It has been said that a credit score is the key to everything from getting a mortgage to getting lower insurance rates. But author and radio talk show host Dave Ramsey tells The Early Show that credit scores are not nearly as important as you may believe.
He says Americans today are "worshipping at the altar of the FICO score," and that this attitude needs to change.
The FICO score is comprised of five elements:
- 35 percent of the score is based on your debt payment history
- 30 percent is how much debt you have
- 15 percent is the length of your credit history
- 10 percent is the type of credit/debt you have
- 10 percent is any new credit
Based on these five elements, Ramsey calls the FICO score an "I love debt score." In other words, he says you cannot have a high score unless you carry debt. And it's not worth enduring the burden of debt in order to have a high credit score. If you follow Ramsey's route to financial success, paying for everything in cash, you are guaranteed to have a low credit score. If you don't use credit continuously, your score will be low. But this won't prevent you from being a financial success.
Contrary to popular belief, you don't need a credit score to get a mortgage, Ramsey says. Granted, four out of five lenders now base your credit worthiness on your FICO score, but it's still possible to find lenders that do "manual underwriting." Basically, this means that the lender researches your financial history, instead of simply reading your credit reports. This will not negatively affect your interest rate or the terms of your loan.
Some insurers are also using FICO scores to determine rates on auto and homeowners insurance. Ramsey agrees that this is unfortunate. However, he believes that it's better to pay higher insurance rates than to carry other debt.
To help you better understand Ramsey's take on credit scores, he shares two letters that were sent to him at his radio show e-mail address, asking questions about credit scores.
- When I was 18, I acquired $21,000 in car loans and credit card debt. I was unable to pay these debts. Now that I am 22, I am starting to repair my credit. Should I pay these old debts or let them fall off my credit report?
Justin from Delaware
While Ramsey does not think people should focus on their credit scores, there's a difference between having a low credit score because of lack of credit, and a low credit score due to bad credit. Any credit report that's full of unpaid debt will hurt you.
So, Justin needs to "go back and clean up his mess from the past," Ramsey says. These unpaid debts will remain on his credit report for seven years, and if a collection agency pursues the debts, they can stay on even longer. Ramsey recommends getting rid of any active, current debt first; then turning to these old debts. Call the companies and work out a repayment plan. Get the agreed upon plan in writing before sending any money.
- My husband and I were discharged from Chapter 7 bankruptcy in June. My goal is to improve our credit so we can purchase a town home by the end of 2007 or early 2008. We currently have one car loan and $15,000 in student debt. What can we do to improve our credit?
Unfortunately, Susanna and her husband have just had a bomb dropped on their credit score, Ramsey says. Bankruptcy is a heavy black mark on anyone's credit report. It's the worst thing that can happen to a credit score, and it will be listed on the report for seven years. This couple will not even be able to qualify for a good mortgage with reasonable interest rates until June 2008.
Although that's probably disappointing news, it gives the couple three years to get back on solid financial ground. That's time to pay off the school loan, build an emergency fund and save for a down payment for that town house. If they can show that they've been paying rent on time over the next three years, and hold down a job for that same period, they will be able to apply for and obtain a mortgage. Once they are out of debt and own a home, they should not have to worry about their credit score again.