By all accounts, you’re a living success story. You’ve worked hard to get a good education, you’re moving along in your chosen profession, and you’re a positive figure in your community. It seems that those factors alone should be enough to affirm your good name and character. But while all those things are nice (and important), the biggest factor standing between you and your next upward move might be a three-digit number between 200 and 800.
That number is your credit score, and while there’s a bit of mystery as to how it’s calculated, there’s no mystery at all about what it means to customers and lenders alike. Lenders extend credit to customers based on their likelihood to repay the credit in a timely manner. Your credit score is a snapshot of how you’ve handled credit in the past, your current obligations, and your wherewithal to meet them. If you’ve been timely with bills, loan payments and other obligations, lenders will be more likely to consider you a good credit risk, and you’ll have more flexibility to plan your finances.
Unfortunately, most people don’t have perfect credit. There may have been some rough patches where bills weren’t paid on time, or other obligations piled up. Also, many consumers in the last few months have been hurt by the crisis in the sub-prime loan industry. Incidents like those will bring a credit score down, and more serious financial situations may raise a red flag to some lenders.
But the good news is that even a poor credit score isn’t a permanent mark. By following some simple rules and establishing a routine of common-sense habits and discipline, any credit score can be improved.
What is a credit score?
Your credit score (mortgage lenders call it your FICO score) is a numerical index, which represents an estimate of your financial creditworthiness. Three main bureaus – Equifax, Experian and TransUnion – do most of the score calculating and reporting. Scores above 720 get the best rates. The ideal credit score is made up of both installment and revolving accounts, including mortgages, automobile loans, and about four or five credit cards.
Your prior payment history – paying bills as agreed and on time – accounts for about 35 percent of the score. It’s based primarily on the most recent six months, and while larger loans such as mortgages have a large bearing in this area, credit bureaus also look closely at credit card debt. While there is a predetermined amount you pay each month on a mortgage or other installment loan, you’re in complete control of your credit card debt.
Balances carried, or the balance-to-limit ratio affects 30 percent of your score. Having a low balance-to limit ratio on all cards is better than having a low ratio on some cards and maxed-out balances on others.
Credit history accounts for 15 percent of your score. Essentially, the longer the account has been open, the higher the credit score (as long as payments on the account stay current).
Your credit score is also affected when you’re shopping around for a mortgage or auto loan, as multiple inquiries about a mortgage or auto loan reduce your score slightly, Note that job-related inquiries, applications for insurance or to start a new utility account, and lender reviews of other accounts don’t affect your overall score.
Simple Steps to Better Credit
As in most other endeavors, knowledge is key to improving your credit score. Unlike most endeavors, the most basic piece of knowledge is absolutely free. Every consumer can receive one free credit report per year from any of the three credit bureaus. You can also purchase the reports directly from each bureau to track your credit more frequently,
The report shows you what lenders see – how many loans you have outstanding, and how well you’ve been keeping up with them. It will tell you at a glance which bills and loans merit the most attention. It will also help you catch and correct mistakes (if left unchecked, they can wreck havoc on your rating), and alert you to possible cases of identity theft. You can also get a free copy of your credit report if you are denied credit.
Now that you’re armed with the facts, start paying off high credit card balances. This could improve your credit score by 60 to 70 points. Also, pay off all accounts with a past due balance on your credit report. Remember that payments can be only one day late and still show as past due on a credit report.
Don’t pay judgments or collections when applying for a mortgage. Wait until the close of escrow, if possible, and pay them at closing. Paying judgments or collections could bring down your score by making the collection seem more recent than it may actually be.
Sometimes, late payments can be removed by contacting creditors. If the creditor honors your request, request a signed letter on the company letterhead of the creditor with your name, address, account number, and the specific late payment(s) in question.
Don’t charge more than 50 percent of your credit limit to any credit card on any given month. The credit bureaus look at the amount you pay on your credit card(s) as well as if you pay them off every month. If you have to charge more than half your limit on a card, try to plan the expenses around the payoff date. Better yet, spread the charges across several cards to keep the balances down.
Because the bureaus look at the balance-to-limit ratio, you can improve that ratio by requesting to increase your balance. Increasing a $1,000 balance to $4,000 can reduce the ratio significantly, assuming usage and payment habits remain consistent. If the creditor pulls a credit report before increasing your limit it will count as an inquiry, which will reduce the overall boost to your score.
Many advisors have suggested closing old accounts that you no longer use. But those accounts, especially if there’s a long history of keeping them paid off, can actually help a credit rating. Keep those accounts open and use them periodically. Just be sure to pay the balance in full as soon as the bill arrives. (Closing those accounts reduces your exposure to identity theft, so the added security to your overall finances may be worth the trade-off against your credit rating.)
If you’re in the market for a house or a car, try to complete your shopping within 45 days. Remember – multiple inquiries can count against your score. If all credit reports are pulled within 45 days, it will only count as one inquiry.
If at all possible, avoid bankruptcy. It will lower your credit score by 200 points or more, and will stay on your credit report for ten years. Before your finances get to that point, seek credit counseling, which will raise your credit score in the immediate run.