When it comes to our financial health, our credit score often tends to take center stage. The problem is, our credit score isn’t a gauge of how well we are doing financially, but many people believe it to be. If you have a poor credit score, more than likely, you’ve made a few mistakes, but having a high credit score doesn’t mean your finances are in order; it just means they aren’t a mess.
We’ve been led to believe that a high credit score is an ultimate goal when it comes to our finances. There is a whole industry that revolves around us knowing our credit score and raising it. Although the information is helpful to understand the general standing of our finances, it does not precisely measure what you might think. Paying someone to help fix or improve your credit score is already a sign that your mindset is in the wrong place.
So, what gives? Are our credit scores important or not? From my point of view, they are practically worthless.
What is a Credit Score?
At its most formal definition, a credit score is a three digit number between 300–850 that depicts a consumer’s creditworthiness or, in other words, how likely you are to pay your debts on time. A lower score means that banks and other financial institutions will see you as a risky loan. A good score will mean they view you as a less risky loan and more likely to pay back your debt in full. Typically, the higher your score, the more favorable your terms will be for any loan. Most notably, you are more likely to get a better interest rate on your loans.
How Is A Credit Score Determined?
There are a lot of factors that go into a credit score scoring system. The three major credit bureaus (Fico,Experian, and TransUnion) can use credit scoring models with factors that include but are not limited to:
- Your Payment History (on-time vs. late payments)
- Total Debt Owed vs. Total Credit (Credit Utilization)
- Average Length of Your Accounts
- Debt to Income Ratio
- Type of Credit
- New Credit
- Recent Credit Checks or Credit Inquiries
- Late Payments
There are more factors, and some are weighted more than others, but overall, these are generally what will appear on your credit report and what the three credit bureaus will determine your credit score range on.
What is a Credit Score Used For?
Essentially, your credit score or credit history indicates how safe it is to lend your money to banks or any money lender. The score is used to determine the terms and conditions, most notably the interest rate. Depending on your score, you might not be able to secure a loan at all.
Why Your Credit Score Doesn’t Matter
With how ingrained our credit score can be with our financial health, you might be wondering why it shouldn’t be important to you. The answer is simple; you don’t want to borrow money and take out loans in the first place. In most cases, taking on debt is not a good idea, no matter what the terms and interest rate are. Whether you have a low credit score or an excellent credit score, you’re still paying interest on that loan, which is money out the window.
This is true for both low and high credit scores. If you have a low credit score, the interest rate will be higher, and you’ll be paying much more in interest. This will make it even more difficult for you to gain any footing when getting your finances in order.
Having a high credit score doesn’t mean you should be taking out loans either. Remember, the credit score is simply showing your ability to pay the money back. Just because you could pay the money back doesn’t mean you should take a loan out in the first place. If you are constantly taking out loans and paying back interest, you could have a high credit score but low net worth since you’ll have so much debt and interest to pay back.
How to Avoid Loans
Now that you know that your credit score doesn’t matter, what should you do to avoid taking loans? Here are a few ideas:
Budget Your Money
One of the most significant fundamentals of personal finance is having a budget. Having a budget will allow you to understand where your money is being spent and how to allocate it better. When putting together a budget, make sure to cut out unnecessary expenses. Pump up that emergency fund and make sure you put funds away for all the necessities first.
Save for Big Purchases
Part of your previously mentioned budget should be saving money for big purchases. These funds are separate from your emergency fund. Saving for big purchases has a few benefits. The obvious being that it will allow you to make them without taking out the dreaded loans. However, it has a few other benefits as well.
By saving, it will give you enough time to think about the purchase and make sure that you really want it. Sometimes after a few weeks or months of saving, you realize the initial excitement of making the purchase is gone and that you can do without it.
Depending on the purchase, paying in full or even in cash can sometimes give a discount. This will typically come from not needing to pay the sales tax on certain purchases. In this case, not only are you saving by not paying interest on a loan but the overall cost of the purchase is reduced.
When Your Credit Score Does Matter
Ok, so there is always an exception to the rule, and there is a big one here. The one loan most of us simply cannot avoid is our mortgage. In this case, your credit score will be significant because, for a typical 30-year mortgage, even a slight difference in interest rates can make a big difference.
For example, on a 200k loan with an interest rate of 3.8%, you’d pay roughly 135.5k in interest alone over the entire thirty years! Drop the interest rate to 3.5%, and your interest payments drop to 123.3k, and at 3.2%, the interest drops all the way down to 111.3k. So for roughly half a percent, you’re looking at 24k in savings or almost 1k a year in just interest. The difference between a bad credit score and a good credit score can be tens of thousands of dollars in this case.
Before attempting to purchase a home, make sure that you’ll be able to get the best interest rate possible by improving your credit score. That doesn’t mean you have to have the best credit score, but having a high credit score doesn’t necessarily mean you are entirely ready for a home either. Most importantly, you’ll need to make sure you are financially stable and can handle all the costs that come with owning a home as well, not just a mortgage.
Most of the time, you really don’t need to care about what your credit score is. It’s merely a general indicator as to how well you’ve paid back debts and loans in the past, which is precisely what you should be trying to avoid! Loans create interest and debt, and if you want to succeed financially, you should avoid them at all costs. Our mortgage is a big exception, but credit score should not be used as your only indicator that you are ready for homeownership. Forget about your credit score. Pay your bills each month, make a budget, save and start building a better financial foundation!