Why a high credit score doesn’t mean you are winning financially

A good credit score in many ways has become the holy grail of American finance. Everyone wants to have a good credit score. Having a good credit score means you are a success, right? Well, actually it doesn’t. What a good credit score really means is just that you are very good at borrowing money and paying it back.

What is involved in calculating your credit score?

  • 35% is based on your payment history

Have you made all your payments on time and as required? Or do you have accounts with late payments? Obviously, if you are behind on your payments that makes you a risk to pay future loans. 

  • 30% is based on the percentage of credit in use.

This part of the rating is based on how much of your available credit you have used. So if you have a $1,000 outstanding balance with only $2,000 total credit available from all sources, that’s actually worse than if you owed $10,000 but had $50,000 worth of available credit.

  • 15% is based on length of credit history

If you have accounts that have been open for many years, that is considered better than an account that was more recently opened.

  • 10% is based on how recently you have obtained new credit

If you have recently added new credit, this is seen as a negative since it might indicate you are overextended.

  • 10% is based on the mix of types of credit you have.

The score takes into account how much of your credit is revolving vs. installment based.

So notice what was missing.

Let’s consider some of the things that have no bearing on your credit score.

What is your income? Do you make $20,000 a year or $2,000,000?

How about your employment history? Have you been with the same company for 20 years? Or have you had 12 jobs in the last 5 years?

How about savings? Do you have several thousand dollars saved away?

Also certain kinds of debt are not reported on your credit history. Medical debts are not reported because of HIPAA laws . That loan you got from your parents? Not reported. Also loans from small local companies may not be reported unless the company has a relationship with the credit bureaus.

Not much to do with financial success

The truth is, the credit score really has very little to do with measuring whether or not you are financially successful. There’s no indication of your income or work history. No consideration of how much you have saved. And for that matter it’s really not a good indication of how much debt you have since you could conceivably have hundreds of thousands of dollars of debts that are not included in your FICO calculation, if they happen to be debts that are not reported to the credit agencies.

All a good credit score really means is that you have been faithful at borrowing from certain types of accounts and have done a good job making payments on time.

To me the bottom line is I could give you a million dollars today and it wouldn’t change your credit score one point. But if you had an extra million dollars would you be a better bet to pay your mortgage on time? Of course you would. The credit score is just not a true indicator of financial success.

My big pet peeve

 Which brings us to what really annoys me with credit scores. The problem is a good credit score has become this gold standard of financial responsibility. So much so that it gets used as a measuring stick for totally unrelated things. Your credit score can affect your insurance rates. Some employers will check your credit report when considering hiring you. Some utilities check your credit when you sign up for new services. Some landlords use a credit score as a determining factor when deciding whether to allow you to rent from them.

I have a major objection to taking a number that we’ve already seen is not really that good an indicator of the strength of your finances and using it as a determining factor in so many things.

So what is the alternative

If you decide that you do not want to play the borrow money rat race anymore, then a few months after you pay off your final debt your credit score will go to 0. If you are dealing with someone who understands credit scores properly, a 0 credit score should be handled much differently than a low credit score. Unfortunately, some companies just plug-in numbers with no consideration of any other factors. If you run into one of these companies, then you may just have to take your business elsewhere.

Can you get a home mortgage if you have a 0 credit score? Yes, you can. You just need to find a bank that is wiling to do manual underwriting. Many still do, particularly smaller regional banks and credit unions. Manual underwriting is basically just what the banker would have done 50 years ago if your grandparents had sought out a loan. Instead of just plugging a number into a formula, manual underwriting means that the banker will look at your employment situation, your finances, and make a determination if you are a good risk for the loan or not.

Same thing is true for renting. You may have to look a little more, but find someone who is willing to make an intelligent evaluation as opposed to going by the number.

For things like cell phones or insurance, you may be forced into leaving a bigger deposit or paying a slightly higher rate. But if you don’t have a bunch of loan and credit payments taking a bite out of your wallet, you will be in a position to afford making a larger deposit.

So what’s the bottom line

It’s unfortunate that our obsession with credit scores can leave people facing this conundrum. If I am very responsible and pay off all my debts, I potentially leave myself with the possibility of getting lumped in with those who don’t pay their bills well. Yet on the other hand the only way I can maintain a good credit score is by continuing to put myself in debt and then paying it off.

Ultimately, you must decide if you are going to chase after the holy grail of an 800 credit score or not. For me I’d much rather have the peace that comes from being debt free and living with whatever inconveniences a 0 credit score may cause.

Photo credit: 401K

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