Every evening on my way home from work, I have the pleasure of listening to Dave Ramsey on our local radio station. Dave is an absolute genius at delivering no-nonsense advise and motivating people to get their financial house in order. He certainly helped motivate me to pay off my medical school loans. If you haven’t ever listened to Dave Ramsey, I recommend you give him a try.
Dave Ramsey Isn’t Always Right
However, I take issue with a few of Dave’s recommendations. One of these is the idea that you don’t need a credit score. Dave is vehemently anti-debt, and he reasons that if you never take on debt, then you won’t need a credit score. He even recommends that you close all your credit cards and simply use a debit card. If you do this, and have no other debt (such as a mortgage, student loan, or a car payment), eventually your credit score will go to zero, or be listed as “indeterminable”.
A High Credit Score Does Not Necessarily Mean You Love Credit
I agree that all depreciating consumer assets should be purchased with cash, including your car, and that you should NEVER carry a balance on your credit card. However, some things, like your primary home or rental properties, are nearly impossible to purchase with cash. Moreover, your credit score may be used to define you when renting, applying for a job, or securing insurance.
Therefore, I recommend that you maintain a credit score and try to keep it near 800. Even if you pay off all your other debts (which you should!), you can maintain a high credit score by simply making purchases on your credit card and paying them off at the end of the month. My wife and I are completely debt free and our credit scores are each around 800. We hate debt almost as much as Dave Ramsey. However, we also understand the importance of having a high credit score. Here’s why:
You Will Need a Credit Score to Purchase a Home
Unless you live in a VERY low cost of living area or are exploring the tiny house movement, you will most likely not be able to buy your house with cash. Most people are fortunate enough just to save up a 20% down payment to avoid private mortgage insurance. Therefore, you will likely need to finance at least part of your primary residence. The higher your credit score, the lower your interest rate and the less you will pay in interest payments over the life of your mortgage.
Even if you have enough cash saved up to purchase your home outright, you might actually come out ahead financially by borrowing through a mortgage at 3.5% interest and investing at an expected 5-6% rate of return. There is a lost opportunity cost having hundreds of thousands of dollars wrapped up in your primary home. Again, the higher your credit score, the lower your mortgage interest rate and the wider the spread between your borrowed rate and your expected rate of return on other investments.
Don’t Buy Too much Home
Even if you have a great credit score and can enjoy low monthly payments on your mortgage, I generally recommend NOT buying too much house. Unless you live in a rapidly appreciating housing market (which is difficult to predict in advance), your house is not a great investment. Historically, home prices simply keep pace with inflation (around 3%), which is generally less than the expected return from the stock market. A house is a place to live, and can help diversify your investments, but be careful not to have too much of your net worth locked up in your home.
Avoid Cumbersome Manual Underwriting
If you don’t have a credit score, it is still possible to purchase a home through a process called “manual underwriting“. Instead of simply looking at your credit score, the lender will manually verify your income and assets to determine your readiness to purchase a home. However, this process is more complicated and time consuming and not all lenders will participate. Therefore, I still recommend you have a credit score to make the process quicker and simpler.
You Will Need a Credit Score to Purchase Rental Properties
It would be completely epic to walk up to a real estate deal with $400,000 cash in a briefcase, but this is impractical for all but the most wealthy of individuals. Moreover, part of the power in real estate investing is using a degree of leverage. This is expressed in something called the cash-on-cash return.
Here’s a quick example:
Let’s suppose you purchase a $500,000 rental property with cash, and it brings in $3,000 in rental income per month, or $36,000 per year. Your return on investment would be 7.2%. You put in $500,000 cash and get $36,000 cash back per year, so another way to express this is a term called the cash-on-cash return.
Next, let’s suppose that you purchased that same $500,000 property with 20% down, or $100,000 and took out a 30 year mortgage on the remaining $400,000. Your mortgage payment might be around $2,000 per month. Your rental income should be the same $3,000 per month, so your net income per month would be $1,000 per month, or $12,000 per year. In this case, you put in $100,000 cash (down payment), and get back $12,000 per year, for a cash-on-cash return of 12%, which is greater than the 7.2% return if you purchased the home outright.
The higher your credit score, the lower your monthly mortgage payment and the higher your leveraged cash-on-cash return. Obviously, you want to be careful with using too much leverage, and there is certainly peace-of-mind in having a completely paid off rental property. So use leverage judiciously and with caution.
Your Credit Score May be used to Define your Character
Even if you are not planning to purchase a home or rental properties, your credit score may be used to define you in other ways. For example:
- If you are renting, your future landlord may check your credit score to determine how likely you are to pay the rent every month.
- Your future employer may check your credit report (but only with your permission), and this may affect whether you get the job.
- Your credit score may affect your insurance rates, such as your auto insurance rates.
I don’t know how often someone would actually get turned down for a job because of their credit score, or how much additional you might pay for your auto insurance, but I don’t necessarily want to take any chances. It’s very easy to use your credit card like a debit card and keep a healthy credit score. There’s no need to go to the extreme and completely abolish your credit score.
Although I recommend eliminating all debt and paying for depreciating assets with cash, I also recommend that you keep a credit card to maintain a high credit score. This will help you qualify for lower interest rates on home and rental property purchases, and may also help with renting, obtaining a job, and securing lower insurance rates. Just make sure to treat your credit card like a debit card and pay it off every month!