For most people, this thing called “credit” is a black box. We know it’s there, we just don’t know what’s inside. And day-to-day, credit doesn’t show up much. You can go months or years without so much as thinking about your credit score.
So, with all that in mind, does credit score matter? If you don’t see it all that often, can it impact your life? You don’t sit around deciding whether you should hang out with someone based on their credit score, so why bother with it?
Today, we’ll be taking a brief look at what credit scores are and why credit score matters. (Yes, even to “regular people” like you.)
What is “Credit”, anyways?
To answer this question, let’s take a trip back to ancient Rome. There’s this guy, let’s call him Brutus. Now Brutus owns a tavern, and he sells food to people from all over the city. One day, someone named Julius comes into Brutus’s tavern.
“Look, I don’t have any money right now,” he tells Brutus, “but I’m getting paid next week and I’m super hungry. Can you get me some of your stew and I’ll pay you back as soon as I can?” Now, Brutus knows Julius. He knows that the guy is an upstanding citizen, a man of honor, and an all-around chill dude.
So Brutus tells him, “Sure, I’ll give you some stew. I know you’ll come back to pay me for it as soon as you can.” In Brutus’s eyes, Julius has good credit.
Just a few minutes later, Antony comes into Brutus’s tavern and says the same thing. Only Brutus knows this guy, too. He’s in there all the time, promising to pay Brutus back, but he never does. So Brutus tells him to move along. He’s tired of giving stuff away and never getting paid back. In Brutus’s eyes, this Antony has bad credit.
The last customer in our little story is someone from out of town. He tells Brutus, “I promise I’ll come back tomorrow to pay for this, but I can’t today.” Brutus isn’t so sure about that. He has no way of knowing whether this guy will come back or not. In Brutus’s eyes, this last guy has no credit.
It really is that simple. The only difference is that nowadays, “Brutus” is one of the three main lenders in the US and “Julius” is, well, you.
What is credit like now?
As life has gotten more complicated, credit has gotten more complicated along with it. In the interest of fairness, credit is no longer determined by a “good feeling” about someone, or even whether an individual has done good things in their life.
This can be a mixed bag. On the one hand, the credit system as it is today has laws in place to prevent discrimination. You can no longer be denied a loan or credit card because of your gender, race, religion, or sexual orientation.
This is a good thing! However, it also means that you can be a perfectly trustworthy person, and still be denied. There are many reasons that otherwise trustworthy people might have bad credit.
A big one for millennials? Student loans. High school students are often not well-educated on credit. So they sign up for these huge student loans with no way to pay them back. Then, your credit score takes a hit. The same goes for credit cards, personal or payday loans, and even medical debt (but only if the medical debt is turned over to a collections agency).
Other than the protected classes, credit functions much the same as in our story. If you took out a credit card or loan and did pay it back, you have good credit. If you took out loans or credit cards and didn’t pay them back, you’ll have bad credit. And if you’ve never had any debt, you have no credit.
This is why “no credit” is a bad thing. The lending companies have no way of knowing whether or not you’ll pay back the money they give you. So they tend to take the safe route and just not lend to you at all.
Mostly, people just don’t know a lot about credit, so they don’t take steps to improve their credit score. This is why you can feel like you’re reasonably responsible with money but have bad credit. You just don’t have the tools to fix your credit score.
Does your credit score matter?
In one word? Yes. In lots of words? Credit can affect just about every major purchase you make, and sometimes, even your job.
It’s tempting to say “no”, but that is just not true. There was a time in the not-too-distant past when you could get away with having bad credit or no credit. Unfortunately, that time has well and truly passed.
Now, even with laws in place around who can access your credit score, having bad credit or no credit can still cause you some major problems.
Why does credit score matter?
Some people are still perpetuating the myth that you can make every purchase in cash, so you should avoid going into debt at all costs because your credit score doesn’t matter.
This is patently untrue. First of all, due to the rising cost of living, saving the entire amount for a car or house before you need it is unlikely. Even if you do, sellers may request a credit check. It’s important to note that if you’re paying in physical cash, you can refuse a credit check, but you may need to fill out some extra forms.
Auto and housing issues aside, banks often check your credit before allowing you to open an account. Why does your credit score matter here? Remember, credit is a measure of how good or bad you are with money. If you have a bad credit score, you’re more likely to overdraft or abandon your bank account.
When you’re renting, landlords will check your credit. They may require a co-signer or a larger deposit for people with bad credit or no credit. Utility companies are the same – you’ll probably need to pay a deposit if you have bad credit.
Finally, you have insurance. Statistically, people with bad credit are more likely to file claims. So insurance companies will often perform a credit check before selling you a policy. Bad credit? No credit? Expect to see your insurance bill creep up above that initial quote.
For some kinds of secure jobs, even your job can request a credit report. While the report they get will be slightly different from the kind other businesses get, they’ll get the gist. Usually, employers will request a credit check to make sure that you’re responsible and trustworthy. Although it is illegal to deny someone a job based on credit history alone, a better credit history could be the tipping point that lands you the job.
How can I improve my credit?
So, does credit score matter? Yes. We might not like it, but that’s the world we live in. So how can you improve your credit? Can you improve your credit?
There’s good news and bad news here. The good news is that you can improve your credit score. The bad news is that it might take a long time.
Let’s go back to our story about ancient Rome for a second to explain why. Remember that second guy, Antony? The one who came in asking for stew all the time but never paid Brutus back? Let’s say one day he came in and started paying Brutus what he owed.
How long do you think Antony would need to pay his debts on time for Brutus to trust him again? Just once? Five times? A hundred times? It would probably depend on how long he went without paying Brutus, right?
The same is true for your credit score. If you’re in your 30s, but you’ve been struggling with debt and missing payments for 10 years, it’ll take a while for your credit score to go up. Meanwhile, if you have no credit but you immediately pay back your debts, your credit score will go up.
Let’s look at the three main things you need to be aware of to boost your credit as quickly as possible.
1: Pay things back consistently… but not all at once
This is one of the most obvious things you can do. Make those payments consistently, and pay a little more than your minimum amount (if you can). One thing you want to avoid? Paying a debt back in one huge lump sum.
Why? Well, think of it this way. When you pay things back in one lump sum, you communicate to the credit companies that you’re “all-or-nothing”. Sort of like if Antony came and paid Brutus for a year’s worth of stew at once, but then came in the next day saying he had no money and needed more stew.
Your credit functions the same way. Credit companies want to see that you can handle your money well consistently, not just that you can pay things off when you have a lot of money.
Practical Tip 1: When you get enough money to pay off a debt, budget it so you pay that debt off across several months. You can always make higher monthly payments to pay the debt off more quickly, but the longer you can be consistent with it, the better!
2: Have several “lines of credit” open at once
Credit lenders like to see that you can manage your money well in lots of different situations. This means that while you’re paying off your student loans, opening a credit card isn’t a bad idea. If you have an auto loan, you can also take out a personal loan.
This communicates to credit companies that no matter how much money it is, when you borrowed it, or why, you can be responsible for it.
Practical Tip 2: Have several kinds of credit open at once.
You might be asking yourself, “Is this telling me I need to be deep in debt for the rest of my life???” No, not at all! The one thing you want to be careful with here is what’s called your utilization. Just because you can doesn’t mean you should.
If you qualify for $20,000 on your credit card, don’t use the full $20,000. Using all $20,000 right away tells credit card companies, again, that you’re “all-or-nothing”. The general recommendation is to use no more than 6% of your limit at any time. So with a $20,000 credit card, use no more than $1,200 before you pay it off.
Practical Tip 3: Check your credit limits and use no more than 6% of what you qualify for.
3: Don’t close lines of credit (if you can help it)
Finally, try not to close a credit card, bank account, or savings account. With things like personal loans and auto loans, you’ll eventually close them, and may see your score go down temporarily.
Closing a credit card tells credit companies that you only want to work with them when you’re struggling. Struggling people are a risk to credit companies, so they’ll lower your score. When you can, keep lines of credit open for as long as possible.
Practical Tip 4: If your card is paid off and you want to close it, ask your credit company if you can switch to a fee-free card instead. This way, even if you aren’t using the card very often, you don’t hurt your credit score.
How to navigate credit
Credit can be a tricky thing. Some aspects of it are just like building trust with a person, while other times the impersonal nature of business gets in the way. This is part of the reason having an emergency fund is so important. Credit companies don’t care if you’re in between jobs – they want to see you paying back what you owe.
The more you learn about credit, and the more you use it in your everyday life, the less of a “black box” it becomes. This can help you be ready to buy a home, a new car, or send your kids to college someday.
For more tips on building credit, saving money, and getting out of debt, subscribe to Millenial Dollar’s newsletter. We’ll deliver articles like this right to your inbox and help you build a brighter financial future.