Credit health is a unique and critical area of personal finance. Some think of credit scoring as a very established form of financial health measurement. But it’s not actually that old, and it’s still evolving. The very first personal credit card was launched in 1958 by American Express. It wasn’t until the 1970s that credit scores began to emerge. By 1989, the FICO score was introduced, and it’s now the industry standard.
While there is some concern that many healthy or unhealthy financial indicators don't get picked up by the current credit-scoring methodology, lenders (and even some insurers and employers) rely heavily on them to make decisions. In fact, some employers are using credit checks during the hiring process to screen applicants. Some general insurance companies use credit scores to accept new customers, while others may use them to offer discounts.
For your clients, taking good care of their credit and regularly checking it could be about a lot more than getting a good rate, or being approved for a loan. Even retired clients who are unlikely to borrow funds need to keep vigilant with their credit.
So how can clients do that?
In recent years, several free credit score apps have popped up. These tools can be very helpful in giving your clients an idea of their scores. But they should be cautious using them. In order to be free to the user, these app makers sell ads to a range of lenders, and then recommend specific debt products to people accessing their free score. These products may or may not be suitable for your clients.
CBC News did a piece on credit scores that contains some helpful facts about how credit scores work, and the types of products that may be recommended regardless of how healthy the score is. It's also important to note that the score a user sees in these free apps isn’t the exact number that lenders see. Instead, it should be considered a gauge and enable your clients to keep track of their credit health.
Many banks now offer customers access to a version of their credit scores for free as well. In most cases, the bank’s free credit score tool is only available through online banking when a customer is logged in. Your clients should look at who is providing the score. Most banks are either using scores from TransUnion or Equifax. This is also not the score a lender uses to approve anyone for a loan, so clients shouldn’t focus on that number either.
Your clients could also choose to pay for their score and receive more detailed information from one of the credit bureaus directly. While they like won’t get any debt product offers this way, they still aren’t getting the exact score that a lender would see. Many of these credit bureaus encourage people to sign up for a monthly subscription to get regular access to credit scores. These subscriptions can be relatively expensive if you compare them to something like a streaming service that your client’s entire family may use every day.
So what does the lender see? Most Canadian lenders use the FICO score (previously called a Beacon score) in their underwriting process. But in the Great White North, individuals cannot actually access their own FICO score. In fact, some lenders will claim they can’t show customers the credit score details they can see when they pull their history, though most will tell your client the number if they ask. Further, more regulations are being introduced that will give people the right to their own personal information held by organizations, especially when that data affects how the individual is treated. So we may get access to the same score the lender can see. For now, help your clients understand that the number the lender sees could be different from the one they see when they check their score.
For financial professionals who don’t deal with lending products, there may be gaps in their credit knowledge. A mutual fund representative doesn’t necessarily need to know how credit works, since there is no credit score section on the KYC form. Having a credit blind spot can be dangerous not only because it reduces a financial professional's capacity to give holistic advice, but it can also be a danger to that professional’s own credit health. If you’ve never taken the time to invest in your own credit knowledge, now’s the time!
Here are a few tips to support your client’s credit health.
1. Watch for balances too close to the limit
Clients with revolving credit products, like credit cards and lines of credit, need to mind how much of their limit they're using. For example, if you have a client who has a credit card with a balance of $11,000 and a limit of $12,000, they are using nearly 92% of their available credit. This is likely to negatively affect their score. The best practice is to keep any revolving credit account below 35% of the limit. Even better, use cards every month and pay them off completely when the monthly bill arrives.
2. Be careful when cancelling cards
When your clients have a credit card they’ve been using since they enrolled in university, they could, at least temporarily, reduce their credit score if they close that account. In fact, closing any major credit card is likely to impact their score. That doesn’t mean they shouldn’t do it. They just need to take care when closing major credit cards. If they don’t want the features of the card anymore, calling the company and asking to transfer to a different card is a great idea. They need to make sure that cancelling a card doesn’t drastically increase their utilization percentage, which means their credit availability is reduced, and that can hurt their score.
Store cards, like the ones often used to get an extra special deal or finance a larger purchase like a sofa or snow blower, should be cancelled if your client isn’t going to use them regularly. And that won’t hurt their credit score.
3. Think carefully before increasing or reducing limits
People may mistakenly think that reducing their limits might be a good thing for their credit score. After all, cardholders can’t possibly rack up as much debt with lower limits. The issue is that they could be inadvertently increasing their credit utilization, which will reduce their score. For example, let’s say your client decided they are only going to keep one credit card open, they only want to be able to put up to $1,000 on their credit card every month, and they plan to always pay it off. But if the moment that their score is compiled they owe $900 out of a $1,000 limit, and it’s their only card, they’ll be using 90% of their available credit. This is bad for their credit score.
Creditors also make it way too easy to increase the limits on various cards and line of credit products. For years, they would just do it automatically, which could leave clients with way too much access to credit. These days, they are supposed to ask for a cardholder’s consent to increase the limit on credit cards; they are adding easy-to-accept requests in online banking and banking machines. But there are still some institutions doing automatic increases on unsecured lines of credit. Increasing limits too much may not affect your client’s score, but it could still affect their credit worthiness. A lender may become concerned that the client will suddenly use all of their credit, and they won’t be able to make payments on that much debt.
4. Avoid using credit to pay for spendable expenses
Using a credit card for any Spendable expenses is a bad idea. Clients are at risk of overspending on these types of expenses. Spendable expenses are items like groceries, coffee, clothing, eating out, and entertainment.
Spendable expenses meet at least one of the following criteria:
- High frequency
- High volatility
- High variability
- High enjoyability
The points aren’t worth it if your client is overspending. Most cards reward users with points values between $1 and $5 per hundred dollars spent. If your client earns $3 per $100 spent, and they have a $125 a year fee on their card, they have to spend over $4,167 on that card before they are actually earning any points. As soon as your client spends an extra $1 to $5 per hundred on spendable items, they’ve reduced the points impact to $0, or worse, they’ve spent past the points benefit.
Would you like to learn more about how the spendable and committed expense concept works? Check out our CacheFlo Suite demo, or join our next Cash Flow Planning Implementation Program!
Encourage your clients to check their scores at least once a year. It’s important to review all credit statements every month, even if they have automated payments. And don’t worry. When your client checks their own credit, it’s a soft check, and it will not impact their score. They could check it every day if they really wanted to.
Keep an eye on the evolving world of underwriting in the lending industry. We can’t know what the future holds, but one thing’s for sure: various industries will continue to look for ways to predict good and bad risks when dealing with others.
About CacheFlo
CacheFlo is a financial education company that builds eLearning and tools to help financial professionals and individuals make behaviour-based changes, which allow them to get more life from their money. We want to make it easier for people to predict the impact of their financial choices before they make them.
About the Certified Cash Flow Specialist (CCS) program
CCS professionals go through enhanced cash flow-based training to develop the skill set to deliver behaviour-based cash flow advice. They start the financial planning process with a cash flow plan to genuinely help their clients get more life from their money.
