Imagine, you’re standing at the pearly gates (whatever those look like for you), and instead of the big guy cracking open a book that details all of your good deeds, he instead opens a shiny black box and out flies your credit score. He looks at it for a second. The 700 gleams in the air and you take a thankful breath. 700 is pretty good. Surely, that will get you through.
“Ah, pity,” he says.
“But wait!” You reply, “I have a score of 700! Isn’t that good?”
“No, my child. Do these pearly gates look free to you? They’re literally made out of pearls. We can’t take the risk on anyone who doesn’t have the highest credit score.”
Thankfully, that’s not the way things work. While your credit score does impact important aspects of your life, the highest credit score of 850 is not the perfect score. Aspiring to have a FICO credit score of 850 will actually cost you unnecessarily, and you could miss out on some great experiences for no gain at all.
So let’s break it down.
What is the perfect credit score?
Although there are multiple types of credit scores available, the one that is most commonly used by lenders is the FICO score. FICO is otherwise known as the Fair Isaac Corporation, which was an early pioneer in the credit scoring field. Your FICO score can range from
300 to 850.
To qualify for the lowest interest rates and the best deals, you only need a credit score between 720-760. There is no reason to bend over backward for that elusive 850 score.
But let’s back up for a moment. If you want to know why credit scores are important, what actually affects your score, and how to maintain a healthy one to help you reach your goals, keep reading.
Credit scores are access tools. People who are able to maintain a higher credit score are approved for car loans, home loans, and even things like short-term mattress loans, with lower interest rates.
Increasingly, car insurance companies are charging higher premiums to people with low credit scores. Landlords, cell phone providers, car rental agencies, and all sorts of other companies are using credit scores as a way to screen out risk.
Those with low scores will be required to pay higher deposits. Lately, even prospective employers are checking out your credit history.
Let’s start with what doesn’t affect your score, because there is a lot of misinformation out there. How much money you have, how much money you make, your investments, how many cars you own - none of those things impact your score.
|Things That Impact Your Score||Things That Don’t Impact Your Score|
|Late Payments||Your Financial Condition|
|Lack of Credit History||Bank Account Balances|
|How much you’re borrowing relative to your credit limit||Investments|
|Installment Loans||Assets (Cars, Houses)|
|Favorite Sports Player|
1. Zero new debt
Follow the red-phase strategy of paying down all your existing non-mortgage debt to zero, with-out missing any monthly deadlines along the way. Once you’ve gotten it to zero, keep it there!
2. Zero late payments
Pay on time. Every month. Every bill.
3. Review your credit report regularly
Errors on your credit report often impact your score. When you spot an error, the credit bureau is required by law to work with you to get it corrected. You are entitled by law to get a free copy of your credit report once a year, from each one of the three major credit bureaus. The place to request that - and the only place you should ever go for this - is AnnualCreditReport.com.
4. Minimize your credit utilization score
Divide your average balance by your credit limits across all of your credit cards. The lower this ratio, the higher your credit score.
Three ways to lower your utilization score are:
1. Add new credit cards (up to an upper limit of 5).
2. Request credit limit increases on your current credit cards.
3. Pay the full balance more frequently than monthly.
The important takeaway here is that once you reach a score of 760, you have access. Access to the best loans and rates and therefore, the ability to save more of your money for the ultimate goal: financial independence. Once you hit that credit score milestone, focus on your net worth and ultimately, your ability to live a life you choose without financial constraint.
Accumulating net worth is your single most important financial goal. That doesn’t mean you don’t want a high credit score, though. You do. But remember that increasing net worth is the goal, and your credit score is simply a tool to help you achieve it.
I’m generally not a fan of shopping. But when I find myself in need of visiting my favorite retail therapy office (also known as Target), I have several choices for payment options when I get to the register. After a fruitful and soul-soothing shopping session, I have come to the moment of truth where I must exchange money for my handbasket full of goodies.
Now, the question is, should I use cash, my debit card, or my credit card? And further, is any choice better than another?
Let’s break all of this down to get a better understanding of our options. (For the purposes of this post, we won’t be discussing the use of paper checks.)
I suspect some of you are thinking: “Who cares which payment method I choose, as long as I pay for it?”
That’s a fair question. In the big scheme of things, if you’re able to pay for what you want and need then these details of the “how” may be irrelevant to you. However, if you came here with the goal of being strategic and intentional with your finances, then how you pay matters. And it matters a lot.
Let’s start with cash. One of the best things about cash is that it’s easy to keep track of how much you have. You can see the bills and feel the weight of the coins in your hands. Though it can take a bit longer to complete your transaction if you choose to take time to count out exact change, it’s simple and straightforward.
Debit cards offer the same core benefit of cash in that they allow you the power to make purchases easily. But there are some added features to consider like the ability to shop online, digital expense tracking, ATM access and fraud protection from your bank or credit union. Most financial institutions have a mobile app and services that allow you to manage your money matters on the go.
Moving money around digitally can be easier than trying to withdraw and deposit cash in person. However, the switch to digital money management brings the added responsibility of ensuring that your account balance stays positive. If you can do that, you’re in a good position to manage a credit card.
Credit cards generally take the cake as the best payment option when you’re able to use them responsibly because of the rewards you can get. Now before you sprint out to apply for one, it’s important to consider some recommended skills and clearly define what it looks like to successfully manage credit. We are looking for a few specific parameters -- the ability to keep your expenses below your income, the organization to pay bills on time, and an understanding of how credit cards work. If you’re missing any of these things, you could accidentally get yourself into a sticky and painfully expensive situation.
A good challenge to give yourself before you dive into using credit cards is to get your debit card use under control. If you can handle not overdrafting your checking account for six consecutive months, that is a fantastic place to start. If you think overdrafts are expensive, you likely won’t enjoy paying unnecessary interest on your credit card purchases. Use this time period to experiment with different ways to organize your finances until you find the one that works for you.
Be patient and kind with yourself as you’re on that journey. When things go awry, consider seeing it as a useful data point for making adjustments to the way you’re handling your finances. Don’t let the discouragement keep you from trying again!
For those of you who have a handle on your cash flow and are able to consistently pay your bills on time, it could be a good time to add credit cards to your list of payment options. I mentioned earlier that there are some cool benefits you gain access to when you use a credit card.
Here are my favorite 7:
Support with disputes: If there are billing issues with a company or service provider you’ve paid, you can count on your card issuer to support you with getting it sorted out if you run into trouble. Issuers want to make sure you pay the credit card bill, so helping ensure that charges are correct is a high priority for them.
Cash Back: Depending on the card you choose, you can get cash back for using it. Some cards have a flat percentage of cash back for all purchases, others have rotating categories, and others have cash back on certain types of purchases. For example, a card may offer 1% cash back on fuel and 2% on groceries. The total amount of cash back typically shows up on your online account portal, and you can choose to use it to pay back the bill. Some issuers allow you to claim gift cards or other prizes with your cash back. Fun!
Credit Score Improvement: Demonstrating responsible credit card usage over the years will help boost your score by doing the things I mentioned earlier, like paying your credit card bill on time and making sure you don’t spend more than you can pay back. We’ll go into more detail in a bit.
Expense Tracking: It’s totally fine to use cash and manually track your expenses. If you’re into bullet journaling, this can actually be quite fun! If you prefer to have digital aids, your credit card will keep a log of expenses for you online.
Fraud Protection: Should anyone obtain your card information or physically take your card away from you, most cards have a zero-liability clause. This means if someone spends all of the credit you have available with the information they stole from you, you’re not responsible for a single cent of it. The rules for debit cards are not as generous, but there is still a level of protection. But if someone gets your cash, there’s nothing much anyone can do about that.
Extended Warranties: Many major issuers like VISA and MasterCard offer extended warranties if you use your credit card. It’s wise to look up the specific details of your agreement to know what information you’ll need should you need to use your warranty to request repairs or replacement. It’s a great option to have if you want the added protection without paying the extra cost of the extended store warranty.
Freedom from account holds: It’s common for hotels, gas stations, rental car companies, and some other businesses to place a ‘hold’ on the card you use. This means that a relatively large amount will be charged to your card temporarily, because the actual, final total won’t be known until later. If you use a debit card, the money is actually taken out of your account and the difference will be returned to your bank account a few business days later. Credit cards can give you instant access to your funds instead of waiting for the deposit to come back to your account.
While the concept of choosing a credit card is simple, the process itself can be overwhelming. There are countless cards out there to select. If you’re similar to me with being easily prone to decision fatigue this sounds like a walking nightmare. I promise you it doesn’t have to be that way!
Let’s look at some criteria to help you quickly narrow your search and save you a headache.
1. Unsolicited cards: If you’re tempted to apply for one of the cards that you get an offer for in the mail, I’m going to encourage you to pass it up. You can usually get better offers and terms if you do your own research. Just because they sent you the application doesn’t necessarily mean that they’ll approve you.
2. Cash Back: Cashback is an awesome benefit to using credit cards. One of the best reasons is because you can use the cash back to pay your credit card bill. Typically, you’ll have the option to send the cash to your account or redeem it for gift cards. Everyone can find a purpose for extra cash! If you’re currently working your way through the red phase, then cashback is going to be your best bet.
3. No/Low Annual Fee: Some cards require an annual fee to use them, but it’s not necessary to have a card like that. There is certainly a wide variety of no-fee cards in the marketplace to choose. If you can’t qualify for one without a fee, it’s not the end of the world. You may find things you like about those cards; some of them have more opportunities to earn cash back. Just do your best to find one with a low fee that you’re comfortable with. Remember, personal finances are personal so focus on doing what’s best for you. One place to look for a no-fee card is your favorite credit union if you belong to one. You can find more information about this in volume 9 of the I Am Net Worthy series.
4. High APR: The APR is the interest rate you’re charged on your purchases if you don’t pay off your full balance when the credit card bill comes. There are two reasons why you shouldn’t let a high APR deter you from getting a card when you’re first starting out. First, it will be higher than ideal when you’re first starting out because you need time to build a compelling credit profile. Second, you’re not getting a card with the intention to pay interest because of The Golden Rule (we will get to that shortly in the Utilization section). Granted, it shouldn’t be 99% but don’t be surprised if you see something in the high teens or twenties.
5. Secured Card: This is an easy and stress-free way to get going with credit cards. You pay a deposit equal to the amount of credit you have available. This way, if you have trouble along the way and can’t pay the bill for whatever reason, then you don’t have to worry about the card issuer sending you to collections. Instead, they can take the money out of the deposit you gave. Secured cards are a way to ensure that you don’t spend more than you have and you don’t get yourself in trouble.
With those 5 things in mind, you’re in good shape to look for a card that could be a good fit for you. Once you have it, responsible use is important and that brings us to one of the most important indicators of your credit health.
As I mentioned earlier, it’s important to understand how credit cards work if you’re going to use them effectively. Utilization measures how much you use of the credit you have available. Your credit utilization ratio is important because it’s one of the biggest influences on your score since it’s worth about one-third of the weight.
For example, if you have a credit card limit of $1,000 and you’ve spent $250 with the card, then your utilization is at 25%. If you were to have a balance of $500 on the card, then your utilization would be 50%. Ideally, you want to keep your utilization under 30% but the lower you can keep it, the better!
Simply put, the lower your utilization, the higher your credit score will be. This shows the credit bureaus that you can handle borrowing responsibly and helps you have a higher score. When you’re first starting out, you’re in the perfect position to set yourself up for success by limiting your spending and being diligent about keeping up with your payments. Following the Golden Rule is one way to keep your utilization low.
The key to responsible credit card use to is pay off the entire balance, every single month. Read that last sentence again. And maybe a third time. It’s that important, and that’s why it’s called the Golden Rule of safe credit card use. The purpose of a credit card isn’t to rack up debt and give yourself stress. It’s to give yourself a chance to have benefits and more secure shopping experiences.
Golden Rule Concept Check: Utilization is an important consideration when using credit cards.
If you can avoid swiping something you won’t be able to pay off completely when the bill comes, then you don’t have to worry about paying interest on the balance you carry forward. Additionally, your utilization will stay low because you’re making mindful purchases.
If you’ve been in the credit card game for a while, and you’re looking to reduce your utilization it requires intentional discipline and strategy to create the results you’re looking for. Here are three ways to go about that:
1. Focus on paying down your current credit card balances, without spending more.
2. If you’ve been handling things well, consider applying for another credit card to increase your total amount of credit available. Be sure that you’re diligent about not spending more, otherwise, you’ll stay right where you are.
3. Ask for credit limit increases on the card(s) you already have, so your total credit limit increases.
Phew, that was a lot of information. Let’s summarize.
So, should you use cash, debit, or credit?
Credit is your best bet if you’re able, debit is second best, and cash in third.
All of them are valid payment methods. Cash certainly gets the job done. Debit is the next best thing and using that well can prepare you for responsible credit card use. If you’re ready to improve your credit score, use the 5 criteria I gave you as a guideline to help you narrow down your options for selecting your first credit card. As you expand your financial prowess, you can get to a point where credit cards are your primary payment method without taking on debt.
And the Winner for Most Powerful Force in a Financial Drama Starring You is…
It's Compound Interest!
In the mid 1800's, a British colonist in rural Australia introduced exactly 24 European rabbits into the wild, so he could hunt them. Ten years later, the area was so overrun that two million rabbits per year could be shot or trapped without any noticeable decline in the population. This is a classic example of an immensely powerful mathematical effect called exponential growth.
The population of rabbits grows at a constant percentage rate with each generation - but as that same percentage is applied to a bigger and bigger population, the number of new rabbits each generation gets bigger and bigger too. Result?
The bigger the population gets, the faster it grows! That's the amazing power of the math behind exponential growth.
Hmmm.... is there any way to make the dollars in your accounts multiply like those bunnies? There is!
When the same math that unleashes exponential growth is applied in a financial situation, it's called "compound interest.” It’s the unequivocal superstar of the financial world and a wonderful tool to have on your side. Compound interest is the way your investments have the potential to bloom more significantly than without the help of time. The earlier you can put your money aside to take root, the longer it will have to grow and multiply. We’ll go more into the details about how this powerful force works in a bit, but know that taking advantage of it is truly a situation in life when a little time, a little effort, and a little money does go a long way.
When we think about the Net Worthy goal of achieving financial independence, this is the golden ticket. If you’ve ever heard the saying “make your money work for you”, this is what everyone is referring to. You want to get to a point where your money is making money for you and your nest egg continues to grow. We should care about compound interest for the simple reason that it helps your money grow faster, which is great!
Now that compound interest has stepped up to the podium to accept its “Most Powerful Force” award, it’s time to learn the juicy details about this superstar’s celebrity lifestyle.
Here are four “must know!” facts about this mathe-magical miracle:
1. You can’t get to financial independence without it.
To illustrate this conceptual idea of compound interest with worldly things, imagine that the bed of money you want to rest on when you’re financially independent is an air mattress.
In this case, compound interest acts the electric pump to fill the mattress so without it, you would be left with just a few centimeters of plastic between you and the floor. Sure, you won’t die by sleeping on the floor and there are certainly some of you who would prefer the firmness for back support.
But for the sake of this argument, let’s assume that you want to have a plump and comfy mattress to rest on during your mid-afternoon naps once you’re retired. Mathematically, you should do all you can to take advantage of compound interest and get yourself a piece of this pie.
2. It’s a Slow Starter.
Though we live in a microwave, hyper-speed society, compound interest does not work that way. It can be deceptive!
Conceptually, it’s a similar phenomenon as “the overnight success story”.
Think about popular athletes, performing artists, writers, or entrepreneurs who seem to have popped out of the woodwork and appear to have suddenly become a star in the span of a weekend. The underlying lie with all of these stories is that they happened overnight. That is usually quite far from the truth.
In fact, most things like this we see are very much crockpot experiences. There were countless hours, days, years, and even decades put into the moment when the scales tipped. The ingredients had to cook for a while before it was ready to be served and shared with everyone.
The same thing applies to you when you’re trying to wait patiently to see the fruits of your financial discipline. It may not seem like you’re doing well because things are growing so slowly at first. But it’s important that you don’t let your eyes get so focused on the present that you can’t zoom out and look at the future.
If you looked at a bunch of raw ingredients thrown into a crockpot, it neither looks nor tastes nearly as good as the finished product. And for the first several hours of cooking, it doesn’t look like anything is happening. That’s not true, it just feels that way. The big idea here is most good things take time and are well worth the wait.
As you’re taking advantage of compound interest in your savings and investments, it’s important to keep in mind the air mattress example we’re working with. When your mattress is empty and you just begin to fill it up, it’s difficult to see the progress at first. You know that you’re down on your knees pumping it up and trying to wait patiently. Judging the first few minutes of the experience can be quite discouraging But if you turn off the pump & stop trying to inflate your mattress before you see the results you’re looking for, then you can expect to basically be sleeping on the floor. Patience is the name of the game here. Easier said than done, I know.
3. This superstar is two-faced.
When I say that compound interest is two-faced, I mean that it can work for you in a powerful way by helping you achieve financial independence or against you by keeping you tied up in a stressful debt cycle. Consider thinking of compound interest as that schoolyard bully you had growing up. Before you get too triggered and close this browser window, take a breath and let me explain.
I had a bully in the 2nd grade named Jasmine. While I won’t go so far to put her in the same category as a fire-breathing dragon, it certainly felt that way sometimes. She would call me names, take toys from me, trip me during recess, and generally go out of her way to make sure I was as miserable as her. Elementary school was rough.
As I grew older and learned to open my heart so I could be more compassionate towards others, I realized that it wasn’t personal. She was bullying multiple people. I don’t know her life story but I could tell that Jasmine was having a rough go at things and wanted someone to suffer with her. That’s all.
(If you’ve never had a bully, watch Mean Girls and think about Regina George. She could get a doctorate in personally victimizing people.)
This is not to be mean-spirited to people who struggle to express difficult emotions in a healthy way. I want to highlight that people who exhibit bullying behavior have a dual-nature. While they can go around like a bulldozer leaving behind a trail of tears and broken hearts, they can also be extremely protective and helpful. They can have a keen eye for injustice and use their voices and strength to help those who can’t help themselves.
So when we put this in the context of carrying debt, compound interest acts like a bully. It’s not personal, anyone dealing with debt is eligible for the unfavorable treatment of trying to outrun the interest building up on your accounts with minimum payments. Whether it’s student loans, credit card debt, or otherwise, compound interest makes it challenging to get out of debt since you’re always being shaken down for money. It can feel like each time you check your email or mailbox, you’re going to catch verbal lashing and it’s genuinely stressful!
But, what if you had that bully on your side? Instead of always coming at you and holding you down from reaching your goals, they’d help you. Giving you a boost when you need it and taking you closer to your goals by doing the heavy lifting for you. Giving you the air you need to help you get that air mattresses filled up so you don’t have to do it on your own by filling it hopeful thinking. Wouldn’t that be wonderful?
When you have compound interest on your side, it’s about growing your money. Which is why it’s so important to focus on getting out of the red-phase by clearing your debt and other financial strongholds so you can release that bully from your life and turn that relationship around.
Big Hero 6 has a fantastic example of how compound interest can work for you or against you depending on the program you’ve set up. The adorable and inflatable robot in this movie is named Baymax and has been programmed not to cause harm to humans. This would be compound interest working for you; it’s there to help you get to your goals and live comfortably. In this scene, his programming is changed to set him to destroy the masked villain. When you find yourself in a situation where your debt has grown to become a burden, sometimes it feels like you have an angry robot chasing you with the mission to destroy you. Determined and relentless, it certainly feels personal even though it isn’t.
4. This amazing force is available to everyone.
The most beautiful thing about the power of compound interest is that it’s accessible to everyone. You don’t have to be famous, be born into a wealthy family, or be a financial expert to experience the boosting power of compound interest. The only requirement is that you understand it, and then have the patience to let it work its magic. Especially if you’re a young person like me, you have the power of time on your side to allow your money to grow and support you in your later days to have a nice and comfy time.
Before you borrow money for anything official—that is, other than borrowing from your mom or dad—there are four items you should review, a checklist of sorts. Always consider:
1. The Interest
2. The Lost Investment Opportunity
3. The Habit
4. The Depreciation
Review these four items as they relate to your hypothetical borrowing situation to gauge whether the decision is good or bad.
Consider these examples:
You want to buy a car that costs $12,000. You put down $2,000 and borrow the additional $10,000 at a 5% interest rate to be repaid over the next 6 years (60 months total). Why is this such a bad idea? Let’s go over the checklist:
1. The Interest
When that car is finally paid off, you didn't just pay $12,000. Over the subsequent 6 years you will pay hundreds of dollars more in interest.
2. The Lost Investment Opportunity
That money you paid into your loan/interest is money you cannot put into long-term investing.
3. The Habit
For the rest of your life, regardless of income, you will be tempted to buy things you can't afford. That is how the off ramp to financial independence is worn.
4. The Depreciation
You thought you only paid $12,000 for your car, but in reality you paid almost $13,000. After your final loan payment, the only thing you own is a (now used) car only worth $7,000.
You might as well get used to driving in reverse because at this point you are moving away from financial independence.
A Credit Card
Let's say you are more concerned about your everyday spending habits. If you are living paycheck-to-paycheck you might be a little short, so you think you can use a credit card or two, and only pay your monthly minimums.
Check that checklist:
1. The Interest
The real cost of credit cards is the interest. Whatever monthly balance left and not repaid within 30 days will accrue interest. Consider this:
Amount charged: $60 for a new jacket
Minimum payment: $10
Remaining balance due: $50
Amount charged: $40 for an on-sale pair of boots
Minimum payment: $10
Interest on remaining balance due Month 1: $12.5 ($50 x 25%)
Remaining balance due: $92.5 (remaining balance of $50 from month 1 + interest on remaining balance from month 1 + $40 amount charged month 2 - minimum payment of $10 for month 2)
Amount charged: $20 for dinner to celebrate a promotion
Minimum payment: $10
Interest on remaining balance due Month 2: $23.12 ($92.5 x 25%)
Remaining balance due: $105.62 (remaining balance of $92.5 from month 2 + interest on remaining balance from month 2 + $23.12 amount charged month 3 - minimum payment of $10 for month 2)
In three months, the total amount charged was $120. $30 was paid toward that debt. But rather than only owing $90, $105.62 is owed.
2. The Lost Investment Opportunity
This lost investment opportunity is the same as taking out a loan for your car. All of that unpaid balance money on your credit card is unavailable. It will slow you down as you make your transition to financial Independence.
3. The Habit
It can become detrimental if you fail to stop and do the math, calculate how much you are legitimately paying for something when you put it on a credit card.
4. The Depreciation
You will have nothing to show for the money you have put into your credit card. Zero, zilch, nothing.
Remember that credit card interest rates are unsecured. This means they are the highest legally allowable interest rates. Compounding interest works against you at a furious pace.
Let’s go over the checklist:
1. The Interest
Mortgage interest is a big deal, but it is secured. Moreover, it is compounded over the course of 30 years.
2. The Lost Investment Opportunity
Money that goes into your house can't be put into the stock market, but a house is a type of long-term investment strategy itself.
3. The Habit
Unlike the two other examples, it's really difficult to get into the habit of buying more houses than you can afford.
4. The Depreciation
The biggest difference is the compound interest which works for you and against you simultaneously. If your mortgage rate is 6% per year, and your house appreciates 6% per year, you break even. Why is this different? You and your dependents can live in that house—you can't live inside your stock portfolio.
Moreover, mortgage interest is tax-deductible so the actual after-tax impact on your net worth isn’t as great. The gains you make on your house when you ultimately resell is NOT TAXED AT ALL.
This is a different, good financial decision.
Overall, we don’t recommend borrowing—except for a house.
The lost investment opportunity, the interest, the bad financial habits cultivated will all compound into a financially unsound decision.
The ability to grow your net worth requires an entirely different skillset from that needed to acquire income. Like any life skill, mastering it requires commitment, time, and practice
Where to set up your checking and savings accounts? Credit unions and online banks are great choices.
Always use a credit card...but never use credit.
You'll make wiser long-term decisions, financial and otherwise, if you talk them over with the "future you." Make a habit of it.