How to Earn Your Financial Freedom

What is financial freedom? It’s having enough money to not worry about the important things in life. A big part of that is building your credit. And that means understanding concepts like the four kinds of credit and the five factors of your credit score. I know that already sounds daunting, but it’s really not. And when we’re done, we’ll show you specific ways to build your credit and get rid of your debts. So let’s get started.

Before we talk about what a credit score is, let’s talk about what CREDIT is. Sounds so obvious, doesn’t it? But it’s worth a refresher: Any time a bank, finance company, or business lends you money, and you agree to pay it back at a later date, you’re using credit. Almost always, you pay for the privilege of borrowing this money, either in the form of fees or interest — or both.

Of course, when it comes to money, nothing is simple. Credit is no different. There are four kinds of credit. You’re probably familiar with them all, even if you don’t recognize their names. So let’s quickly go over them.

First, there’s revolving credit. You’re given a credit limit, you can borrow money up to that limit, and each month, you can pay it off or carry it forward. Basically, it “revolves” — in exchange for paying interest, of course. Does this sound like your credit card? It is!

Next up are charge cards, which are NOT credit cards. These cards are just like credit cards, except you MUST pay them off every month. American Express is the best-known charge card, but there are many others.

Third is something called service credit. You essentially sign a contract for services that you promise to pay each month. You do this with your utilities, your cell phone, and your gym membership. Same with all those streaming services you have.

Lastly, there’s installment credit. In this category, a lender gives you a chunk of money up front, and you promise to pay it back with interest, but in fixed amounts over many months. Think about your auto loan or mortgage. They’re both examples of installment credit. They’re mostly reserved for your biggest purchases.

Now, you don’t need to memorize any of these, but it’s helpful to keep them in mind. Why? Because your credit score depends on who keeps track of the credit you have, and what you do with it. For instance, not all service credit counts toward your credit score. So let’s talk about what DOES go into your credit score.

There are five factors that comprise your credit score. Any one of these can raise or lower your score, depending on how you handle them. But here’s the thing: They’re not all created equal. Two of them are actually three times more important than the other three. If that sounds confusing, let me explain in plain English.

This is actually the biggest chunk of your credit score. It represents more than a third of your overall score. So what is “payment history”? Simple. It’s how often you pay your bills on time vs. how often you pay them late. If you’re wondering why payment history is such a big deal, think about it from a lender’s perspective. They use your credit score to decide if you’re reliable. If you are, they’ll charge you a lower interest rate. But if you can’t pay your bills on time, that means they don’t get their money back. So the worse your payment history, the higher your interest rate.

This is why bankruptcies, foreclosures, repossessions, charge-offs, collections, and tax liens can crater a credit score very fast. It’s also why it can take so long for your score to recover.

The next biggest chunk of your credit score is equally simple: How much debt do you have? In a minute, we’ll talk about tips for raising your credit score quickly, and it’ll involve this category. But first, we need to learn about something called a “credit utilization ratio.” This is a fancy term for a simple concept: How much of your available credit you use at any given time. To figure out your credit utilization ratio, just divide your total credit card balances by your total credit card limits. The resulting percentage is what lenders use to decide if you’re a good credit risk — and whether you get a good interest rate.

Most experts agree that you want your overall credit utilization to be lower than 30 percent. That tells lenders, “Hey, I can use credit responsibly without leaning too much on it.”

So as you can see, just two factors are responsible for nearly two-thirds of your credit score. Let that sink in for a moment. While everyone is bombarding you with life hacks for boosting your credit score, paying on time and lowering your credit utilization ratio are the quickest and easiest ways to do that. Now let’s look at the other factors that comprise your credit score. But never forget this number: 65 percent.

From here on, the percentages drop. At a measly 15 percent is your credit history. Specifically, this is the AGE of your credit history. Up till now, we’ve talked about paying bills on time and how much you owe. Now we’re talking about HOW LONG you’ve had your credit accounts. How many years have you been paying your mortgages? How many months have you had that credit card?

Generally speaking, the longer you’ve had your accounts, the more lenders like you. Why? Because it shows you have experience managing credit and debt. That means you might be savvier about handling a NEW line of credit. In a few minutes, we’ll talk briefly about how you can use this knowledge to boost your credit score.

Now we’re down to the smallest slices of your credit score. Think of new credit as the opposite of credit history. This category is mostly about HURTING your credit score, not helping it. With few exceptions — and we’ll talk about those in just a bit — you don’t want to add too much new credit. In other words, you don’t want to suddenly sign up for a half-dozen credit cards.

When lenders see that, they get nervous. Say you just got a new credit card, took out a new auto loan, and got another student loan. If I’m a lender, I’m thinking, “Hey, if this person wants to borrow MY money, how will I get paid back if they also owe all THESE people?” While it’s only a small piece of your credit score pie, it’s still worth keeping this in mind.

Last and almost least is type of credit. This is also called “credit mix.” Lenders not only like to know how long you’ve had your credit accounts, they want to see some diversity. Remember when we talked about the four different kinds of credit? Revolving credit, charge cards, service credit, and installment credit?

Well, everything else being equal, lenders want to see you deftly juggling all four. You’re less of a credit risk because you’ve seen it all. And if you have a long history of these accounts, you’ve done it all, too! Basically, what we’re trying to do here is put you in the head of a lender, so you can understand how they make their decisions to give out money. Once you grasp that, then it’s a short step to using that knowledge to raise your credit score. Let’s talk about that right now.

So one of the easiest ways to boost your credit score is to make sure nothing is dragging it down. You’d be surprised how many credit scores are suffering for reasons that have nothing to do with their owners. We’re talking about MISTAKES on your credit report. Mistakes you had nothing to do with.

First thing to know here: A credit report is NOT your credit score. It’s the raw data that determines your credit score. The Big Three credit bureaus each have a credit report on you. Those private companies are called Experian, Equifax, and TransUnion, and their entire business is collecting a whole heck of a lot of financial information about you.

With nearly 330 million adults in this country, times three credit bureaus, that’s a lot of credit reports — and a lot of room for error. The federal government estimates 5 percent of those reports have serious mistakes in them. That’s millions of mistakes.

Those mistakes can range from saying you defaulted on a loan when you didn’t, or you were late paying a bill that wasn’t even yours. Maybe someone has the same name as you, and a computer glitch assigned that person’s debt to you. Maybe it’s a clerical error or maybe it’s unexplainable, but it happened. Now what do you do?

You need to scour your credit reports for mistakes. Luckily, federal law makes that free and easy to do. Equifax, Experian and TransUnion are REQUIRED to give you a copy of your credit report weekly at no charge. And now, those Big Three credit bureaus have made it even easier to stay up to date by making credit reports available online on a weekly basis.

Best of all, you don’t have to go hunting them down. You go to one official website: annual credit report dot com. Checking frequently allows you to protest a mistake much quicker and get it removed. That’s right, you can force those Big Three credit bureaus to fix mistakes. Here’s how.

A federal law called the Fair Credit Reporting Act gives you the legal right to easily contest anything that you think is wrong on your credit report. Each credit bureau lets you dispute charges online, and they MUST investigate. To learn more about this process, you can contact us. But the important thing to remember here is: An accurate credit report can boost your credit score because mistakes are anchors that drag it down.

Before we talk about what you can do to boost your credit score, let’s talk about raising that number without lifting a finger. First, don’t apply for more credit cards. Every time you do that, it creates what’s known as a “hard pull” on your credit report. Lenders know that lots of hard pulls means you’re shopping around for more credit — which means you might not be able to afford a loan from them.

That lowers your credit score, albeit by only a few points. But some people load up on credit cards, and the cumulative effect isn’t good. And who needs all those cards, anyway? If you can’t keep track and miss a payment, then your score REALLY takes a hit.

At the same time, if you have credit cards you’re not using regularly, don’t close them out. Why? Because as long as they’re not costing you money in annual fees, their mere presence helps your credit utilization ratio. Remember, your credit utilization is about how much you’re spending against your credit limits. Those cards add to your limit, even though you never pull them out of your wallet. And if you’ve had these cards for a while, they also add to your credit age.

Let’s talk briefly about credit card protection plans and cash advances. Strictly speaking, neither of these things directly affect your credit score. But they’re bad news for so many people, and they indirectly can trash a credit score. Let me explain.

Credit card protection plans are a kind of insurance. They’re advertised as giving you a break on making payments if you suffer a “financial hardship.” You can pay up to $1 per $100 charged for this protection. But in our research, we’ve found this adds up to a lot of money per year for a benefit that’s not as easy to claim as you might think — there’s a lot of rules, fine print, and red tape. Meanwhile, your money is going to this plan instead of paying down your balances.

Likewise, cash advances aren’t part of your credit score, but they come with steep fees that can get you behind on ALL your bills. Just avoiding these two costs can spare you big bills and big headaches later on.

Some credit score myths arise from a simple truth that gets stretched into a ridiculous theory. Let’s look at two we hear a lot. First, your job title and income have no direct effect on your credit score. Those Big Three credit bureaus care only about how you pay for what you spend.

In fact, we’ve worked with plenty of six-figure-income Americans who are deeply in debt and have a TERRIBLE credit score. Your prestigious job and hefty paycheck just don’t matter when it comes to credit scores. So where did this myth come from? Probably the fact that a higher income makes it easier to make lifestyle changes that can pay down debts faster — and thereby boost your score.

Also, when you apply for credit, LENDERS will probably ask about your income — because that matters to them, sometimes as much as your credit score.

Likewise, getting married doesn’t help your credit score. There’s a myth that once you get married, you have a “joint” credit score, kind of like you might get a joint bank account or have both your names on a mortgage. Not true with credit scores. In fact, those joint items will appear on both of your credit reports, and they’ll affect both of your scores — for good or ill. But your credit report is yours and yours alone.

This myth probably got started because there are many studies that show married couples have higher credit scores than single people. The reasons are quite clear: You share a home and incomes, and if one spouse is a spendthrift, the other might be able to rein them in. But marriage itself doesn’t directly affect your credit score.

By now, you might be asking: Hey, how do I build my credit if I can’t get a credit card? Maybe I’ve never had one before, or maybe I made all the mistakes you just mentioned, and now no credit card company will give me one of their cards. Well, you’re in luck. There’s an interim step that’s safe and still builds you credit. They’re called secured credit cards.

A secured credit card is quite different than a traditional credit card, even though both build your credit. Unlike traditional credit cards, which aren’t secured with any collateral, a secured credit card requires a security deposit. That becomes the basis of your credit limit. Let’s say you deposit $500. Then your credit limit is $500. Other than that, you’ll make payments just like any other card. The deposit eliminates any risk to the card’s issuer, so it’s easy to get approved, even when you have bad credit.

If you have poor or no credit, the credit card company usually sets your credit limit for you. It’s typically low — ranging from $50 to $300 — but you can deposit more to receive a higher credit limit, too. For example, if you deposit $1,000, the card’s issuer will likely set your credit limit at $1,000.

With traditional major credit cards, you generally need fair-to-excellent credit to get approved. But you can get a secured card even if you have poor credit, or no credit history at all.

That’s because with your deposited amount, the credit card issuer doesn’t assume the same risk. If you default on the account, the issuer simply uses your deposit to pay back the balance.

Lest this sound too good to be true, a secure credit card typically has a higher interest rate than many non-secured cards. You can get around that, though, by paying off your balance each month. Another plus of paying it off every month is that you’re establishing a solid and positive payment history. Remember, that accounts for 35 percent of your credit score.

Now we finally get to the best part. Once you have a secured credit card, you can begin building a positive payment history and working towards a better credit score. Even though you’re essentially funding your own credit card, it counts toward your credit score. But remember, you need to pay on time, because being late will drag down your score even as you try to build it up.

Some credit cards might offer you the option of getting your deposit back after several months of making payments on time. They’ll immediately allow you to get a regular ol’ credit card right after. Regardless, it’s important to know that when you close a secured card for any reason, you get your deposit back.

If all of this sounds really complicated, and you need professional help getting out from under steep credit card balances, the easiest solution is also the most powerful: Consult a professional.