Question: What is the best tool you can use for judging your financial fitness?
You think it’s your credit score? Think again.
There’s been much written lately about how pitiful financial education has been for most grown-ups. Because of the lack of formal education, people learn on the job, from the internet, from their friends, and from their parents.
While a person can stockpile a lot of money savvy from these sources, sometimes what “everybody says” also turns out to be wrong. Or, at the very least, somewhat misleading.
Take your personal financial situation, for instance. How do you know when you’re doing okay, when you’re struggling, and when you really need to reach out for help?
Is it, a dip below a certain balance in the ‘ol savings account? Is it your credit score? Or is it when the creditors’ calls interrupt every waking minute of your life? (Hint, if you’ve gotten there, it’s definitely time to call in some backup).
For many people, credit score is the be-all and end-all financial metric that has them resting easy at night. As long as that’s okay, they’re doing things right.
That’s only true for your creditors. If you understand Canada’s credit system, you’ll know that the creditors are happy when you can keep up with your minimum payments.
Further to that, your credit score will stay pretty perky as long as you pay all your bills.
Here are some other things that affect your credit score:
- Extra points if you’re not borrowing all of your available credit (around a third of your available credit is where most companies like you)
- Extra points if you regularly use your revolving credit
If you’re using only a third of your available credit, though, that can be a ton of debt. For instance, if you have three credit cards, all with 20,000 limits, and you’re carrying a third of your available debt on all three you’re about 20,000 in debt, give or take just on your credit cards. At 19% interest that’s far from ideal.
Add to that you’re mortgage and two car payments, and you’re really up to your neck in debt.
All this adds up to one point: just because your creditors are happy, doesn’t mean you should be.
Don’t get me wrong, your credit score is definitely worth paying to, because it’s a tool to access financing for things you might not be able to buy with cash. It can also affect your job prospects, your ability to sign up for a cell phone plan, and tell a landlord whether or not she should rent to you. So definitely, keep your credit score in check. Just don’t use it to judge your financial health.
Instead, here’s where you should aim:
The one aspect of your personal finance that you should focus on:
Your net worth. That’s right: all that you have minus all that you owe. This little math equation will tell you what shape you’re in to handle the future. The banks use it to help calculate your suitability for a mortgage for a reason: if you liquidated all your assets (that is, sell off your house, your cars, your investments, and your stamp collection) and used the cash to pay your bills, where would you be?
Now, I’m not saying you need to end up in the black on this. If you’re a new homeowner, for example, you probably haven’t got a lot invested in your house yet. But it’s a sobering look at what you’re doing and where it’s leading you.
You can feel really wealthy if you lease a hot car, rent some swanky digs, and buy high-end duds on credit. And you may feel like you’re doing alright if you can keep up with all these payments. But if you figure your net worth, you’re likely in the hole. Not so hot. Here’s a simple example of a net worth calculation, also called a Personal Financial Statement:
Net worth: 82 000
Net worth can improve in one of two ways: buying more assets, or paying down debt.
Assets are things you buy with your money: they can be investments or houses or jewellery or art. When you apply for credit at a bank they’ll count cars as assets because they can be sold off for money, but for your own figures I would count them as an expense since they devalue over time.
Paying down debt might not mean too much for your credit score, but it sure improves your net worth.
So there you have it. Lighten up on the credit score, and focus on improving your net worth. It’ll pay off in the future.
The information contained on this blog post is the opinion of the individual author based on personal observation, research, and experience. Because each individual’s situation is different, the reader should consider working with a Financial Planner for their specific financial needs.