Your Credit Score Explained

You might want to open a new credit card to receive a bonus for signing up, or reduce the number of credit cards in your wallet with an annual fee, but opening and closing credit card accounts can impact your credit score. The question is, just how much does it impact your credit score, and is it worth sweating?

Most banks and credit lenders use FICO, which is the most common type of credit score. FICO scores range from 300 to 850. The score is based on the credit files of the three national bureaus – Experian, Equifax and TransUnion – with the following breakdown:

  • Payment history 35%
  • Amounts owed 30%
  • Length of credit history 15%
  • New credit 10%
  • Types of credit used 10%

Payment history (35%)

This makes up the largest component of your score, which makes sense because your payment history demonstrates your ability to make payments on time. Even if you cancel a credit card, the payment history on that card will stay on your credit report for 10 years after the day it was closed. Positive credit data, created by otherwise using the card for purchases and making payments, stays on your account indefinitely.

If you’re just making minimum payments, it still counts as paying your credit card as contractually agreed, so that alone doesn’t hurt your credit score. If you find yourself forgetting to make payments, though, consider adding calendar reminders.

Amounts owed (30%)

Also known as debt burden, this category measures how much you’ve charged in relation to your overall available credit. This can be called your credit utilization rate, and it’s best to keep it lower than 20% of overall limit. Credit bureaus use three other metrics in addition to the credit utilization rate, including the number of accounts with balances, the amount owed across different types of accounts and the amount paid down on installment loans.

Canceling a credit card that has a high limit can hurt your credit score because it impacts your utilization rate. One way to remedy this is to ask for a higher credit limit to make up for the overall decrease on a remaining credit card. Be careful not to close credit cards before a big purchase like a home or a car, because you want your credit score to be as high as possible to get the most favorable interest rate and terms available.

Having a credit utilization rate of over 30% can hurt your credit score. If you’re just making minimum required payments, it’s likely that you’re also using more than 30% of your available credit, and the balance keeps increasing due to interest building up rather than being paid down.

Length of history (15%)

As your credit history ages, it can have a positive impact on your credit score. The two metrics tracked include average age of accounts and the age of your oldest account. It can be said that the oldest credit cards are the best credit cards for your credit score. This also takes into account how long other types of credit (auto, student, mortgage, etc.) have been established.

Closing a credit card may reduce the average age of accounts. Opening a new credit card will also reduce your average age of accounts, which hurts your score. The ideal age of credit card accounts is eight years or older.

New credit (10%)

Recent searches (also called hard inquiries) into your credit history, such as when you apply for a new credit card, can hurt your credit score. Hard inquiries also occur when a lender is evaluating whether to extend credit to you for an auto loan, student loan, business loan, personal loan or mortgage. Keep these inquiries to a minimum.

A soft inquiry, which occurs when opening a new brokerage account or part of a new employer’s background check, does not impact your credit score.

Types of credit used (10%)

This includes installment (auto loan), revolving (credit card), consumer finance (high interest rate, short-term loans like from Payday loans) and mortgages. Having a mix of different types of credit helps your score. This is based on the number and mix of accounts. If a loan is paid off recently, it will eventually be removed from your history.

The creators of the FICO score have an online credit score estimator you can use. Lastly, if you’re looking for a new credit card or you want to better understand the benefits of your existing credit cards, visit NerdWallet for comparison information.

Student Loan Protection Riders and Retirement Protection Riders

Disability insurance helps protect you by providing income in the event of a disability. This insurance is particularly important because people are much more likely to become disabled than they are to die, which would be covered by life insurance. In fact, according to the Disability Insurance Resource Center, a 32-year-old is 6.5 times more likely to suffer a serious disability lasting 90 days or longer than to die.

In a previous post, we looked at a program designed to help young professionals, and even some students, protect their future earning ability in the event of a disability. There are two other disability benefits that individuals should consider, depending on their specific needs.

Student Loan Protection Rider

Student loan debt now totals $1.2 trillion, and the total student loan debt in the country is now greater than the total credit card debt. Not surprisingly, student loans are now the largest financial concern for many people. One reason for concern is that it’s almost impossible to get rid of student loans in the event of a financial hardship. For recent graduates with significant student loans, these can become an even greater burden in the event of disability.

The student loan protection rider can be added onto a disability insurance policy. With this rider, if the insured becomes disabled, the insurer will pay $500 to $2,000 per month for the student loan payments. Payments are made directly to the loan provider so that the beneficiary will not be over-insured. The rider has the flexibility to be dropped when student loans are paid off and it’s no longer needed.

The student loan protection rider is generally an inexpensive addition to a supplemental disability insurance policy. As medical students and other professionals increasingly graduate with over $100,000 in student loans, this rider can be a significant benefit for young professionals.

Retirement Protection Rider

With the loss of income that results from a serious disability, an individual also loses the ability to save for retirement. The retirement protection rider can be added onto a supplemental disability insurance policy like the student loan protection rider.

With this plan, after a client has been disabled for 180 days, the monthly benefit will be given to a fund where it’s invested as the client or advisor allocates. The benefit received from the insurer is non-taxable income because it’s a disability benefit purchased with after-tax dollars, but any income later earned by the investments would be subject to income tax.

Parting Thoughts

The riders described above are more appropriate for some people than for others. Merriman does not sell insurance, but it’s important that we work with our clients to develop comprehensive financial plans. We are proud to work with our clients and their family members to identify what may be appropriate based on their specific needs and circumstances.

New Professionals Program – Future Income Protection Plan

Disability insurance is a well-known and valuable tool for protecting future income. In most cases, an individual can get insurance that pays up to 60% of her current income if she becomes disabled. This can be especially valuable for high-income professionals like physicians, who would have a difficult time finding work at a comparable salary in the event of a disability.

As valuable as this resource is, traditional disability insurance has a significant gap for a specific type of professional: those who have recently completed or nearly completed their training, but do not yet receive the salary they expect to eventually earn.

New Professionals Program

For new professionals, the ability to earn your future income, or human capital, may be your largest (or only) asset. Also, medical residencies generally involve long hours and low pay – especially relative to what you can earn later. Traditional disability insurance that pays 60% of current income doesn’t accurately reflect the medical resident’s future earning power.

Disability insurance under the new professionals program provides the ability to get a salary based on future income, rather than current income. In fact, current income isn’t considered when determining benefits – it’s based on a formula.

Let’s consider Nicole, a hypothetical fourth-year ER resident. She’s making $60,000 per year and has a group disability policy provided through the hospital that would cover up to 60% of that salary. She purchased a disability insurance policy using the new professionals program, which gives her an additional $6,500 monthly benefit if she becomes disabled. It also continues to provide a partial, residual benefit if she’s able to return to work at lower pay. This policy would cost her $4,698 per year with the level premium option. However, she also has a graded premium option, which costs less at first, but increases slightly each year. This would initially cost her $2,172.

Nicole completes her residency the next year and receives a contract with a $360,000 salary. She already has a disability insurance policy in place with a future increase option (FIO) that can increase the benefit without having to undergo additional medical underwriting. Also, she can choose to continue paying premiums on the graded option, or she can switch to the certainty of a level premium.

Protecting Your Most Valuable Asset

Most insurance providers now offer disability insurance through the new professionals program. It’s available to various medical professionals, as well as CPAs, attorneys, engineers, architects and others. Medical professionals are generally able to enroll in the program as early as their third or fourth year of medical school. The available benefit starts around $2,500 per month and gradually increases throughout the residency to a maximum of $5,000 to $7,500 per month, depending on the specialty. read more…

Tyler Bartlett featured in “How to Go from Middle Class to Millionaire”

Our very own Tyler Bartlett was recently featured in an article from Guide Vine: How to Go from Middle Class to Millionaire, about the patience and discipline required to become a millionaire. Here’s a snippet:

Here is the good news: millionaire status is very much within the reach of America’s middle-classes who earn higher-than-average incomes. A typical middle-class family has a combined household income of $97,000, with upper middle class households bringing in incomes above $100,000. Bartlett offers an example of a couple living in Seattle. Like typical upper middle class Americans, both are college-educated professionals with good, steady incomes. The couple, a real estate and a sales executive, together earns $150,000 per year. For 13 years, this couple saved as much as $1,000 per month. They maxed out their 401(k)s. Today, they have more than $1 million in investible assets. “They took hard steps,” said Bartlett. “They worked full-time jobs and had the discipline to do the right thing financially.”

Do you have what it takes? Read the full article at Guide Vine here.

Remaining Q&A from Breakfast with Paul Merriman

We recently hosted an event with Paul Merriman, which ended with a Q&A. There were so many great questions asked, we didn’t have time to respond to them all, but we hate to leave any question unanswered. Here are some of the questions we didn’t get to, with answers written by Merriman Advisor Michael Van Sant, and our Associate Advisor team.

question_markWhat factors should be considered in deciding if a couple has enough net worth to self-insure for long-term care?

There are a number of factors to consider in deciding whether to self-insure for long-term care:

Income streams and portfolio assets: Determine your income streams (including Social Security, pensions, and annuity distributions) and compare this value with your spending needs to maintain your desired lifestyle, plus the cost of long-term care. If a gap exists between income and needed funds, determine if your portfolio can be called upon to close the gap.

The most expensive long-term care facilities price out at an average of $300/day, with a typical stay in a nursing home lasting 3 years for a total of $328,500 per person. Taking the benefit of income streams into consideration, long-term care for a couple lasting 3 years would likely result in an out-of-pocket expense of $500,000. If your portfolio can handle that expense, it may be wise to self-insure. A general rule of thumb is that if a couple’s net worth is more than $2,000,000 they can likely afford to self-insure. Some people consider their home as part of their net worth when making this decision. Be sure to consider whether you are truly willing to sell your home and move if necessary. Many people envision receiving care in their homes and should not factor the value of their home into their net worth for these purposes.

Genworth offers useful tools and calculators to determine the costs of care in your area.

Bequest goals: Do you have a desire to leave your children an inheritance of a specific amount? Paying for long-term care out of pocket in the event you will need it could cause that desire to go unrealized. Purchasing long-term care insurance can provide for help in guaranteeing your heirs the inheritance you wish to leave them. Think of long-term care insurance as ensuring an inheritance floor for your survivors.

Sleep at night: Purchasing long-term care insurance, even if you could self-insure, can help you not to worry about the “what-ifs.”

Other care options: Who will care for you if you do not have coverage or the means to pay for long-term care? If your children are not close by or you can’t or don’t want to rely on them for care, long-term care insurance will provide for a caretaker.

Do you believe in the bucket strategy?

The bucket strategy is a financial planning concept that involves separating money into different buckets to achieve different goals. At a minimum there are two buckets. The first is for any expenses you are expecting in the next 2-3 years. The money in this bucket is always kept as cash or cash equivalent, with the belief that investing in the market is too risky and volatile in the short term. The second bucket is money you won’t need in the near term and is therefore invested in stocks and bonds. There can be multiple buckets and deeper planning involved, but this the basic description.

Back to the question, does Merriman believe in the bucket strategy? While we certainly weigh your short-term needs with your long-term goals, our strategy dives much deeper than the idea that everyone’s lives can fit into two buckets. We spend a lot of time up front covering all areas of your financial life to get a truly comprehensive understanding of your situation before we recommend an investment strategy. Only in this way can we ensure we are recommending an investment strategy designed to help you stay on track. We believe prudent asset allocation is the most powerful tool to align portfolios with client return objectives and risk tolerances. We also hold regularly scheduled reviews and make necessary adjustments to stay on track to meeting short and long-term goals.

What is the best investment to generate income and preserve principal?

At Merriman, we believe in a total return approach that is designed using academic research to achieve long-term growth. We do not use any specific investment to generate income. Rather, we use dividends, interest and appreciation to fund each client’s income needs.

We have two different core strategies (MarketWise and TrendWise) available for clients, and we build portfolios from those and other specialized securities, based on their risk tolerance

  • Our MarketWise portfolios, which are fully invested at all time, use low-cost mutual funds that are diversified among various asset classes.
  • TrendWise is an actively managed strategy that uses a trend-following discipline to limit downside potential.

When frequent withdrawals are needed from the portfolio, your advisor will help to preserve principal by being sensitive to costs associated with trading fees. If your advisor knows of an upcoming distribution, they will allow cash from dividends and interest to build up to reduce trading costs.
If you need to withdraw from the portfolio and there is not cash available, your advisor will use appreciation to trim from the asset class that is most overweight. This allows for a periodic rebalance to ensure your portfolio is in line with its target allocation. Using this approach, we are able to sell high while letting the underperforming investments recover.

How does Merriman add value to investment accounts?

Merriman adds value to the investment accounts in two ways:

First, we build our portfolios using an academic approach that is evidence-based. We recognize that markets are generally efficient and, through broad diversification and proper asset allocation, we create portfolios that meet each client’s risk tolerances and long-term objectives. The universe of investment products is very large and new products come out all the time; 95% percent of them are worthless, 5% of them are worth investigating, and 1% of them are actually worth investing in. Merriman’s research department culls through this vast and complex set of products to find those that will truly enhance investor returns and reduce their risk over the long-term. The average individual investor has neither the time, nor the expertise, nor the access to find the needles in the haystack. We provide portfolios that offer better value over the long run by combining carefully selected investments that have higher expected returns, like small companies and value companies, while including other assets classes that have a lower correlation to US equities, like reinsurance, international equities, global real estate, and peer-to-peer lending.

Second, as your Wealth Manager, we provide guidance and behavioral coaching through different market cycles. As an example, portfolios are regularly rebalanced to restore target allocations by trimming asset classes that have done well and adding to asset classes that have lagged – this is done with an objective perspective. This disciplined approach will help ensure your investments are still the right fit for your wealth management plan.

Is it reasonable to evaluate performance by comparing returns to appropriate index?

When evaluating performance, comparing returns to an appropriate index can be helpful, but an investor must also keep in mind the long-term goals of the portfolio. It should be stressed that comparing returns to an appropriate index is sometimes easier said than done. Typically, a well-diversified portfolio made up of many different asset classes will not compare accurately with some of the most commonly referenced indices – e.g. The Dow Jones Industrial Average, S&P 500 or the NASDAQ.

Your advisor should be able provide the most appropriate index that can be used for comparing returns. An investor should also be careful to recognize the long-term goals set forth when creating a portfolio. Often, short-term market volatility will not reflect the long-term objective of a portfolio, and typically comparisons made in the short run provide little to no help.

If Merriman can’t see the future or rely on past performance, how do you use research?

As stated in the question, past performance is unlikely to repeat exactly, and because of that, we’re not able to predict the future. However, over periods of time long enough to include multiple market cycles, there are trends that emerge with investing. By studying the past, research helps us identify strategies to improve client performance in the long run.

First, research helps create our asset allocations. History has shown that various asset classes (US stocks, international stocks, bonds, real estate, etc.) have rotated in and out of favor at different times. Research helps identify the correct amount to hold in each asset class to provide the greatest expected return for a given amount of risk.

Next, research helps identify appropriate times to rebalance portfolios. If a client’s appropriate portfolio is 50% stocks and 50% bonds, and stocks do very well over the next year, the client will have a portfolio with more risk than appropriate one year later. Research helps us identify how far the portfolio can drift from our original allocation before we need to rebalance and move back to the original allocation.

Third, research helps client performance by identifying the most tax-efficient ways to invest. There are some investments we only hold in taxable accounts, and some we only hold in tax-deferred accounts, like IRAs. We will also use Roth IRA conversions for some clients, and research helps us identify when that is appropriate and how much to convert.

While we believe that you can’t rely on past performance, as stated in the question, we use research to develop our best estimate for the expected return and volatility for a portfolio (such as a 50% stock portfolio that is rebalanced appropriately). These expected return and volatility numbers are used when we create a financial plan and help clients identify if they are on target for meeting their goals.

Finally, we rely on research to help identify the best investments to use when creating client portfolios, which takes us into our next question:

Do you still rely exclusively on Dimensional (DFA) funds?

Our research department looks at all investments to find the best options for our clients. We do use DFA for all of the stock and some of the bond holdings in our MarketWise portfolios, which make up about 80% of Merriman accounts. DFA has consistently proven to be the best option, and we use their funds much more than any other investment.

DFA’s funds are broadly diversified. Also, they don’t try to pick individual companies that are expected to outperform the market. However, because they are not index funds, they have some additional flexibility that helps to lower costs and increase returns.

DFA also relies on academic research to identify types of stocks that are likely to perform better over the long run – specifically value and small-cap stocks. DFA slightly overweights these stocks, and slightly underweights stocks with the opposite characteristics.

Our research department is constantly evaluating various investment options. For now, the combination of tilting toward small and value stocks, broad diversification without being tied to an index, and low fees have consistently made DFA the best option for many of our portfolios.

Tax Benefits that Come with Raising Kids

We all know the cost of raising a child is significantly higher than any tax benefit you may receive. Every dollar you save on taxes counts, especially when you have more than one child. Whether it’s through tax deductions, exemptions or special tax-advantaged accounts, taking the necessary steps can help reduce the cost of raising a child.

Dependent exemptions

On a 2016 tax return, your spouse, any dependents and you receive a personal exemption that reduces your taxable income by $4,050 each. Let’s say you’re in the 28% marginal tax bracket and receive four exemptions for your spouse, two kids and you. This leads to a tax savings of $4,356 [($4,050 x 4 exemptions) x 28%]. When you start a family, make sure to adjust the tax withholding from your paychecks to include the correct number of exemptions. This reduces the tax withholding, thereby increasing your paycheck to account for the additional exemptions.

Child tax credits

For each dependent under age 17, you may be eligible to receive up to a $1,000 tax credit for each child. Credits are better than deductions and exemptions as they directly reduce the taxes you owe versus reducing your income that’s subject to tax. The credit amount starts to get phased out at income levels of $110,000 on a joint return, $75,000 for an unmarried individual and $55,000 for married filing separately. The credit is reduced by $50 for each $1,000 your household income exceeds these income levels, so it’s completely phased out at $130,000, $95,000 and $75,000, respectively. This credit is also partially refundable, meaning that in some cases, the credit may give you a refund, even if you do not owe any tax. This is also known as the additional child tax credit.

Consider a married couple with two children under age 10 and a household income of $108,000. This puts them near the start of the 25% marginal tax bracket after subtracting the standard deduction and exemptions. So the $1,000 credit for each child in the 25% marginal tax bracket provides for $8,000 ($2,000 / 25%) of income not to be taxed. Another way of looking at it is that this couple would owe $2,000 more in taxes if their dependents were age 17.

Dependent Care Flexible Spending Account (FSA)

The $5,000 that can be contributed to this special account is not subject to payroll taxes, federal taxes and most state taxes. It’s a reimbursement account for qualified childcare expenses for dependents up until age 13. This FSA can be used to pay for daycare, nanny services, summer day camps and many more. Make sure to spend the money in the account by year end as it’s a use it or lose it situation, where any leftover balance is forfeited. However, your plan may offer a grace period extension that could allow you to use the unused funds within 2 months and 15 days after the plan year ends. Unfortunately, dependent care FSAs are only available through employer benefits plans.

To illustrate the tax savings, consider a couple living in California with taxable income of $250,000. Their marginal tax rate is 33% to federal, 9.3% to California and 7.45% to payroll taxes (Social Security and Medicare), leading to an overall marginal tax rate of 49.75%. The $5,000 contributed to a dependent care FSA effectively saves you $2,488 on taxes for expenses you would be paying normally with after-tax dollars.

Child and dependent care tax credit

If your employer doesn’t offer a dependent care FSA, or you have more than one child, you may still be able to qualify for a tax credit to cover part of the costs for daycare. The maximum amount of expenses you’re allowed to claim is $3,000 for one child or $6,000 for two or more children. You can use 20% to 35% of these expenses to get a tax credit, depending on your income. If your income is $43,000 or more, then you can use 20% of these expenses. There’s no limit on income for claiming this credit. read more…

Stay Informed

Stay Informed

Get the latest blog posts delivered directly to your inbox

You have successfully subscribed!