Are you underestimating the importance of credit?

My top 5 areas of the financial plan that are often overlooked and undervalued include:

• Estate planning
• Emergency fund
• Insurance coverage
• Tax planning
• Credit

To be fair, none of these are very exciting to think about…especially if you are focused on more inspiring goals like investing, making a large purchase, giving, or paying down debt where you can feel the progress.

Let’s take a closer look at one of these areas…credit.

Credit is one of those threads that touches many parts of the financial plan.

Having good credit puts you in a position to take calculated risks (in the form of leverage) and do so at the lowest cost possible.

Fair or not, our financial system rewards those who can take on, and pay off credit.

We were all told at one time or another to “build your credit” but how much does it matter?

Let’s look at one example.

If we assume one home buyer has a credit score of 810 (excellent) and another has a credit score of fair (640), that might be the difference of a 6% versus a 7% interest rate on a 30-year mortgage.

That results in a monthly payment of $2,661 (principal & interest only) versus $2,398.

Over 30 years, that ends up being a total cost of the loan of $958,036 (principal & interest) versus $863,353. (principal & interest).

Same house but a difference of $263/month or ~$94k over the life of the loan.

Apply this concept to securing other debt (e.g., credit card, car purchase, investment property, business, etc.) and the cost of credit adds up in the form of less favorable lending terms.

Since your credit score is a key metric that will be used by lenders to determine how favorable (or not) the lending terms are, it’s important to understand what goes into your credit score.

Here are the top factors impacting your credit:

1. Payment history - This is the highest impact factor, accounting for ~35% of your credit score. Lenders assess payment history to gauge the likelihood of making on-time payments. Even a single payment that is more than thirty days late can lower your credit score. Setting up automatic on-time payments is an effective strategy to avoid late payments and other issues, helping you maintain a clean credit report and protect your credit score. While we often think of credit card payments here (and for good reason…to avoid high interest rate debt), don’t forget about your student loan payments, mortgage payments, car payments, and any other less obvious debt hanging out there such as the financing of a furniture purchase.
2. Credit utilization - This is the second highest impact factor, accounting for ~30% of the credit score. It reflects the percentage of your available credit that you're using, and keeping this ratio low is beneficial for maintaining a strong credit score. For example, if you have a $10,000 credit limit and are utilizing $5,000, on average, per month, your utilization rate is 50%. Ideally, you should aim to keep your credit utilization under 30% for good credit and 10% for excellent credit. Beyond keeping your expenses (utilization) low, one effective strategy to manage this is to request a credit limit increase from your lender. By raising your credit limit, you can reduce your utilization ratio, which can positively impact your credit score.
3. Age of credit history - As you may expect, a longer credit history generally benefits your credit score, as lenders prefer to see a track record of experience with credit. While this can disadvantage younger consumers who may have limited credit history, it reflects a lender's preference for established credit patterns. For instance, a lender would be more inclined to trust someone nearing retirement with a long credit history than a recent college graduate. To enhance your credit history over time, it's advisable to keep your accounts open and maintain them in good standing, thereby gradually building a more robust credit profile.
4. Total accounts - Though it might seem counterintuitive, having a diverse mix of credit accounts can positively impact your credit score. Lenders prefer to see a range of credit types, such as revolving accounts (like credit cards), installment accounts (such as auto loans or mortgages), and open accounts (including utility and cell phone bills). This variety demonstrates that different creditors have trusted you with credit, reflecting your ability to manage various financial responsibilities effectively. Balancing these different types of accounts can help build a stronger credit profile and enhance your overall creditworthiness, so long as you can effectively manage the various accounts and make on-time payments.
5. Hard inquiries - Fewer hard inquiries on your credit report generally lead to a better credit score. Hard inquiries occur when you apply for new credit and can remain on your report for up to two years, potentially impacting your score. To minimize their effect, it’s wise to avoid unnecessary hard inquiries. What is a hard inquiry? This is a result of applying for credit…think car loan application, opening a new credit card, getting a loan for a home purchase, etc. For those who are in the midst of a large purchase (such as buying a home or investment property) or securing other debt (such as a line of credit for a business), you’ll want to do everything you can to minimize hard inquiries during your application process. Lenders want to see stability when they are underwriting a loan.