Credit Scores are Overrated for Measuring Your Financial Health
Credit scores are the new black. Wherever you turn, it seems, someone is throwing a free credit score your way.
Many credit card issuers offer them with your monthly statement. Log-in to your bank account and you may be able to see your score, updated weekly. There are businesses that offer free credit scores, some building their business model on providing the free score, then selling you a range of products or selling your data to other businesses.
The offers for free credit scores come with the message that your credit score is of the upmost importance. The same message of how important your credit score is echoed in do The never-ending number of news articles about credit scores echo the message of the vital importance of your credit score.
These sources state or imply that good overall financial health relies on having a strong credit score.
It would not be shocking to see an article claim that a good credit score is tied to eternal salvation, "St. Peter says, 'No entrance to heaven with sub-600 FICO!'" OK. That would be shocking.
The fact is that your credit score is overrated when it comes to measuring your overall financial health.
What Your Credit Score Measures
Your credit score is important when you want to borrow money, to you and to lenders.
Lenders use your credit score to determine if you qualify for a loan or credit offer. They look at your score to assess whether you are likely to pay the debt responsibly. Lenders also use your score to determine what interest rate to charge you.
When you go to buy a car or home, you want to have strong credit, so you can get the best terms. Still, that doesn't make your credit score the key to good financial health.
Credit Scores are One Piece of the Puzzle
Building good financial health is like putting together a puzzle. There are a number of pieces you have to connect, and your credit score is just one piece.
Focusing on your credit score as a primary goal can lead you to making poor financial decisions. You could think that once you have excellent credit, you will end up in good financial health. That isn't true.
Your credit score doesn't indicate how you are doing in other areas. In fact, you could have an excellent credit score and not be doing the other things to build good financial health.
Spending, Building Savings, Borrowing, and Planning
One way of looking at your overall financial health is to examine how you are doing in four separate areas:
- Your spending
- Building Savings
- Borrowing and repaying debt. (Your credit score is part of #3.)
- Making financial plans, including plans to protect yourself from problems that can cause great financial harm.
Good Credit and Bad Financial Health
Credit scores are not an overall indicator of your financial health and they can en be misleading.It may seem counter-intuitive, but you can have an excellent credit score and be in poor financial health. There are a number of reasons your credit score could be great and your financial health not good, including:
- Your credit score gives no indication of your spending habits. You could be overspending, even to the point of living from paycheck to paycheck, and still have strong credit.
- Your credit score doesn't measure your assets. You can own nothing and have excellent credit.
- Your credit score doesn't measure your savings. You could have a big fat $0 in a bank account, retirement savings, or investment accounts and have excellent credit
- Your credit score doesn't weigh if you have taken steps to protect yourself from financial shocks from big to small. You can have excellent credit and have no emergency fund, lack the types of insurance that make sense for someone your age with your specific family needs, and without any long-term or short term financial planning in place.
In fact, you could have problems in all four areas listed above still have excellent credit.
Paying Cash and Credit Score
You build your credit score by opening credit accounts and paying on them as agreed. Paying cash for everything, because you don't want to owe anyone money, could harm your credit score or leave you without a credit score, even if you have strong income and assets. Cash payments for purchases aren't reported to the credit bureaus.
Take two people. One has excellent credit, but has built no savings, lives paycheck-to-paycheck, owns no assets and has no life or disability insurance.
The other person owns her house outright and paid it off so long ago that the mortgage no longer appears on her credit report. She also owns other property, earns an excellent income, paid cash for her car, and puts a large percentage of her earnings in savings each month.
Which would you rather be, the rich person who doesn't have good credit, or the person with good credit and no assets, savings, insurance or emergency fund? Pretty easy to answer that!
This illustrates why it is important to look at building good financial health with the big picture in mind.
When it is Smart to Harm Your Credit Score
Overemphasis on the importance of credit scores can cause you to avoid taking some action that harms your credit score even when it is helpful to your financial health.
- Getting out of heavy debt- If you are deep in debt, working to get out of debt is wise. Your best choice may be to file for bankruptcy or to use a debt settlement program. Both harm your credit. If credit were your biggest concern, neither bankruptcy or debt settlement would be acceptable, but it is far easier to rebuild your credit score than it is to pay off a lot of debt.
- Choosing to go delinquent on a bill - There can be times when it makes sense not to pay a bill on time, even to the point of going 30-days late when it harms your credit score. If you are having trouble paying for your basic needs, given a choice paying for the last ten days of the month or staying current on your mortgage, it makes sense not to pay a bill, and take the hit to your score.
- Carrying Debt that Harms Your credit Utilization - As your credit card debt balance rises, it uses up a larger percentage of your credit limit. This harms your score. Still, it can make sense to take on debt and harm your score. If you suffer a job loss, an unexpected medical emergency, you may have no better option than taking on debt.
Don't be a slave to your credit score. Look at your financial choices in a way that weighs the impact on your credit score, but also look at solutions that could harm your credit score.