Rich Girl Roundup: How Does Credit Work?

Katie: Welcome back, Rich Family, to the Rich Girl Roundup weekly segment of The Money with Katie Show. I'm your host, Katie Gatti Tassin. And every Monday, Henah and I are gonna engage in an interesting money discussion, debate. These episodes are gonna continue to hit your feeds on Mondays. So thank you so much for deciding to start your week with us. Here is a quick message from our sponsors before we get into it. Okay. Onto the roundup, Henah. Pulse check. How we doing?

Henah: We're good. I graduated from the big over-the-head earphones to these in-ear ones, so I feel like I've made it. I feel like Lizzie McGuire in The Lizzie McGuire Movie, where she's like “Sing to me, Paolo.” So there's a niche reference for you.

Katie: I was just gonna say, we're starting strong with our early 2000s lore.

Henah: Hey, we have a millennial audience and we are two millennials. So I could read this week's question if you'd like. 

Katie: Go for it. 

Henah: It's from Rachel B, and they wanted to know how credit works, whether it's okay to close old cards, and what should we know about credit utilization. So I think this is a really, really interesting topic. Mostly because I learned in the last couple years that credit scores weren't a thing really before 1989, which is not that long. Not that long ago at all.

Katie: No, that's not that long ago. When you said that, I was just imagining like a bunch of cavemen looking at their FICO scores. They’d be like, “Oh man, I can't get funding for my new cave painting.”

Henah: So I did look it up and credit reporting has been around for many centuries, but I don't think it was formalized until 1989. And the reason was because, interestingly enough, Fannie Mae and their equivalent, Freddie Mac, they wanted sort of an industry-wide way to report on people's credit. And so that's how FICO came up with the credit score. So for those who are unfamiliar, your scores today run from like 300 to 850, and 850 is the highest you can have, and it uses I think five factors to figure out what your credit score is.

Katie: Yeah, five or six.

Henah: Yeah, it's like payment history, the length of credit that you've had, the amounts you've owed, new credit, and then what kind of credit mix you have. So I guess like credit cards versus loans and mortgages, that kind of thing. Obviously informs your housing. It informs your transportation and what you get approved for. It informs your employment sometimes, like your financials. So I was reading that this is a fact per Consumer Finance that in the US, 26 million Americans, so just under like 10% I think, are considered to be “credit invisible” due to having a lack of credit history, and surprise, this issue mostly affects low-income individuals but also minority groups. And so I think it's a very nuanced topic to talk about, but to get into sort of the meat of like closing cards and credit utilization, Katie, do you wanna give maybe like the TL;DR on how that all works?

Katie: Yeah, I guess there was one other thing that you said that I want to circle back to. Ooh, circle back. 

Henah: Circle back to? Oh no. 

Katie: I'm sorry, I'm so sorry, everybody. That I wanna revisit which is this idea that, it's funny because your credit score is simultaneously one of the most impactful factors of your financial well-being, from the standpoint of it's gonna determine how much it costs for you to borrow money and the types of interest rates you can get. Which if you're talking about ginormous sums, like what you need to borrow money for a house or even a car in some cases, even just a few percentage points difference in the interest rate is a hugely impactful difference over time and the amount of money that you're gonna be spending to borrow money.

So it's kind of a paradox, 'cause it is simultaneously that important, but also something where, like you said, it's kind of made up, and it's a little bit of a black box 'cause they tell you what they're looking at, but sometimes the things that help or hurt your credit seem a little bit…

Henah: Counterintuitive.

Katie: Incongruous or counterintuitive. Yeah. 'Cause you'll like pay off debt and then your score goes down, and you're like “What the hell?” Or like in your mind you might think, “Oh, I'm not using this credit card, let me close it.” That's also gonna make your score go down at least temporarily. So I think that it's not intuitive what is gonna make your score better or worse, and simultaneously there's no secret formula. They are telling you in a very straightforward way, albeit an infuriating way, how your scores are determined. So I guess to start out, I almost wanna caution people to any services that purport to increase your score in exchange for money. Because if you read the fine print on a lot of that stuff, it's like, “Hey, actually, we have no guarantee this is gonna increase your score.” And you're like “Cool, thanks.” 

So anyway, they're intended to be and that you know why they are in existence is they're supposed to be a measure of confidence for a lender. So yeah, they're trying to find an industry standard way for people to determine how creditworthy an individual is. And if you've never had credit extended to you before, you've never taken a loan of any kind, you're just a big question mark to a lender. They don't know whether or not you're gonna…even if you've never done anything “wrong” or you've never made bad credit moves, they don't know that. So I think this question in particular that refers to closing a credit card is really referring to two things, both credit utilization, which is how much credit do you have available to you, and how much of it are you using? And then credit history or credit age, how old that credit is. So if you have an old card that you're no longer using and maybe it's the oldest card you have and you wanna close it 'cause you don't use it anymore, that's gonna ding your credit for those two reasons, 'cause it's actually gonna increase your credit utilization 'cause now you have less credit available to you, and it's gonna lower your credit age which kind of works against you, right? So typically it's not really recommended to close old cards you're not using. 

And I know that sometimes maybe those cards have annual fees and so the hack that I've heard work well for people is downgrading your cards with fees. So keeping the line of credit open but asking to switch to a card without an annual fee.

Henah: I've done that.

Katie: Yeah, perfect. How did that go?

Henah: So the reason I did it was because I had opened a Chase Sapphire Reserve hashtag #Chasequeen and I didn't wanna pay the annual fee for the Chase Preferred anymore. And so I just asked if I could downgrade to the free Chase Freedom or whatever, and it was super easy. I kept my credit line open but I wasn't on the hook for the annual fee anymore. So great tip.

Katie: Perfect. I'm so happy that we just had an on-air example that proved my point, and you weren't like, “Oh I tried that and it didn't work.” But yeah, I know that's not always possible. Like especially if you're talking about maybe a store card, you may get to the point where “Hey, you know what? This card is only a year old. I have six others and there's no alternative; I'm just gonna close it.” It's not the end of the world. 

And I think that the other thing is that when you're trying to build good credit, I hate to say there are no hacks to this, but there are kind of no hacks. It's just small, good decisions accruing over time. So like paying bills on time to utility companies, not having things go to collections if you can help it. Obviously medical debt is, I think there's some changes in the laws around medical debt going to collections. But paying your cards off on time, not missing payments, and that's where autopay can come in handy, where you're not even having to remember. And if you're having a hard time getting a credit card and you're trying to build credit, you can check out secured cards that you basically give the company, say, $300 and that is their collateral, where now you get a credit card in exchange with a $300 limit. They already have the $300 so they know you're not gonna default. But making those payments on time every month can help rebuild credit and you know, there are other credit repair tips.

Henah: That's a great point. I'd never even heard of that. And I think the other piece of this, which is if you've decided you're gonna close a card, is that you wanna be mindful of when you're doing it, because if you're planning for certain things in life, like you know you're gonna apply for a mortgage or pre-approval for a loan, whatever, and they see that your credit has been dinged recently, that's not gonna look great. So you wanna be really mindful of that. 

The other thing is, when you're talking about paying things off on time, you wanna make sure that there's no recurring payments or existing balances or leftover rewards that you haven't considered before you close that card. And obviously you're gonna wanna double check your credit reports and just make sure that it all your i’s are dotted and t's are crossed and the card was closed, they have it on file, there's no other fraudulent info out there, and you wanna check for that temporary credit hit because you just wanna kind of always keep a pulse on what that looks like.

But I love your point that there really is no hack, it's just kind of consistency and trying to be as on top of it as possible.

Katie: Yeah. And those secured cards can be a good alternative if you're having a hard time getting a traditional card. I believe, is it annualcreditreport.com? I think you can go and pull it for free every year, your official credit report. I don't think that originally the Social Security number was intended to have such a huge financial implication or be the skeleton key to your financial life. But it is, and so if your Social Security number has been stolen or misappropriated, you might see things on a credit report that help you catch fraud that someone has opened something using your name and likeness or using your identity. So I echo that for sure.

Henah: That happened to me once.

Katie: Oh, it did? Oh gosh.

Henah: I got an alert, like I got it from Amazon at first, being like “Thanks for opening this card” and I just kind of threw it out thinking it was spam or whatever, and then it showed up from Credit Karma being like “Hey, did you open this?” And I was like “Nope, no I didn't.” So I had to freeze my account, 'cause first of all these people who tried to steal from me, I don't even shop at Amazon. So that was the real giveaway. But you do wanna keep an eye on it 'cause people can get away with a lot without you noticing.

Katie: Yeah, and I love that you mentioned Credit Karma. That is also the site that I used to keep an eye on things. It is free and I do have my credit frozen. So what you just referenced where you go to all three credit bureaus, Trans, what is it? TransUnion, Experian and Equifax?

Henah: Yeah. Yeah.

Katie: Okay. Those are the three and you can freeze your credit for free with each one. That way if you are going to apply for a loan or you're going to take out a credit card, you can go back, unfreeze it temporarily to apply, and then refreeze it. But that way it's not kind of out there susceptible in the event that someone does steal that information from you. Freezing it is just kind of a secondary measure of protection that I did when I had my identity stolen, and I was concerned that someone was gonna use my identity to wreck my credit score and take out a bunch of loans. 

So I would say, conversely too, on your point about be wary of when you're gonna close if you're gonna take out a loan or something. I would say the opposite is also true, that if you're stressing about a slight ding on your credit score 'cause you're trying to pay off debt or you do decide to close a card and if you're not planning on taking out a loan anytime soon, it doesn't really matter. I mean obviously, you wanna maintain a good score for when you need it and it does take time to build up a good score, but those temporary dips and stuff are not really gonna long-term impact you. It's one of those things where it's, again, a paradox. It's extremely important, but it's only important at certain times. So as long as you're aware of it and timing those decisions appropriately, it's not something to lose sleep over. If month to month your score suddenly changes and it's like “Oh my god, why did it dip five points?” I mean that's kind of not really relevant.

Henah: So as usual, the answer is “It depends.” Good luck.

Katie: The most frustrating show in personal finance.

Henah: I think the other quick note I just wanted to talk about, 'cause you had talked about building good credit and getting a secured card and stuff. If you are someone who's younger, who's listening, or you have kids who are reaching their teenage years or early adult years, I think supporting them on building those good credit habits. You can listen to last week's episode about teaching your kids about how to save for their future. Having that guidance from your parents can be invaluable. And that was a big thing that my parents helped me with, was getting my credit score in a strong place before I had to deal with credit cards on my own.

Katie: Hashtag #blessed.

Henah: Hashtag #privilege.

Katie: And that's our show. Thanks for listening to this week's Rich Girl Roundup. We'll see you on Wednesday for some more riveting financial information.

Henah: Are you saying this wasn't riveting enough?