What’s up real estate investors and wealth builders! In today’s blog we’re talking about credit score! Why is your credit score important? Because investing in real estate and other cash flowing assets is best done with credit so we don’t have to pay entirely in cash for what we invest in. One of the beautiful things about real estate and why it can build so much wealth so quickly is because we can leverage our money. We can control a $100,000 asset with only $25,000 and benefit from 100% of the cash flow, appreciation, and tax benefits.
A Tool, Not a Toy
The first thing we need to understand about credit is that it’s a tool, not a toy. Lenders don’t extend credit to borrowers so they can go out and overspend on new clothes and cars. Lenders give borrowers credit to make a return on the money they are lending out. You may be thinking, wait, don’t credit card companies want you to overspend? They may, but they’ll want to get paid eventually. They just want you to get trapped in the cycle of high interest rates on your credit card balance.
This is why we must use credit and especially credit cards responsibly. Secured credit on the other hand, or credit that has an asset backing it up such as a car or home loan. If you don’t pay, the lender will come and take the financed asset back faster than you can say “repossession”. Remember, credit and credit scores are a qualification criteria that is used to show how trustworthy you are with handling borrowed money.
So what makes up your credit score? There are 5 main factors that determine your credit score. These 5 factors will then produce a score between 300-850. The closer you are to 850 the more trustworthy you’re seen as by lenders.
On-time payments are one of the biggest factors in determining credit score. It seems fairly obvious, but the more on-time payments you make, the more it shows you are trustworthy with credit. This one is pretty straightforward. You pay when you say you are going to pay.
Credit utilization can be thought of like a glass of water. The size of the glass is how much total credit you have available to you. Say you have 3 credit cards and they all have a $10,000 limit on them and you have no other loans or lines of credit with your name on them. You have $30,000 in total credit available to you. Then, if you max out one card at $10,000 in a month, your utilization would be 33.3% for that month. You would have filled up that glass of water ⅓ of the way before dumping it out at the end of the month. You want to shoot for under 30% utilization and definitely under 50% utilization. The lower the better in most cases.
Just make sure to use a little credit to show you’re an active borrower. Remember that our utilization is a percentage of total credit available. So you can decrease your utilization just by increasing the size of your water glass! Call your credit card companies and other lenders and ask for a credit increase so your utilization percentage will show up lower each month. You can also make manual payments throughout the month. So when your utilization is reported to the credit bureaus, it will show up as lower than if you waited until the end of the month.
Average Age of Credit
Our average age of credit means adding up the “lifespan” of each credit line and dividing it by the amount of credit lines we have. If you have 2 credit cards, one is 10 years old and the other was just opened, you’d have an average age of credit of 5 years. This metric in the credit score algorithm shows that you’ve been able to handle credit over longer periods of time. You haven’t been opening credit accounts like gangbusters. The higher average age of your credit accounts the better.
Total Number of Credit Accounts
The more credit accounts the better for building credit! But wait, then our average age of credit will decrease if we open a bunch of accounts, right? Yes, this is where credit score starts to become a little esoteric. By doing one thing to help your credit, you may be simultaneously hurting it. But credit is all about time and usage in the long run. Open new accounts when you need them. Don’t worry, your score will quickly recover. This metric shows that you can use a bunch of different credit accounts and not just one.
Credit inquiries are when a new lender checks your credit history to see if you’re trustworthy and whether or not they want to lend to you. The more credit inquiries you have, the more it will bring down your score. But think about our “total number of credit accounts” metric. Don’t we need more accounts to increase our credit? Yep! So again, it takes hurting your credit in the short term to build your credit in the long term.
Be okay with this single digit dip that may occur for a credit inquiry and know that your score will recover quickly. When shopping for a mortgage, you’ll usually have a 45 day window to get your credit checked as many times as you want with the effect of just one check. This allows borrowers to compare rates and terms without lowering their score too much.
In mortgages in particular, there are credit tiers which determine how favorable of interest rate and terms you will get on your loan. This being said, you don’t need to have an 850 credit score to get the lowest rate. Usually the highest tier starts at 740 so if you have a credit score anywhere above that, you’ll be getting the same loan product as someone with a score above 800. However, if you’re under 740 , other tiers will start, in which lenders change less favorable rates and terms. You’ll usually need a minimum credit score of 600-620 to qualify for a mortgage.
If you need help with getting your credit score up to qualify for a mortgage or just get better terms, I highly suggest signing up for sites like Mint.com and Credit Karma. These sites will keep an eye on your credit score for you and make sure you’re building good credit in all 5 factors we talked about. Remember, credit takes time so don’t rush things! Build good credit habits and you’ll see that score rise in no time.