“Essentially, credit ratings are like a report card for how you handle your finances,” said Chris Moen, northern valley lead financial guide with Alerus Financial in Grand Forks. “It’s one way that lenders can determine your risk.
“With that being said, having a higher score can save you considerable amounts of money, due to better interest rates that you qualify for. It can also help you qualify for financing throughout the journey of your life, whether it be a car, a home, a business. And, really, it can help enable you to take advantage of opportunities that can actually help you make money down the road.”
Moen recommends checking your credit rating at a website the federal government promotes, www.annualcreditreport.com, where “you can look at all three bureaus each year for free,” he said. “That’s kind of the gold standard.”
Review each of the bureau reports for accuracy, he said. It’s a good idea to check your credit rating annually for errors, because oftentimes there could be errors – a misspelling, an incorrect middle initial or address – that can cause problems.
“Those are all things that could lead to somebody else potentially tying in to your credit report and mucking up some of that information. So just doing a good review of that each year is a great process.”
The credit score is a three-digit number, usually on a scale of 300 to 850, that estimates how likely you are to repay borrowed money and pay bills. Any score of 720 is considered excellent, and a score between 690 and 719 is considered good credit. Scores between 630 and 689 are fair, and scores below 630 are poor.
Damaged credit rating
The credit score is determined by an algorithm that takes into account several factors, Moen said. Understanding the algorithm that credit-scoring agencies use “is really the only way that you’re going to have control over it. It might seem mysterious but, turns out, there’s a pretty simple formula to follow.”
The biggest single factor that can hurt your credit score is missing payments, he said. “You definitely don’t want to have anything that’s reporting 30 days plus on your bureau.”
Another factor is the amount of credit used versus how much you have available, or “credit utilization,” said Moen. Based on some formulas, the consumer should try to use no more 30% to 35% of available credit, he said.
“You want to use credit. It’s a tool, and you can also improve your score by using it. It’s just staying underneath that 30% to 35% range so that you’re not maxing it out.”
Having only one type of credit can also be a factor in a low credit rating, Moen said. Diversity of credit is important and should include revolving accounts, such as credit cards that have no specific end, and installment loans, such as a fixed-term auto loan or a home loan for 25 years, which have a finite end date.
“It’s fine to have lines of credit that are revolving,” he said, “but if you have credit cards with a high rate (of interest), those are the ones that are going to do the most damage if you max them out. But the installment loan that you want to add to the mix – to have diversity in your types of credit – having some of those, mixed with the revolving line, really helps to increase your score as well.”
The consequences of a low credit score include “not qualifying for a loan when you need or want to – say life throws something at you and you don’t have any emergency savings, you’ve already used it, and you need to take out a loan to replace a refrigerator that went out or fix the car that blew up.”
“Or if you do get qualified, with a low score, the odds are you’re going to end up paying a lot more in interest because of the higher risk,” he said.
Improving credit scores
The good news is people can improve a credit score by taking several steps, Moen said.
First, look at all three credit bureaus, review them all for accuracy, and check the balances, he said. “If something truly is inaccurate – which happens more often than we’d like to admit – you want to dispute that. … Odds are it’s going to be taken off and that can help your credit score out quite a bit.”
The next step is to develop a plan and have a goal, he said. “Follow a system that’s going to work. Have a plan and be intentional.”
That could include paying down the limits on credit cards that are over 50%, in utilization, or building “emergency savings so you don’t have to tap into that next time.”
The final step is measuring results, Moen said. “You really can’t manage what you’re not measuring.” He and his Alerus Financial colleagues use tools daily to help their clients develop a plan to improve their credit rating, he said.
The difference between good and bad debt has to do with “how the debt is going to play a role in meeting your financial goals,” Moen said. “Will it take you closer or is it going to take farther from achieving them?
Typically, “low-interest debt that can help you increase your income or your net worth, for example, could be considered good debt,” he said, noting examples of student and car loans and home mortgages.
“Higher interest, larger revolving balances like credit cards that are maxed out, for example, that would be considered bad debt, since it’s adversely affecting your credit score, and it’s also costing you in high-interest payments that take you away from building your financial future and reaching your goal.”