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There are contingents of the internet that view a credit score while debt-free as a bad thing. The theory is that a credit score is a measure of your responsibility with debt and all debt is bad.
However, nothing is that black and white. There are legitimate, real reasons to maintain a credit score while debt-free. All debt isn’t necessarily bad either. I’m not saying debt is good either, but you have to weigh the pros & cons of debt in your specific situation.
It’s not always possible to save up enough to pay cash for a new car; your old car could die before you have enough saved. You could need to buy a handicap-accessible vehicle more urgently than your savings rate allows. The local housing market might make it impossible to wait until you have 20% saved.
I think it’s important to pay off debt, don’t get me wrong. I also think it’s important to approach your finances with realism and not make life harder than it needs to be.
What is a credit score?
Your credit score is a numerical measurement of how likely you are to pay back a loan you have taken out. Obviously, it’s not a perfect measure, but your history with debt can be a predictor of your future behavior.
Scores can range from 300 to 850. You can also have no credit score, which isn’t necessarily bad. A better credit score helps you qualify for loans at better interest rates. If your score is too low, you won’t even be able to get a loan.
What impacts your credit score?
Your past and current debt and payment behavior affect your credit score. There are many factors that go into your score calculation, but the exact formula isn’t readily available.
Your score is impacted by:
- Your payment history
- How much debt you currently have
- The percentage of available credit you’re using
- How long you’ve had your credit accounts
- Any collections, foreclosures, or bankruptcies
- The type of loan accounts you currently have
- How many times you’ve applied for credit recently (called hard inquiries)
Who reports your credit score?
There are three major credit reporting bureaus: Equifax, TransUnion, and Experian. Each will calculate a score for you and record the debts associated with your social security number as part of your credit report.
You can request a free credit report from each agency every 12 months. If you space them out, requesting one every 4 months, you’ll be able to consistently monitor your credit report. You should know that your credit report doesn’t provide a credit score. Instead, it’s just a list of the current debts known to be associated with you.
Request your free credit reports now (TIP: use your credit report to also calculate & track your net worth). You should never pay for a credit report since you can get a free report from each bureau every year. Beware of anyone who requests payment in exchange for your credit report.
What happens to your credit score while debt-free?
When you first start paying off debt, your credit score will likely go up. Using a smaller percentage of the available credit will improve your score initially. Paying off debt shows you are acting responsibly in the eyes of the credit bureaus.
When you have paid off all of your debt, there will no longer be debt-related information reported for your social security number. That means that, as time passes, your credit score will drop to zero, since there will be no activity at all.
If you follow Dave Ramsey, you know he is a huge proponent of a zero credit score, because that means you have no debt. Don’t get me wrong, no debt is great… but a zero credit score may not be.
Do you need a credit score while debt-free?
Yes, you probably need a credit score when you’re debt-free.
There are many life events that require a credit score, beyond getting more debt. Unless you’re independently wealthy, with millions in assets and cash, you are likely going to need a credit score again. The super-rich can afford to self-fund the equivalent of life insurance or pay higher rates for car insurance. Regular people can get by without a credit score, but it won’t be convenient, easy, or even practical to do so.
Renting a home
Landlords, especially corporations, often use applicants’ credit scores to determine who to rent to. Choosing a new tenant is risky for landlords, so they want to select the person who is most likely to continue to pay rent.
It’s possible to rent without a credit score, or with a poor score. However, in a competitive rental market, you’re more likely to lose out. It will also be more difficult to find a rental that meets your needs and has a landlord willing to work with you.
Establishing new utility services
Requesting new utility services is applying for credit, although not a loan. The water, gas, or electric company bills you at the end of the month for the services you used, rather than requiring a pre-payment. This isn’t a loan because no interest is charged and you’re expected to pay the full balance each month.
In some locations, the utility company will require a credit check to establish a new account. The company can decide whether to use the “regular” FICO credit score or a specialized utility-related credit score.
Having no credit score or a low credit score may mean you need to pay a deposit to set up the account. Some locales even charge the fee annually, so your utility costs increase due to your credit past.
You may also need someone to sign on the account for you, stating they will pay the bill if you default. Finding a person willing to take on that risk could prove difficult, depending on your history and work stability. It’s unfortunate, but money can have a big impact on personal relationships.
Certain high-level jobs in security or finance are likely to require at least a credit check. Your credit score and credit history may be considered indicators of your trustworthiness. Some professions also view certain debts as vulnerabilities to blackmail or bribes.
Obviously, very few people will ever be affected by this, but it is a consideration if your profession is somewhat related.
The largest loan most people take on is a mortgage. A higher credit score leads to a lower interest rate, which can save tens of thousands of dollars over the life of the loan.
Having no credit score makes it hard to get a mortgage, but Dave Ramsey loves to talk about the possibility of getting a mortgage using manual underwriting. I’m not even going to pretend to understand the process of manual underwriting, but it involves “lots and lots of documentation.”
Having obtained a mortgage and refinanced it, I know a traditional mortgage requires tons of documentation. Increasing the stress of the process doesn’t seem like the best option, but you do you.
My take? If you can get a mortgage with no credit score, great. Go for it.
But for most people, that’s not the most straightforward path to homeownership. Most people have a credit score of some sort and need it while debt-free.
It can take 10 years, or more, for derogatory marks to fall off your credit report. Unpaid taxes or unpaid student loans can actually show up on your credit report indefinitely, so there is a chance your score will never go away.
Even when the credit account has been paid in full, it takes up to 7 years for your credit report to no longer reflect those accounts. That means you will still have a credit score and it will impact your mortgage interest rate.
In some states, it’s legal for auto or homeowner/renter’s insurance companies to consider your credit score when issuing policies or pricing those plans. While they usually use a different insurance credit score, the score could incorporate elements of your financial history too. Individual insurance providers can determine the exact formula used to calculate this score.
California, Hawaii, Massachusetts & Michigan do not allow insurers to set rates based on credit scores. In other states, that score cannot be the only reason for a denial or rate increase. The insurance credit score is intended to estimate how likely you are to file an insurance claim, rather than the likelihood that you will not pay back a loan.
Technically, your credit score doesn’t directly impact your life insurance premiums or likelihood of approval. Your credit history, on the other hand, may affect these things so I wanted to include the information.
Each insurer will treat major credit factors differently, but the following can be considered:
- High credit card balances
- High percentage of credit card use
- Late payments
Property insurance includes auto insurance, renter’s insurance & homeowner’s insurance. If you’re looking for ways to save on these types of insurance, check out the free Frugal Year Challenge section for January, which focuses on property insurance. The course is free during 2021, but the price will go up in 2022.
The practical way to approach credit while debt free
After becoming debt-free, you should carefully work to maintain a good credit score until you become financially independent. You’re probably going to at least switch insurance providers one day, but you might need to move and rent or set up new utilities.
You don’t know what the future will bring and I’m a big believer in being prepared. Part of that preparation is having a decent credit score.
How to carefully keep a credit score while debt free
Maintaining a good credit score can be very simple, especially after you have paid off your debt AND established good financial habits.
- Learn to live within your means by creating and following a budget that spends less than you earn. Hopefully, you’ll learn this good habit during your debt payoff journey (because it will be incredibly helpful to that process).
- Keep at least one credit card account open. Your oldest account will be better for credit score purposes. Financially, it makes sense to choose the card with the best rewards, so choose based on your priorities.
- Use the credit card to auto-pay a monthly bill, like Netflix or your internet bill.
- Set up auto-pay for the credit card from your bank account, so you will never carry a balance or miss a payment.
This should help you maintain your credit score, even when you have no other debt. It’s also very easy and relatively cheap, so I don’t see any harm in following this plan.
The main consideration is your spending behavior. You have to be able to resist the temptation to overspend on the credit card. You have to.
Spending too much on that credit card will pull you right back into debt. After climbing out of that hole, you don’t want to fall back in. If you have any doubts about your ability to stick to your budget, don’t use a credit card for anything other than that single recurring payment.