Credit Traps and No Free Lunch Theory

My first post in my credit score blog series focused on monitoring and tracking credit score, and my second post focused on tips for improving your credit score. This third post in the series walks you through the common traps that you may encounter. If you are not careful, you could inadvertently hurt your credit score – which detracts from your financial goals. After this post, I will move on to other interesting personal finance topics.

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Acropolis of Athens, Greece, 2012

Trap 1: The Enticing “0% Financing” and “0% Balance Transfer” Credit Card Promotions

I just got another “0% financing” advertisement from Home Depot today. These promotions sound so attractive! As a cardholder, you get to make any purchase without paying interest for the next 24 months. There are no shortage of 0% financing and 0% balance transfer credit card promotions out there. Frequently furniture retailers offer this to consumers who just paid the majority of their cash into their home and don’t have much cash left to purchase furniture. In order to take advantage of the 0% financing, you only need to pay the minimum balance due in order to avoid the finance charges (could be as low as $25 per month). This means you can effectively borrow for free and invest at a higher rate of return, right?

My “No Free Lunch Theory”

If something sounds too good to be true, it probably is. There must be a string attached to this seemingly great deal, right? Yes and No.

Why there isn’t a string attached? As long as you keep paying the minimum amount due and abide by the lenders’ requirements, you can avoid any interest and late payment charges. As long as you follow the rules, your lender should too.

Why there is a string attached? Taking advantage of this seemingly attractive offer could hurt your credit score. To illustrate, if you decide to take advantage of this promo and borrow $5,000 and pay $25 each month and pay off the remaining balance at the end of 24-month term, your average balance for the next 24 months will be $4,524. This will meaningfully increase your credit utilization ratio. Recall from my prior post, credit utilization rate accounts for 30% of the credit score – the higher the ratio, the lower your score! Therefore, if you have the cash for the purchase, I would pass on this type of promotion.

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Franklin Zoo, Boston, MA 2015

Trap 2: Purchasing A Car with Auto Loan Instead of Cash

When you purchase a new or used vehicle, car dealers often will offer you an attractive financing option (e.g. 0%, 0.9%, 1.9%, etc.). These rates are typically lower than your mortgage rates. Wouldn’t it be great get an auto loan and pay down your other debt (e.g. mortgage, credit card) at higher rates first?

One way to evaluate whether you should pay cash or borrow, think about the follow aspects:

  • Alternative use for your cash: what can you do with the cash to invest?
  • How does the loan affect your credit score?
  • Are you willing to monitor the payment and balances and even take the risk of missing on a payment?

I recommend paying for your car with cash. Because if you start an auto loan, it will increase the “amount you owe”, the factor that accounts for 30% of your credit score. In addition, running a credit inquiry could (temporarily) hurt your credit score as well.

If you do decide to get an auto loan, always make sure you are paying on time. If you prefer to use autopay, be careful when the first payment is set (I would also call the lender to confirm). If autopay is set incorrectly, it is possible to get off cycle and unintentionally miss a payment. I would avoid the hassle of auto loans altogether if you have the cash.

Trap 3: Closing No Longer Used Credit Cards

As you go through your purchase needs and take advantage of the initial credit card opening promotions, it is common to cycle out of certain cards as they became less attractive (e.g. smaller rebates) than newer cards. In order to reduce the number of cards you need to manage and store, does it make sense to close the unused cards?

Before you close your next unused card, think about how this will impact your credit score. When you close an account, it will decrease your credit capacity and effectively increase your credit utilization ratio. Remember, the credit capacity is the total amount you are able to borrow across all your credit lines, so you want that number to be as high as possible. If your ultimately goal is to maintain a top credit score, consider leaving the account open (and storing the cards in a safe place).

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The Greek Parliament, Athens, Greece, 2012

Bonus Tip: Credit Quick Fixes

Lender typically report a late payment to the credit report agencies after it is 30 days past due. If you are ever late on payment, call your lender and ask whether they have reported your late payment to the credit reporting agencies. If your lender has not reported it, your late payment won’t show on your credit report.

If you have very good or exceptional credit score, kindly ask the representative on the phone to reverse the late fee (chances are they would as they want to keep you happy). If your lender has already reported the late payment, try to negotiate to see if you can have them modify that record and count it as current payment. Most lenders are reasonable and it never hurts to ask.

 

Dear readers, have you fell for one or more of these traps? After reading this post, what would you do differently to protect your credit score?

 

Credit Score Part 2: Improving Your FICO Score

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In my last post I focused on understanding and tracking FICO credit score. In this post, I am excited to share with you some of the (easy) ways to improve your score. Hopefully you can strengthen your score over time and lower your interest rate on your mortgage and improve your financial health.

Remember from my last post, under the Equifax credit system, your score is based on five factors: payment history (35%), amount you owe (30%), length of credit history (15%), type of credit (10%), and new credit opened (10%). Out of these five factors, you can control at least four of them. Below I give you detailed tips on improving the four key factors that account for 90% of your credit score. With my strategy, even with the same income profile and greater spending needs, I was able to improve my score from 796 (very good) to 862 (exceptional).

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Source: Equifax, Citi, and Finance Cappuccino

Tip #1: Improve “Payment History” Factor Always Pay Full Balance on Time

Misconception: Paying the minimum amount due each month is good enough.

Among the factors determining your credit score, having a pristine payment history is the most important, accounting for 35% of the score. This is also the factor that is most within our control. My recommended approach is to pay the full credit card balances on time or before the due date.

One good way to always pay mortgage and credit cards on time is to set payments on autopay. Most lenders give you that option online. Simply create an account and set payments on autopay. Funds will be deducted automatically from your checking accounts on the payment due date. Make sure you are paying the FULL amount and not the minimum payment due. Do not fall asleep during this step as it is easy to click on the wrong button and inadvertently select the wrong option. Once you receive a confirmation, go back to the account and check.

In today’s (still) low interest rate environment, we are getting almost 0% interest on our checking accounts so if you have the cash, I would recommend paying off the balances early.

Tip #2: Improve “New Account Opening” Factor Open New Accounts Sparingly

Misconception: Fewer accounts are better; don’t apply for new credit that you don’t need

When you are reviewing your credit report and notice that your scores are lower than what you expected even though you pay all balances off on time, a common culprit is that you have too many new accounts open. Having too many inquiries in your credit report could temporarily lead to reductions in your credit score. I would recommend opening accounts sparingly and try to group them around the same time to minimize the exposure of credit inquiries. This is especially important if you expect to be shopping for mortgage rates in the near future.

Having few accounts does not necessarily mean higher credit score; having more accounts can have positive effects as well. I will discuss more in detail in Tip 3. To give you an example, my dear husband and I have many shared accounts and our credit profile are similar. However, I have more than two times the number of credit cards open than he does, yet I have consistently had higher credit score.

In short, I think it is ok to have new and more accounts as long as you are opening them sparingly and for good reasons. After all, the “New Account Opening” factor only accounts for 10% of the credit score. I typically open new credit card accounts to take advantage of account opening bonus, higher rebates, or merchant discounts. I will do a separate post on the best small business and individual credit cards at a future date.

Tip #3: The “Amount You Owe” Factor – Aggressively Pay down Your Credit Cards

Misconception: You can’t change amount you owe

One key ratio that determines 30% of your credit score is Credit Utilization, which is equal to the amount you owe divided by total credit capacity. The smaller your utilization, the better your credit score.

Ideally, you want a small numerator (amount you owe) and big denominator (total credit capacity). The amount you owe is a function of your spending and total credit capacity is a function of the total credit limits for all your credit cards.

To raise your credit capacity, you need to have enough credit cards (see Tip #2). Remember if you apply for new cards, please do so sparingly (and only if you are also getting a financial incentive). However, over time you should be able to build up your total credit capacity.

To lower my credit usage, I pay all of my credit cards once or twice per week. My average credit balances are near 0 and sometimes even going into the negative territories.

As an example, say I owe $200 on my Citi credit card, I would pay $500 (effectively overpaying) and let my balance be -$300. It will take sometimes before my balance becomes positive again so I don’t need to pay on a daily basis. Note that Chase puts a limit on how much you can overpay. I like the Citi system better since I can freely overpay any (even larger) amounts.

To reduce the hassle of logging on and off on a computer, I prefer to use the Citi iPhone app. I can log into my account when I have a few minutes between meetings to get this done. If you have joint account owners, they can free-ride on your efforts of paying frequently.

Tip #4: Improve “Length of Credit History” Factor – Borrowing Someone Else’s Credit History

Misconception: Credit history must be your own.

This point is especially relevant to family members, e.g., children, who do not have lengthy credit histories. If you (the parent) have a long-standing higher credit score and a teenager without a lengthy credit history, you have two options:

1) Apply for a new credit card in your child’s name and add yourself as a guarantor, OR

2) Add your child to your existing card

Which would you choose?

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Source: Finance Cappuccino

My recommended option is number two. With option number one, you child starts a new credit file and builds her credit history from scratch. But if you have a long credit history, and you are ok with paying all the expenses on the card, it would be much better to let your child automatically gain your decades-old solid credit history. Pick the card that you had the longest credit history and let your child piggyback on that. This will give your child a jump start in building her credit history, and may help her get a terrific mortgage rate in the future.

Dear readers, I hope the above tips are helpful. What is your credit score improvement strategy? Are you focused on getting a top credit score for yourself and your children?

Credit Score Part 1: Understanding FICO Score

What Is FICO Score

The acronym FICO stands for Fair Isaac Company, the original creator of the scoring system for a consumer’s creditworthiness. FICO scores are used primarily by lenders to make credit-related decisions such as mortgage, auto loan, credit cards, just to name a few.

The FICO score is based on an individual’s credit history, which is maintained by the three major credit reporting agencies Experian, Equifax, and TransUnion. The FICO scores from the three credit agencies for the same individual can vary. As an example, my credit score with Equifax is 862, but with TransUnion it is 813.

Equifax’s credit scores consist of the following categories:

  • 800 – 900: exceptional (well above the average US consumer’s score)
  • 740 – 799: very good (above the average US consumer’s score)
  • 670 – 739: good
  • 580 – 669: fair
  • 250 – 579: risky

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Source: Equifax and Citi Bank

What Determines Your Credit Scores

In the Equifax credit system, your score is based on payment history (35%), amount you owe (30%), length of credit history (15%), type of credit (10%), and new credit opened (10%). The other two agencies have slightly different scoring methodologies.

Why Your Credit Scores Matter

For most of us, our biggest purchase is our own primary residence (or vacation home or investment property). The biggest cost of making this purchase is the interest cost, which is directly linked to the credit score. The higher the credit score is, the lower is the interest rate and interest cost – everything else being equal.

To illustrate, if you are purchasing a $1,000,000 home and borrowing 80% from a bank (i.e. borrowing $800,000) with a 30-year fixed mortgage, assuming an interest rate is 4%, your total interest cost over the 30-year period is $574,956 or approximately 57% of the purchase price. And if the interest rate is 4.125%, your total interest cost would be $595,791 or approximately 60% of your total purchase price. The difference in interest cost is $20,835 over 30 years. Hence, a very small difference in the interest rate means a meaningful difference in interest costs for a mortgage.

One key factor determining your interest rate on your mortgage is your FICO score. FICO score not only determines interest rate on your mortgage loan, it is also a key determinant of the interest rate of a variety of other debt. In my view, it is absolutely crucial to keep building your credit score.

How to Track Your Credit Scores

To check your credit score you can request a free credit report from one of the three credit reporting agencies here. Federal law allows you to get one free credit report from each of the credit reporting agencies in each 12-month period. Once you receive the credit report, read over the details and review for accuracy. If you see errors, make sure you correct these by following through the steps outlined on this website.

A number of banks (i.e. Citi and Bank of America) also track for your credit scores if you hold credit cards with them. To see your credit score, make sure you credit card is linked to your online account. Below is my historical credit score for the past six months from Citi. I love having the convenience of seeing my credit report when I log in my bank account online.

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Source: Equifax, Citi Bank, Finance Cappuccino

One easy and comprehensive app I have been using is WalletHub. Once you create an account, it will track your credit score, and show how your score compares with those of other Americans, other residents in your state, other people your age, and other people in your income bracket. In addition, it will track the number of credit inquiries you had recently, the number of cards you have, etc. The app also tracks your mortgage loan balance, your credit card balances, etc.

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Source: WalletHub and Finance Cappuccino

In my next post, Credit Score Part 2 – Improving your FICO Score, I will share with you practical tips for improving your credit scores.

 

Dear readers, how often do you track your credit score? What tools/apps do you enjoy using?

Disclaimer: the writer of this post does not receive any financial compensation from the credit reporting agencies, Citi, Bank of America, or WalletHub.