The FICO score is a numerical value lenders use to determine if a person is credit-worthy. It is compiled by Fair Isaac Corporation using a secret formula. Being a secret, the details of the formula are not known, but it is known that it includes things like how much debt you have compared to your credit limit, if you pay on time, how many different types of credit you have, if you have bankruptcies or forgiven debts, and how long you have had various credit lines.
Unfortunately, the FICO score is more of an indicator of your ability to stay in debt rather than a measure of your overall financial planning capabilities. Because the equation needs factors like the number of years you’ve held a credit card and your available credit limits to be non-zero numbers (zero divided by zero is undefined), a number will not be calculated unless you go into debt and stay in debt. The formula only uses relatively recent debt – accounts which were active up to about seven years ago – so if you don’t carry a credit card or a car loan for a period of time your credit score may vanish.
(Note, this site contains affiliate links. When you click on an affiliate link and buy something, The Small Investor will get a small commission for the referral. You are charged nothing extra for the purchase. This helps keep The Small Investor going and free. I don’t recommend any products I do not fully support. If you would like to help but don’t see anything you need, feel free to visit Amazon through this link
It is perfectly possible to go through life without a FICO score. The only type of debt anyone should take out is a home loan and there are many companies that do manual underwriting where they look at your salary and job history and determine how much credit they are willing to give you rather than simply typing your FICO score into a computer program. Credit card companies are lazy and therefore it is more difficult to get a credit card with a decent interest rate without a FICO score, but then again not having a credit card isn’t such a bad thing. Not having a car loan over your lifetime will likewise net you about a million dollars at retirement if you invest the money you save on interest, so I wouldn’t shed a tear about not being able to get financing at the dealers either.
The main trouble, however, is that employers and insurance companies are starting to use FICO score in making decisions. If you don’t have a FICO score, you might not get the best rate for insurance. I haven’t heard of it happening (you would think that an employer would worry more if you had bad credit rather than no FICO score), but I suppose a human resource office might likewise screen employees based on FICO score and exclude those who don’t have a score along with those with a bad score.
If you enjoy The Small Investor and want to support the cause, or you just want to learn how to become financially independent, please consider picking up a copy of my new book, FIREd by Fifty: How to Create the Cash Flow You Need to Retire Early
FIREd by Fifty: How to Create the Cash Flow You Need to Retire Early
Because of this, I reluctantly agree that, for some people, playing the games to maintain a FICO score might be a good idea. This is particularly true of young people who want to more easily qualify for home mortgages and who would not have the employment history to back them up when looking for a job. The amount you lose on insurance by not having a FICO score is surely much less than you would lose by maintaining a credit card. Even if you pay it off on time each month, studies have shown that people spend more when they use a credit card (or a debit card) than when they use cash. I also guarantee that if you use a credit card for long enough, eventually you will write a check wrong or misplace a bill for a few days and end up paying a late fee and interest. Don’t expect your credit card issuer to call and remind you of a pending payment.
The best goal is to quickly get to the point where you have enough in investments that you will never need a loan and don’t really care about paying a little more for insurance. I also hope others besides me are writing to their insurance companies and explaining to them that someone who is able to budget so as they don’t need to go into debt to buy things is probably a better insurance risk that someone who cannot. Still, many of these decisions are collective so they are difficult to change.
Have a burning investing question you’d like answered? Please send to [email protected] or leave in a comment.
Follow on Twitter to get news about new articles. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
