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Good Credit: How It Works & What They Never Tell You

Tuesday, January 12, 2010 , Posted by Daisy at 12:00 AM




Most people believe that if you always make your payments on time then you will have good credit.  This is not true.  The only thing that making your monthly payments on time does is ensure that your credit rating does not drop. Your credit is actually determined by more important factors. These factors are what I call long-run factors.

Think of it like this.  All things being the same, if you never ever miss a monthly payment, your credit score will reach to a certain level and stay there.   That level is called the long-run level or potential level.  (I use the term level, rating, and score interchangeably here.) The biggest determining factors of your long-run level is the amount of open debt you have and the length of time you've had them.

Otherwise known as revolving debt, open debt are things like credit cards, lines of credits, and department store cards.  They allow you a lot more flexibility than closed debt, such as loans and mortgages.  How much you owe on these debts will be the biggest factor in setting your long-run or potential credit score.

What credit agencies look at is how much you owe as a percentage of the total open credit limit.  Say you have two credit cards, one has a $2000 limit and another has an $8000 limit.  You have a total open limit of $10000.  If you own $1000 on each, you owe 20% of your total limit.

To understand and manage your long-run or potential level, think of the 30-80 rule of open credit.  If you owe anywhere between 1 and 30%, your potential level will increase to its highest level dependent on how long you have had these two credit cards.  The longer the period the higher your long-term level should be.

Now if you owe anywhere between 30-80% and you always make your payments on time, you should not see a change in your potential or long-run level.  If you increase the amount you owe to anywhere between 80 and 100% of your total limit, your credit score will go down to a lower potential level even if you always make your payments on time.

So the strategy here is to owe between 1 to 30% to maximize the potential or long-run level.   That means you have to use your credit cards.  Not owing anything at all does not hurt your credit but it also does not help your credit much.

That being said, you should also try to make your monthly payments so as to not hurt your credit in the short-run.  Being late on any payment for more than 1 month will decrease your score in the short-term.  Only by not being late again for a long enough period of time will your credit score eventually start going back up to the potential level (which I have explained is determined largely by the percentage you owe on your total credit limit and the length of time you've had these credits).

It's important to note that financial institutions will only report late payments to the credit agencies if you're over 30 days late.  That means it's okay to be late on your loan or mortgage payments as long as it's not over 30 days late.  Being over 30 days late will decrease your score even though there is no change in your potential level (given no change in the percentage bracket of open credit you owe).

So those are the two biggest things that affect your credit rating, which luckily you have control over.  The lesson here is to never be over 30 days late on any payments so that it doesn't negatively affect your credit score in the short-run, owe less than 30% of your total open credit to raise it to its highest potential, and never close your oldest credit facilities.  And try not to owe more than 80% if you can.  That means the next time that lady at the mall offers you a credit or department store card, you'll be doing yourself a favor by getting the card even if you don't plan to use it as it will only increase your total open credit limit and lower the percentage that you owe.

Now of course there are many other factors.  As I've mentioned, the longer you've had the credit card, loan, etc, the higher your potential credit score.  In the short-run though, there are other factors you should keep in mind.  One is that the more times someone (the bank, etc.) checks your credit history within the last 12 months, the lower your credit score.  This is because it is a sign to credit agencies that there's a problem.  Most people don't need multiple checks on their credit score in a short span of time unless there's a problem.  Each time anyone checks your credit, your credit score decreases, at least in the short-run.  So don't let anyone check your credit unless it's absolutely necessary.

Another sign of instability is the amount of times you've changed jobs or change address.  The more that happens and the agencies are aware of this, the more downward pressure there is on your score.  But luckily this is a short-term effect and the score can be re-raised eventually to its potential level.

Depending on how long one has had the credit accounts, if you have a spotless credit history but your open credit utilization is over 80%, you will have a potential score of about 650.






So now you know. Always paying your bills on time gives you a spotless credit history but it does not mean you have the highest credit score possible.

Well I hope you understand what I've explained.  Use it to your advantage and make sure everyone around you, your family, friends, and coworkers, are fully aware of the mechanics behind what determines their credit scores.  This is how it works in Canada and the US and this is likely how it works in every other country.

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If you're interested in reading more of this kind of stuff and personal financial matters then head over to my financial blog:  Financial Know-How.

  

Currently have 2 comments:

  1. johnp says:

    Nice article. I too always thought that the only thing I needed to do was pay on time. Now I know much more. Very informative. Thanks.

    So how do you know so much about this?

  1. Markenstein says:

    Glad you liked it.

    I'm a licensed financial planner and advisor with a good knowledge of both lending and investments. If you want to learn more about stuff like mortgages, mutual funds, retirement planning, things of that nature, then stay tuned.

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