’s profits.
- Increasing your credit limit runs the risk of additional borrowing, which, you guessed it, increases your interest costs and maximizes the bank’s profits.
- Borrowing multiple types of loans, and having new loans means you continue to make interest payments and maximize the bank’s profits.
So, if you want a high credit score, keep your utilization rate at around 30% and maintain only the required payments.
But is that good for you? Of course not. If you want to be strong financially:
- Pay off your credit card balances in full each month;
- Keep your term loan amortization periods as short as you can comfortably afford;
- Don’t keep high credit limits if you don’t need them and can’t afford to pay them off.;
- Keep your debt service ratio (the ratio of your debt payments to your income) well below the norm considered acceptable.
You only need a credit score high enough to qualify for the amount of loan you need, not the amount of loan the bank wants to give you. That may mean that you don’t need a perfect credit score, only a score that is good enough to accomplish your objectives.