Any Solid Foundation Starts with the Right Tools
Building a solid foundation of money smarts begins with finding the right tools. Your money toolbox needs a trusted advisor, a solid understanding of options, access to free benefits and of course, low loan rates, fewer fees and ways to save. What tools are ready in your money toolbox? Let's begin with the basics and start building money smarts with these 5 Money Tool Tips.
NORTHWEST SMART MONEY TOOL TIP:
Understanding, Improving and Maintaining Your Credit Score
First things first: What is a credit score? A credit score is a number that is used to predict risk for lenders. To create a credit score, analysts use information in credit reports, account histories or applications. Their goal is to accurately identify the consistency of your timely paid accounts as well as your delinquent accounts. The result of this analysis is a number that becomes your credit score.
Lenders use credit scores to help decide whether to issue accounts or loans, whether to change the credit limit on an existing account and what interest rate to charge on a new or existing loan, among other things. Insurance companies use insurance scores (which are based on credit information, but calculated somewhat differently) to help them decide whether to issue new auto or homeowner’s policies, what rate to charge for those policies and whether to renew existing policies. Some employers use consumer scores (which are also based on credit information) to help them make hiring decisions.
There are different types of scores; Fair, Isaac and Company, Inc. develops many of them. These are commonly referred to as “FICO scores.” It’s important to understand that your credit score is never a single number. It can vary, depending on which of the three major credit bureaus supplied the credit information used to calculate it, what kind of loan is being considered and what formula the individual lender uses to calculate it. For example, mortgage lenders typically request a “tri-merge” credit report, which includes credit information and scores from the three major credit bureaus—Equifax, Experian and Trans Union. Typically, the credit score from each of those bureaus will vary, so the lender will use the score that falls in the middle of the three when evaluating the loan.
Some things to keep in mind about your credit score:
- Your credit score can change frequently as information is updated in your credit reports.
- Lenders may use different credit scoring formulas that are customized for their loan products when calculating your score.
- Credit scores are calculated using the information in your credit report, even if that information is not correct.
- With a FICO score, the higher the number, the better the score.
There are five factors that go into a credit score, but they are not all weighted the same. Your payment history accounts for 35% of your score; amounts you owe relative to your income, 30%; length of credit history, 15%; new credit, 10%; and type of credit in use, 10%. The two most important factors that go into your credit score are your payment history—whether you’ve paid your bills on time—and the amounts you owe—how much debt you carry. Together, these categories make up about two-thirds of your credit score. That means if you want to improve your credit score, focus on paying your bills on time and paying down debt.
The first step in improving or maintaining your credit score is to understand what’s on there now. Each of the three major credit bureaus—Equifax, Experian and Trans Union—is separate, and they don’t share information with each other, so it’s a good idea to order a report from each one. Many apps and websites now offer free credit reports that you can access at any time. As you review your credit report, look for the following potential problems:
- Mistakes in personal information, including name (and variations), Social Security Numbers or addresses.
- Mistakes in account listings. Look for late payments that aren’t correct, outdated balances, duplicate listings of the same account, or other mistakes.
- Negative items including bankruptcies, judgments, liens, collection accounts or late payments.
- Inquiries from companies you don’t recognize. When a company reviews your credit report, it creates an inquiry. While they may be legitimate, inquiries into your report from companies you don’t know can sometimes indicate fraud.
The next step is to understand how long information can be reported. The first thing most people with bad credit want to know is, “How long can this information haunt me?” Under the federal Fair Credit Reporting Act, credit reporting agencies are not allowed to report any information that is too old, incomplete, or wrong. While positive or neutral information can be reported indefinitely, negative information can only be reported for a certain length of time, depending on the type of information. As a general rule, adverse information, including late payments, stays on your report for seven years. Adverse information is any data that may cause an unfavorable result for the consumer; for example, being turned down for credit, employment or insurance or being charged a higher rate than applied for in the case of credit or insurance.
An important part of reviewing your credit report is to dispute mistakes. You can do this by contacting the lender, court or collection agency (furnisher) reporting it and ask it to investigate, or by contacting the credit bureaus that have the information that is wrong and ask to verify the information. When the credit bureau or furnisher receives your dispute, it usually has thirty days to investigate and get back to you with the results. If you disputed the information through the credit bureau, it must provide you with a free credit report showing the updated information, if corrections were made. If information is removed because you challenged it with the credit bureau, the bureau cannot add it back to your credit report without first certifying with the furnisher that it is correct. It also must notify you in writing first that it will be adding it back to your report.
Something to note: Don’t assume that seeing old accounts listed on your report is a mistake. Many consumers who review their credit reports find old credit card accounts they haven’t used for years still listed as open accounts. You may think it’s a good idea to close those accounts and have them listed on your credit report as closed, but Fair Isaac Co. says that closing old accounts can’t help your FICO credit score, and can actually hurt it. Credit scores are based on information about how you’ve handled different types of credit over time. When you close out a lot of accounts, you may limit some of the information that could be helpful in predicting how you’ll pay in the future. You may also shorten the average length of your credit history. When it comes to credit scores, a longer credit history is better. Unless you have a specific reason for closing accounts—you’re getting divorced, for example, and want to close your joint accounts—you may want to leave your old accounts as they are.
You may find that your credit report contains information that is negative, but correct. If this is the case, you’ll want to work on improving your score. You won’t build better credit without positive credit references on your file. It’s not important to carry debt to build better credit, but it is important to maintain good credit accounts. Ideally, your credit report should show three or four active accounts (including credit cards, a car loan and/or a mortgage) paid on time each month. If you use credit cards to rebuild your credit, it’s to your advantage to pay the balance in full each month and avoid interest charges.
A credit counseling program can help you get back on track by negotiating a payment plan with reduced interest and/or fees with your creditors. Credit counseling can improve your credit rating if you work with a reliable agency because you’ll reduce your debt, and many creditors will remove late payments just prior to when you entered the counseling program if you stick with it. But! Beware of companies that prey on people with damaged credit ratings. Be very careful with offers such as: guaranteed credit cards, advance loans for an upfront fee or credit repair companies. According to the Federal Trade Commission, you should beware of companies that: want you to pay for credit repair services before any services are provided; do not tell you your legal rights and what you can do yourself for free; recommend that you not contact a credit bureau directly; suggest that you try to invent a “new” credit report by applying for an Employer Identification Number to use instead of your Social Security Number; or advise you to dispute all information in your credit report or take any action that seems illegal, such as creating a new credit identity.
If you’ve had credit problems in the past, you probably feel frustrated and worried that your damaged credit history will stay with you forever. In almost every case, however, there are strategies you can use to put your credit back on track. If you actively work on improving your credit, you will see results. It may not happen as quickly as you hope, but it all depends on your situation—and the time and effort are certainly worth it. Now that you know the basics of credit reports, how your scores are calculated and what to do with negative and incorrect information, it’s time to start improving your score!
NORTHWEST SMART MONEY TOOL TIP:
Expecting the Unexpected with an Emergency Savings Fund
An emergency fund is crucial to plan for when making financial and budgeting decisions. An emergency fund is usually a savings account which contains money specifically set aside for unexpected situations and expenses. This includes anything unaccounted for in your budget, such as medical expenses, home repairs, natural disasters, illnesses and job loss.
Without an emergency fund, unforeseen expenses–even small ones–can be a major setback. An emergency fund helps you avoid borrowing or using credit cards to cover these expenses, which is important for preventing debt, especially for those who already have debt.
So, how much do you need to save? Since everyone’s budget and financial situations are different, the “right” amount will be different for everyone. Generally, it’s a good idea to have between three and six months of living expenses saved. You can also think about emergencies you’ve experienced in the past and how much they have cost. Once you’ve decided on a goal amount, analyze your budget and create a savings plan–and don’t stop saving once you’ve hit your goal! Having more than the bare minimum in your emergency fund is never a bad idea.
The most important part of creating an emergency savings fund is to begin. Start today and make a plan so that your fund continues to grow. Putting your money in a savings account that earns dividends is a smart idea, as long as the account is easy to access. The last thing you want in an emergency is to have your money tied up and inaccessible.
Finally, remember that not every situation is an emergency. Along with a savings plan, you should decide what constitutes an emergency in your life and when you might need to use your emergency funds. You won’t need to use money from this account every time something unexpected arises, but in a true emergency, don’t be afraid to use it–that’s why you have it, after all!
NORTHWEST SMART MONEY TOOL TIP:
Becoming a First-Time Homeowner
Owning a home is one of the main ways that many Americans build wealth. Instead of renting each month, and having nothing to show for it, you can buy a home and build equity. Equity is the difference between what a home is worth and what is owed on it. There are two ways to create equity in your home. First, your home’s value may rise just because housing values in your area are rising. Secondly, as you pay off the loan, the difference between what the house is worth and what you owe gets larger.
Building equity can give you flexibility. You may be able to borrow against it, take it out as cash when you sell the home, or even leave the home to your heirs as an inheritance. In addition, a good portion of your home mortgage payment each month will go toward paying interest—especially in the early years. That interest is usually tax-deductible, which may mean more money in your pocket each month than if you were making a similar rent payment before.
Buying your first home can be intimidating, but don’t let that stop you! There are thousands of different loan programs designed to allow people to get a loan that fits their needs. Whether your challenge is saving money for a down payment, or a damaged credit rating, there are loans that can help. At the same time, you want to be financially prepared to own your own home, so you’ll be able to afford to keep it!
A general rule of thumb is that you can afford a home of about two to three times your annual income. So if you earn $50,000 a year, you can “afford” a home of about $100,000-$150,000. Be very careful about stretching yourself too thin and buying the most expensive house you can afford. Unexpected repairs, a spouse who decides to stay home to take care of children or aging parents, a layoff or any other financial challenge can make it difficult to keep up the house payments.
Lenders use something called “qualifying ratios” to decide how much house you can afford. There are two ratios used here: the housing ratio (or “front end” ratio) and the debt ratio (or “back end” ratio). Your housing ratio shows how much of your income will go toward making your house payment. Your debt ratio tells how much of your monthly income is going toward all your debts, including your housing payment.
When you buy a home, you’ll need money for the down payment and for closing costs. While it used to be that you had to have 20% of the price of a home for a down payment, those days are long gone. Now you can get loans for 90 to 100% of the home’s price! Those loans, however, may be more expensive, because you may have to pay Private Mortgage Insurance (PMI). PMI protects the lender, not you, if you can’t make your house payment and go into foreclosure. It can add anywhere from $25 to $150 or more to your monthly payment. It’s important to know that PMI is purchased by the lender, the cost may be influenced by your credit rating and it is not tax deductible.
If you’ve never obtained a mortgage, you might not know to factor closing costs into your home-buying budget. Closing costs, also called “settlement costs,” can usually account for about 4% of the loan amount, sometimes more. If you don’t have a lot of cash, it can be helpful to negotiate to have the seller pay part of your closing costs.
Buying a home comes with many costs that you need to account for, but keep in mind that your expenses don’t stop once you close on your home. Besides your monthly mortgage payments, all the repairs you previously left for your landlord to worry about now become yours. Plus, most people want to make changes to their new home to suit their tastes. Keep a cushion for all those expenses that may crop up.
The process for buying a home and all of the paperwork, expenses and steps that come along with it can seem daunting, but don’t let this dissuade you from becoming a homeowner. Owning a home is extremely rewarding and a smart investment for your financial future!
NORTHWEST SMART MONEY TOOL TIP:
Building Strong Financial Habits with Kids
Kids learn about money through many different avenues – parents, television, school, friends and more. If you were lucky, you may have had parents who talked openly about money with you, and perhaps even showed you how to earn and save money. Perhaps you learned in school how to balance a checkbook, or how interest can make your money grow. But chances are most of your financial education came from your experiences–both good and bad. How your parents or the adults you grew up with talked, acted and felt about money probably also rubbed off on you in different ways.
If you never had the opportunity to earn an allowance or get a job, you may have felt powerless and unable to get what you want, and that may have led to overspending when you finally did start earning money. If you want to help your children avoid the same problems you've experienced and grow up with good money habits, start talking with your kids about money, savings and how to build a strong financial foundation from a young age.
Be cautious about the messages you may be passing on to your children when you talk about money. Simply saying you can't afford something, for example, may not convey what you really need to teach your child; that you have choices, and that sometimes you must choose one thing over another. Talk about good values and making choices, rather than just dismissing something as too expensive. One easy way to help kids learn to save and understand making choices when it comes to money is to give kids their own spending power. An allowance can give your child the chance to learn about handling money while the stakes are still relatively small. How much, how often and how to earn the allowance is up to you, but an allowance will provide children the opportunity to learn from their successes and failures with the input of their parents.
Another way to start good habits early is by involving your kids in money-related activities like shopping, finding coupons and making budgets. Let them put what they’re learning into practice so that they can see how the lessons relate to everyday life. Challenge them with helping the family save money at the grocery store and offer a small reward for a successful trip. Let them see how you budget for family activities and what saving up for those looks like, then help them develop goals for their own savings, whether they’re saving up to buy something special, have money for a field trip or buy a friend’s birthday gift. Learning to set financial goals early will help them continue this practice into adulthood. Remember–creating a strong foundation and learning good habits early is the best way to set your children up for future financial success!
NORTHWEST SMART MONEY TOOL TIP:
Savvy Spending: How to Use Credit Cards Wisely
Credit cards can be a convenient way to make purchases, and they may seem like a foolproof way to buy the things you want. But beware—if you don’t have the tools you need to use credit wisely, you can easily damage your financial health and find yourself overwhelmed with credit card debt.
A credit card is not an invitation to spend money you don’t have. Let’s say you run up $500 on a credit card that charges 15% interest and requires a 2% minimum payment each month. Even if you never charge another item and pay the minimum on your account, it will take 6 1/2 years to repay your debt. When you have finally paid your debt, you will have paid nearly $300 in interest on your $500 purchase, making your final cost $800. You’ll pay even more if you make late payments or go over your credit limit.
Always pay on time, even if you just pay the minimum due. Late fees have skyrocketed; it's not uncommon to find a $30 late charge applied to your account for a payment that's only one day late. Issuers can also increase your interest rate if you’re late—without notifying you. Today, your credit report affects more than your ability to get a loan; it can also affect our ability to get a job or get into college. Many employers and colleges review credit reports to judge an applicant’s character. Late payments, over-the-limit charges, and heavy debt can affect you adversely. Learning good credit habits and how to fix mistakes now can help you avoid problems in the future.
Of course, there are many positives to having and using credit cards. You’re able to buy the things you need when you need them, many people feel more secure when they don’t have to carry cash, credit cards are more convenient than writing checks, you’ll have a record of your purchases and, if you use them to pay bills, it’s an easy way to consolidate your monthly expenses into one payment.
However, all those advantages do come with some disadvantages. Because of interest charges, you’ll often end up paying more for an item than you would have if you had bought it outright. There are also extra fees that come with some credit cards, and it can be easy to lose track of your monthly spending. This can mean you’re going over your credit limit, not making payments on time or accruing interest—or all three! Finally, having credit cards can make you less aware of the money you’re spending and increase impulse purchasing.
So, how do you get a credit card? How do lenders decide whether you’re approved, and how much your credit limit should be? They use the Three Cs: Character, Capital and Capacity. Lenders evaluate your character to see if they think you will repay the debt—have you used credit before; do you have a good credit report; does your history reflect on-time and reliable payments? Capital refers to what happens if you don’t repay your debt—do you have property or investments for collateral; do you have a savings account? And finally, capacity is whether you are capable of repaying—do you have a steady job; do you make a high enough salary; are you in debt; what other loan payments do you have?
You should also make sure you’re getting the right credit card to fit your needs and lifestyle. Different costs and fees can mean that you end up paying a lot more for purchases using one card over another. Be sure you research and compare:
- Penalties for missed payments
- Annual Percentage Rate (APR), also known as interest rate—higher interest rates mean you’ll be paying more in total for the purchases you make
- Annual fees
- Transaction fees—these usually apply when doing a balance transfer
- Grace period—how many days past your due date you have to make a payment before you’re charged a late fee
You’ll also want to make sure your credit card has benefits for you beyond just a reasonable APR. Find out what your credit limit will be, how widely the card you’re looking at is accepted and what services the credit card company offers. You may be able to get rewards, such as cash back, or services like travel insurance, roadside assistance and cash advances. Think about what perks would be most useful for your life and consider them when evaluating cards!
Once you are approved for a credit card, it is imperative to be a smart spender and a responsible credit holder. Only borrow what you can repay and avoid impulse buying—don’t let your credit limit make you lose sight of your budget. A good rule of thumb is to never borrow more than 15% of your yearly net income. Be sure you read and understand your credit contract, including the fine print. Pay what you owe promptly, and if you can’t make your payment, notify your creditor as soon as possible. Finally, be sure sites are secure if you’re using your credit card online, and never give out your credit card number. Report lost or stolen credit cards right away.
When you take ownership of a credit card, you are taking on a financial risk. Educate yourself so you can minimize the risk—do your research before you sign up for a credit card, then be sure you know all the features and fees and read your statement every month. Be diligent. Credit cards can be convenient, helpful and a great way to build credit history, but if you fail to practice proper credit card management, it could be very damaging to your personal financial situation.