Why a Great Credit Score Doesn’t Indicate Financial Health

Credit scores are like plastic surgery. They can make you look good, but good credit does not necessarily mean you’re financially healthy.

A lot of consumers don’t realize that until it’s too late. With plastic surgery, “too late” was when Michael Jackson’s surgeon told him, “Sorry, we can’t do another nose job because you don’t have a nose left.”

With credit scores, it’s when the boss says, “We’re laying you off,” and you immediately have trouble paying bills. Or you retire and suddenly realize that even with your good credit score, you’ll have to bag groceries part-time if you want to eat out more than once a month.

That’s not to say a good credit score is meaningless. It will help you get better interest rates on loans, which could save you tens of thousands of dollars. A high score also indicates you have at least a few admirable financial habits.

Good Credit but No Money

A Consumer Financial Health Study survey of more than 7,000 people found that 21% had good or excellent credit scores and looked like the kind of consumers who could handle a big loan, but struggled to pay their bills and save money. In many cases, that 21% had gamed the system to get their credit score up.

The not-so-dirty little secret is that people can artificially inflate their credit scores; some people enhance their scores on purpose. The end result is the financial equivalent of the old Billy Crystal line from his days on Saturday Night Live: “It is better to look good than to feel good.”

Paying Only the Minimum Payment

Sometimes feel-good scores are simply the byproduct of a flawed payment strategy. For example, 35% of your credit score comes from your payment history, but paying your bills on time is not the same as paying your bills. You can rack up FICO points simply by making minimum payments on time. That doesn’t put much of a dent in the principle, and carrying that load can be expensive.
Say you owe $9,000 on a credit card with an 18.9% interest rate, and you make a minimum payment of 2% of the balance every month. It would take more than eight years to pay it off and cost you $8,840 in blood-sucking interest.

So that $9,000 balance would cost you almost $9,000 more to pay off.  But it wouldn’t adversely affect your credit score as long as you make that little monthly transfusion on time.

Raising the Limits on Your Credit Cards

Another way to rig your credit score is with low credit utilization, which is your debt divided by your overall credit limit. It counts for 30% of your FICO score and ideally is no higher than 30% of your available credit.

Say you owe $3,000 on a card with a $5,000 limit. Your credit utilization is an unhealthy 60%. You can fix that by getting another credit card. If it has a $10,000 limit and you don’t use it for anything, your total credit limit is now $15,000 and your credit utilization is suddenly down to an impressive 20%.

The problem is that many consumers give into the temptation of using new credit as if it was newly discovered money. At first, it gets just occasional use, and you begin to improve your credit score. Before you know it, however, it gets even billing in your wallet alongside the old card and your monthly statement reflects more spending than you budgeted for two cards.

Credit Card Balance Transfers

Another trick to game the system is to transfer your balance to a new card with a zero introductory APR. The new rate expires after 12 months, and you get hammered on interest if you haven’t paid off the transferred money.

A good credit score also will qualify for a larger mortgage. Some consumers borrow the maximum they qualify for, but this eats up so much of their monthly budget, they can’t devote money to other necessities.

So don’t let a 700-plus credit score deceive you. It can mask problems that will eventually stick out like the nose that was no longer on Michael Jackson’s face. One way to find out is to answer a couple of questions.

Do You Have an Emergency Fund?

An emergency fund should include enough to cover three to six months of living expenses – housing, food, healthcare, insurance, utilities, and transportation. If not, stop focusing on your score and figure out how to save one up.

Do You Have a Retirement Plan?

Fidelity Investments recommends saving 15% of your pre-tax earnings every year from ages 25–67. The goal is to have 70% of your current income available for 30 years. If you haven’t started saving for retirement yet, it’s time to sit down review your income and expenses and figure out how to contribute regularly to an employer-sponsored account, such as a 401(k) or individual retirement account.

Most consumers aren’t close. An Economic Policy Institute survey found that nearly half of American families have no retirement savings.

It’s safe to assume that at least a few of those people have good credit scores.

That would require more effort than simply nipping and tucking your way to a good credit score, but you have to ask yourself one last question: Do I want to look good or do I want to feel good?

With the proper financial plan, you can do both.