Your credit score is an important part of your financial life.
It determines what loans and credit cards you are eligible for. It also determines the interest rate you’ll pay on those loans.
When you’re taking out a major loan, like a mortgage, even a slightly higher rate can cost tens of thousands of dollars over the life of the loan.
Because your credit score is so important, you should do your best to make sure you have a good score.
However, even with perfect credit management, you’ll probably run into a situation where you need to do something that will adversely affect your credit.
Learn about the situations where it’s okay to do something that will reduce your credit score.
1. Taking Out a Major Loan
One of the reasons your credit score is so important is because it affects the loans you can get and the interest rate you’ll pay.
The problem is, every time you apply for a new loan, your credit score will drop. That means that you need to take a hit to your score to take advantage of having good credit.
If you’re taking out a large loan, such as a mortgage, taking the hit to your credit is worth it. Buying a house without a mortgage is incredibly difficult. Plus, you’re unlikely to save nearly as much by preserving your good credit score for another loan.
Consider this example:
You want to take out a $300,000 mortgage and pay it back over 30 years. If you pay 4.5% interest, your monthly payment will be $1,520 and the total cost of the loan will be $547,220.
If you had a slightly worse score because you applied for a different loan before applying for your mortgage, might wind up with an interest rate of 4.75%. If that happens, your monthly payment will be $1,565. The loan’s total cost will be $563,379.
Taking advantage of your good credit, at the cost of a small hit to your score, will save you more than $15,000.
Saving your good credit score for a different loan is unlikely to save you more than that.
2. To Make a Long-Term Improvement to Your Credit Score
Just like it takes money to make money, it takes credit to improve your credit. Many of the things that you can do to improve your score will result in a short-term hit to your credit.
For example, one way to improve your credit score is to increase your available credit.
The lower the ratio of your card balances to your total credit, the better your score will be. Taking out.
A large loan and paying it down quickly will have a similar effect.
The downside is that applying for a loan or a credit limit increase often requires a hard pull on your credit report. When that happens, your score will drop by a few points. Over time, it will return to where it was and eventually, rise above your original score.
If you already have multiple credit cards, one strategy is to ask your current cards’ issuers for credit limit increases. Many issuers will consider increases without making a hard pull on your credit. If your request is approved, you’ll get all of the benefits of a higher credit limit without the downside of the credit pull.
You can also improve your score by paying down your existing debts. One good way to do this is to consolidate your existing loans into a single new loan.
Applying for the new loan will reduce your credit slightly, but that will be more than offset by the increase caused by paying off your debt.
3. To Close an Expensive Credit Card
When making loans or offering credit cards, banks want to form a long-term relationship with the client.
To help encourage that, the average age of your credit accounts makes up a portion of your credit score. The older your average loan or credit card is, the better your score will be.
Conversely, having fewer old credit cards will result in a lower score. Closing a credit card account could result in the average age of your accounts going down. This could harm your credit score.
Still, it can be worth closing a credit card, depending on the card’s terms. Some cards, especially those that target consumers with poor credit, charge hefty annual fees. On the other end of the spectrum, premium rewards cards charge high fees to offset their monthly impressive benefits.
In either case, you shouldn’t be paying for the privilege of holding a specific card unless you’re getting value out of it.
Premium travel credit cards can charge annual fees of abuot $500. Saving that much each year is worth the temporary reduction in credit score.
How Credit Scores are Calculated
Your credit score is a numerical representation of your trustworthiness as a borrower.
The higher your credit score, the more likely you are to pay your loan bills. The lower your credit score, the less likely you are to pay your bills.
FICO credit scores range from a minimum of 300 to a maximum of 850. Lenders like to look for borrowers who have a high score because lending to them is less risky.
Borrowers are generally broken into five categories based on their credit score.
What category you fall into affects the loans you can qualify for and the interest rates you’ll pay.
Your credit score is calculated based on five factors:
- Payment history
- Amount owed
- Length of credit history
- New credit
- Credit mix
The most important factor in your credit score is your payment history. Alone it accounts for more than a third of your score. It’s easy to understand why.
When a bank loans you money, it mostly cares about whether you’ll pay the loan back. If you don’t, the bank will lose a lot of money. If you have a history of paying your debts, that looks good to the bank.
The best way to improve your score is to always pay your bills on time. Even one late or missed payment can drop your score by a huge amount.
The amount you owe is the second most important factor in your credit score.
The total amount you owe is one aspect of this. If you have a lot of debt, you’re going to have more trouble paying your debts off than someone who has a small amount of debt. As your total debt rises, your credit score falls to account for this.
Another aspect of this is your credit utilization ratio. This is calculated by dividing your total debt by the total amount of credit available to you. If you have a lot of credit available, but don’t have a high balance, that looks good to lenders and will increase your score.
Length of credit history
Lenders want to form long-term relationships with borrowers. The longer you borrow money from them, the more profit they will make.
What they do not want to see is someone who constantly opens and closes loans or credit cards.
Try to keep your older credit accounts open to give your score a boost. As the average age of your accounts increases, you’ll see less of an impact from opening new accounts.
From a lenders perspective, every time you apply for a loan, you become a riskier borrower.
If you need to borrow money, that indicates that you are having money troubles and might be unable to pay off a new loan. That’s why your score takes a hit each time you apply for a new loan.
Records of applications for credit stay on your report for two years. After that time, your score will return to normal. This factor, combined with the impact of the average age of your credit accounts means that opening a new loan can drop your score by a fair bit.
To maintain a good credit score, only open new credit accounts when you really need to.
The final portion of your credit score is made up of your credit mix.
Handling a mortgage is very different from handling a credit card, which is different from handling a personal loan.
The more experience you have with different loan types, the better you will be at handling debt in general. For that reason, the more different types of loans you’ve had, the better your credit score will be.
Your credit score can have a major impact on your financial life, so you want to make sure yours is good.
Unfortunately, sometimes you have to do things that will hurt your credit score.
Knowing when it’s worth taking a hit to your score can help you make the most of having good credit.