Welcome to the 4th Smart Money Debate at ReadyForZero! To see the other side of this debate, read Brad’s post: Why I REFUSE to Play the Credit Score Game. And then let us know which argument was more convincing!
David Weliver is the founding editor of Money Under 30, a blog providing simple, honest financial advice for starting out. He says he stupidly amassed (and then completely paid off) $80,000 of consumer debt – all before his thirtieth birthday. He lives with his family in Portland, Maine.
Imagine you’re a gunsmith living in the year 1875. You’ve heard stories of amazing opportunities to supply cowboys with weaponry to defend their families against bandits, so you pack your bags, ride the Pacific Railroad and set up shop in a booming Colorado mining town.
Business is good, and soon you discover that you can’t afford to buy enough metal to keep up with customer demands. So what do you do? You go to a bank and ask for a small loan.
But there’s a problem. You’re new in town, and the banker doesn’t know you. In fact, he can’t find anyone in town who does know you. So he refuses to lend you money, until you can find somebody the banker does trust to vouch for you.
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Back in the day, that was credit. If somebody could say “Yeah I know Dave, and he pays his debts”, then you could borrow money. If not, or if you had a reputation for defaulting on loans, banks wouldn’t do business with you.
Fast forward 137 years. The world is bigger, faster, and a lot more sophisticated. In the modern U.S., we have a new way of determining how trustworthy somebody is (with money, or as I will point out, in other areas, too): it’s called a credit score.
This seemingly simple three digit number is based upon millions of data points about how people borrow and repay money. Through all that number crunching, a credit score tells somebody — in a matter of seconds – how likely you are to make good on a future obligation. And in those few seconds, people will decide whether to loan you money, what interest rate to offer, how much to charge you for insurance, whether to rent you an apartment and – sometimes – whether to offer you a job.
Are credit scores fair?
Well, if your score is above 800 (which is excellent by most accounts), you probably think so. But if your credit score is not-so-great because you got sick without insurance and couldn’t pay a bunch of medical bills, you probably disagree. And it’s true: a credit score can’t tell the difference between a good person who got slammed with medical bills and a bad person who routinely wracks up credit cards and never pays the bill.
For the bad guy, the bad credit score will make sure he doesn’t get another loan or become the bookkeeper at your local church. Unfortunately, however, the good person with bad credit will face the same scrutiny.
It’s not okay to ignore your credit
Brad, my opponent in this debate, is a friend of mine. We’ve been blogging alongside each other for several years and have similar stories about beating debt and turning our finances around. But Brad is going to argue that you can live life without caring about your credit score, and I disagree.
When you’re in a bunch of debt and scrambling just to get out, you don’t want to take on new credit, so it’s not that important to have a good credit score. And as you go through this experience, it’s commonplace to say “Look at all this trouble borrowing money caused, I’m never going to do this again. I don’t need debt and I don’t need my credit score.”
That’s noble: I totally understand shunning credit card balances and paying cash for cars and other items. I do that myself now. But what if you want to – someday – buy a new home? Unless you live in a very affordable area, most people can’t save the cash it takes to buy a house outright; they’ll need a mortgage.
Bad credit will cost you (tens of thousands)
If you have really bad credit, you may not be able to get a mortgage at all. But even if you can get approved, the lower your credit score, the higher APR you’ll have to pay. According to financial journalist Liz Weston, somebody with a credit score of 650 who gets a 30-year, $400,000 could pay over $70,000 more in interest that somebody with a 750 credit score. Over a lifetime of borrowing, she estimates the 100-point gap in scores could cost $201,712 in extra interest payments!
Your credit score is used for more than just lending
“But I already own my home,” you say. Or: “I’m going to rent for life!”
Fair enough. You’ll still want good credit.
That’s because – like it or not – the world uses credit scores to make decisions about more than just lending money. For example, the insurance industry uses credit scores to determine how much to charge you for auto insurance.
It’s also common for landlords to run credit checks on prospective tenants (even though rent payments aren’t usually included in credit scoring models).
Perhaps most alarmingly, it’s often legal for employers to check the credit of prospective employees, especially if your job will deal with sensitive information or give you access to company accounts. In fact, 60 percent of employers admit to checking the credit history of some job candidates, according to a study by the Society for Human Resources Management. So if you want to avoid an uncomfortable conversation with a prospective employer or a lost opportunity, it will pay to stay on top of your credit score.
You can ruin your credit in a few months, but it takes years to build good credit
If you’re digging out of debt and don’t plan on using credit for a long, long time, there’s no need to obsess over trying to improve your credit score. Instead, you should aim to keep it healthy by avoiding anything that will hurt your credit.
This is why: It can take just a month or two of missed payments on a single credit card to send your credit score tumbling, and negative items like collections and charge offs can legally stay on your report (and influence your score) for up to seven years, according to the Federal Trade Commission’s Fair Credit Reporting Act. Good credit is built (or rebuilt) slowly by month after month of timely payments, and it can take years to undo damage caused by just one or two mistakes.
Usually, you can maintain good credit just by doing the right thing
Hopefully I’ve given you some good reasons to care about your credit score. But if I’ve failed to persuade you, let me say this: if you do nothing to specifically build good credit, remember that you can usually maintain good credit simply by living responsibly.
Although it’s true that you will not build credit if you never borrow money, assuming you have a mortgage or a credit card that you use and pay off monthly, you can maintain a healthy credit score by doing what’s right:
- Paying your bills as agreed – on time, every time
- Only using a small and prudent amount of your available credit
- Avoiding applying for excessive credit
- Once a year, requesting a free credit report at annualcreditreport.com and disputing errors or fraud with the three credit bureaus
Yes, it’s unfortunate that we have to play by arbitrary rules created by Big Financial in order to maintain a good credit score. And, no, credit scoring isn’t always fair. That said, I think the benefits of playing by the rules and having good credit far outweigh the costs of rebelling and saying “I don’t need ya!” to the credit system.
To see the other side of this debate, read Brad’s post: Why I REFUSE to Play the Credit Score Game.
Image by jerseygal2009