It was 1989. As a young college kid, I was walking through the Chauncey Hill mall area at Purdue. Two pretty girls standing behind a folding table asked me if I wanted to sign up for a Visa card to get a free two-liter of Coke and a t-shirt.
I was all about it, and a couple of weeks later my new Bank One Visa card arrived at my dorm room. It had a $300 credit limit.
Looking back, I don’t recall credit cards being a part of our family life growing up. I had never talked about credit cards with my parents, and while I understood the basics that a credit card let me spend money I didn’t have, I had no idea how to manage such a thing. By the end of the first semester, the card was completely blown up. I owed $450 in charges and fees and had to eventually be bailed out by Dad, who was surely the toughest creditor of them all.
The silver lining of this silly story is, no one would give me credit again for about five years, so I ended up graduating college without any debt.
Make no mistake about it, however, in today’s data-driven world, credit is not something to be trifled with. Credit scores are now used in consideration for everything from job offers to insurance rates. Whether or not this is fair or right is irrelevant. It is occurring and will continue to be standard practice.
So, it's important to understand the credit file and credit score system. Fortunately, as credit data aggregation has improved, so has access to information about how the whole system works. The primary product of the credit file industry is called a score (FICO or Vantage), which is based on a model of each individual's credit behavior. The credit score used to be considered quite mysterious in nature, but now plenty of information about the model is available online.
After assisting families with financial planning for 25 years, when I look at the model used to create a credit score, I find it elegant. About two-thirds of the weighting in both models is pretty straight forward and is based on how much the individual owes, and how they have managed their debts in regard to making payments as scheduled.
While these two factors may be straightforward, they are also the areas some borrowers get in trouble. Bottom line here is, if you borrow too much, or use too much of your available credit and/or miss payments on your debts, about the only things that can improve your credit score are a change in behavior and a couple of years. This makes perfect sense, as none of us would want to lend money to someone who is stretched beyond their means and not making payments to others as agreed.
If you are managing these two areas of your financial life well, however, and still want to raise your credit score, this is when things get a little opaquer. The remaining third of both credit score models involves more obscure metrics which vary slightly by model.
Both score models put a strong weighting on the length of the borrower’s credit relationships. This also makes sense, as the longer, any relationship in life is in place, the higher quality the relationship is assumed to be.
After this factor, the remaining factors involve recent borrowing behavior. The logic here is that the more money a consumer borrows, the higher the risk of future default or bankruptcy. If debt is rising quickly, this justifiably raises red flags.
In my house, we now talk about credit cards, not as something evil, but as a dangerous tool needing to be managed. Both of my older daughters also applied for credit cards as college freshmen, not to get a free two-liter of pop, but so Dad could help them manage and monitor these financial products, knowing if they don’t borrow much, pay their debts on time and have seasoned credit files by the time they eventually need a mortgage, car loan or job offer, that process will ultimately go much more positive for them.
Opinions are solely the writer's and are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing involves risk, including loss of principal. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.
