Protecting, Maintaining and Enhancing Your Credit

For years, there has been a fairly profitable industry in credit reporting.  In this age of Big Data, the trafficking of personal information feeds the marketing machine that drives the spending of the all important greenback in our global economy.   But how can the average consumer protect, maintain and even enhance his or her credit?  The fundamental thing to understand from a lender’s point of view though is whether a loan will be paid back –  this is known as default or credit risk.  Typically speaking, lenders are interested in two things:  principal repayment and cash flow while the loan is outstanding.  So, having a good system to evaluate the likelihood of a borrower’s ability to repay is crucial to: whether the loan should be made at all, and what interest rate should be charged.  So let’s see if we can uncover some ways to understand and even take advantage of that system to benefit you!

Protecting Your Credit

Protecting your credit profile is all about knowing the rights afforded you.  The center-piece legislation, the Fair Credit Reporting Act of 1971 (FCRA), provides that US citizens have free access to their credit reports and scores from the three national credit reporting agencies (Experian, Equifax and TransUnion).  Next, you have the right to know why you were denied credit based on the information used in a report. Finally, your responsible use of credit can act as a protection of sorts.  For example, opening multiple credit card accounts as opposed to one may not necessarily negatively impact your score, but it does increase your chances of becoming a victim of fraud.  Why?  Well for starters, it puts your sensitive information in multiple databases (instead of one) that can all be subject to identity theft.  You will also be forced to manage multiple payment dates to avoid missing a payment.  Simplicity, as opposed to complexity, is key here.  Receiving the one-time discount taken at the register for opening XYZ store card is not worth exposing your sensitive information in yet another hackable database.

Maintaining Your Credit

Maintaining your credit profile may begin with being aware, but really should become vigilance.  I like to think of the difference as hand on gun as opposed to gun in holster.  The latter suggests a more ready and proactive stance.  For example, rather than being surprised by an inaccuracy on your credit report (because they do happen–see this article) as you sit down with a mortgage broker to buy your first home, the vigilant stance would be to pull your credit report from all 3 agencies prior to that meeting.  This small act could pay dividends as the interest rates charged on a loan are drastically different given a good vs. average credit score (want to see the difference, click here.)  Better still, you could pay as little as $20/month to have your credit profile monitored and protection in the event you’re a victim of identity fraud.  Companies like LifeLock or IdentityGuard offer these types of services.

Enhancing Your Credit

Enhancing (or increasing your credit score) seems to be the most asked question (on average) of consumers when it comes to their finances. (25 million results on Google while preparing this blog).

improve credit

The steps it takes for this, not only involve the two previously mentioned (protection and maintenance), but also include understanding what goes into calculating the score so you can “play the game”.

Source: www.myFICO.com

Source: www.myFICO.com

As you can see, payment history is the biggest component of your credit score.  So, not missing a scheduled payment date is the best thing you can do to increase your credit score.  Payment history is kept for a rolling seven year period and includes derogatory payment information.  Next, you want to keep the amount you borrow as it relates to your overall limit, low.  This ratio is called “credit utilization” and it accounts for 30% of your score.  Studies show that credit utilization ratios between 1%-30% are considered positive.  Open and unused lines or ratios beyond 30% begin to decrease your score.

Let’s think about why for a minute.  Take the lender’s point of view:  would you rather lend to someone with high income and no credit usage (or history), or someone with average income and low, continuous credit usage?  You may choose the former, but most lenders would choose the latter.  That is because data speaks.  Person A has no data, whereas person B does.  To a lender, it doesn’t matter if you make six figures per year but have opened, unused credit lines.   When compared to the five-figure income person with continuous usage, you are a higher risk.  Although, you may get the loan, it will probably be at a higher interest rate.   This is because credit scores are designed to portray how good you are at borrowing.  So remember, most lending decisions are made in that context.  The last three components (length of credit history, new credit lines and types of credit used) comprise the remaining 35% of your score.  Length of credit history is arguably the most important.  Again, from the lender’s point of view, a longer track record of consistent debt repayment is preferred.  Closing accounts or cancelling cards can negatively impact your score because it shortens your credit history.  This is not to say that you shouldn’t pay off your debts, but when it comes to closing card A (opened in 1998) to open card B, you should avoid that decision.  (Note:  Beware of closing older accounts with enticing balance transfer offers!)  Finally, understand that opening new lines of credit are considered “hard inquiries” and establishing those new accounts with little time in between can appear like a desperate move to lenders.

Borrowing in and of itself is not bad if done correctly.  After all, roughly two-thirds of our gross domestic product is composed of consumer spending and a large majority of that is done with credit (versus cash) purchases.  Consider your own use of credit for a home or car purchase, or even a student loan.

Source: www.bls.gov

Source: www.bls.gov

So credit makes the world go-round, right?  Well, when shifting the focus from “big-picture” to you, remember that your credit score focuses on timeliness of payments, how much you owe, how long you’ve been at it, how frequently you open new accounts, and the types of accounts you open.  With that in mind, your credit score communicates (quite well) to a lender how well you borrow and repay money.  It cares nothing of your annual salary or other assets.  Although these are factors related to your repayment ability or capacity to repay, these are not factored in.  You have to know the rules, if you want to play the game.

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Dominique is owner of DJH Capital Management, LLC. a full service, comprehensive financial planning firm helping individuals build roadmaps to reach their financial dreams.