By Susan Doktor
Paying with credit is a way of life in the US. According to the American Bankers Association, by year-end in 2020, there were some 365 million open credit card accounts in the US.
About 85% of new car purchases are made through auto loans. There are more than 3.6 million mortgages held in the US. The total number of personal loans reached about 177 million in 2022.
Most of us owe money to some bank or credit organization. But how many of us are paying too much for credit? And are you one of them? Would you like to spend less on credit and keep more money in your pocket? Understanding how lenders figure out how creditworthy you are—and, in turn, the interest rates they’ll offer you is the key to spending less when you borrow money.
Your Credit Score Can Save or Cost You Money
A high credit score is one of the most valuable assets you can own. The interest rates you’re offered by lenders are almost entirely dependent on how high your score is. Depending on the purchases you make using credit, maintaining an excellent credit profile can save you many thousands of dollars during your lifetime. Let’s say you buy a home worth $200,000 and make a down payment of $40,000. You take out the most popular kind of mortgage: a 30-year fixed loan. A 1% difference in your mortgage interest rate can either save you—or cost you—about $30,000 over the life of your loan. Double the size of your loan and you’ll more than double that difference in interest payments. Think about it. That savings might be enough to serve as a down payment on a second home. Perhaps a summer cottage in the mountains? And the more purchases you make with credit, the more you stand to save. Lots of folks don’t know their credit score or what’s in their credit report. But you can download free copies of your report from all three major credit bureaus: Equifax, Experian, and Transunion. That’s a great place to start if you want a clear picture of your credit position.
Factors That Influence Your Credit Score
As much as they might seem mysterious, credit scores aren’t assigned arbitrarily. So let’s take a look at what goes into figuring yours. Once you identify your “problem areas”, you can take steps to shore them up. Here’s what you should be looking for on your credit report:
- The number one factor that determines your credit score is your on-time payment history. It amounts to about 35% of your credit score. One sure way of improving your credit score is to make sure you are up-to-date with all of your credit account payments. Getting in the habit of making all of your payments on time—even if you only pay the minimum due—is an essential part of maintaining good credit. Sometimes, making late payments is just a matter of forgetting when they’re due. If you’re on the forgetful side, you may want to use your smartphone’s calendar feature to schedule alerts when each of your credit account bills is due. It’s that important.
- The amount you owe is the next considerable factor. Credit bureaus look at your credit utilization—the portion of credit you use versus the credit limits on your various accounts—when assigning you a credit score. Experts recommend keeping your credit utilization ratio below 30%. But here’s something you may not know. Keeping it at 0% can lower your score. Credit bureaus want to see evidence that you are using credit responsibly. So keep your credit utilization ratio low and continue to make your payments on time for the best results.
- Having an established credit history can raise your credit score. It takes time for your good credit behavior to influence your score. So the longer you practice good credit behavior, the more your credit score will increase.
- Credit bureaus get concerned when you open a lot of new accounts over a short period. That’s a signal that you may be living beyond your means. So let some time elapse each time you apply for a credit account before you apply for another. Avoid taking advantage of those “open a card and save 10%” offers. They’re not worth it. Having too many credit accounts can also hurt your credit score.
- Pay attention to your credit mix. Credit bureaus like to see borrowers use different types of credit such as mortgages, student loans, and credit cards. That’s a factor that can work in your favor if you have multiple types of debt.
- While it isn’t officially a factor used in figuring your credit score, your debt-to-income ratio (DTI) is something individual lenders look at when deciding whether to advance you credit. They want to be sure you’re not over-extended and will be able to make your payments on time. It’s not hard to figure out your DTI on your own. Add up your monthly credit responsibilities. Then divide that number by your gross monthly income. The resulting percentage is your DTI. Don’t care to do the math? Make it super-easy on yourself by using an online DTI calculator. Generally speaking, having a DTI ratio lower than 28% makes it easier to get credit when you need it.
Tips on Lowering Your Overall Debt
As we’ve learned, a little bit of debt can be cool. But having too much debt can get you in serious hot water. If your debt-to-income ratio isn’t ideal or you’re having trouble meeting your credit obligations, you should focus on developing a debt-reduction strategy. Your financial advisor might recommend these tactics:
- Create a monthly budget and stick to it. Reduce your discretionary spending by only paying for things you need, not things you want.
- Use the money you save to pay off high-interest credit debts first. If you carry several credit card balances, consider a debt consolidation loan that may lower your interest rate.
- Check the interest rates on your mortgage and auto loans. If it’s higher than the rate lenders are currently offering, consider refinancing.
- Look for ways to lower any student debt you’re carrying. Student loan refinancing might make sense, but you can also ask your employer for educational loan assistance. In today’s competitive job market, many companies are offering to help pay their employees’ student loans. There are even tax benefits for employers that do so. And if you’re not taking advantage of the student loan deduction you’re entitled to on your federal income taxes, be sure you take it next time you file.
The key to better financial health is becoming financially aware. How can you increase your fund of financial knowledge? Track your own finances monthly and prioritize spending on those things that will reduce your debt obligations. Read the financial press to keep up with trends that influence your economic position. Take advantage of credit card opportunities that offer 0% interest introductory offers. Follow the credit markets, too, and look for ways to lower your interest rate on any loan you’re paying off. Getting out of debt can be a complicated task. But with patience, you can do it.
Susan Doktor is a journalist, business strategist, and business owner. She covers a wide range of personal finance topics in her work, including real estate, mortgages, and credit repair. Her contribution comes to us courtesy of Money.com.