Today begins a four-part series of articles on your credit score – and improving it. Much of the information I will provide is familiar to you; I suggest you review it anyway. You never know when something will “click” and be that special consideration you’ve been missing. Let us begin.
Introduction
One of the first steps in getting your finances under control is understanding the importance of your credit score. In today’s world, a “good” to “great” credit score is one of your best assets. A good credit score can help you get a job, receive a better home mortgage rate, a better car loan rate, a lower interest rate on your credit cards and, if you work for a government contractor or the government itself, a security clearance. A good credit score will help you save money; by maintaining a good credit score, you will ensure that your finances are in proper order.
Keys to obtaining a great credit score include the following.
- Pay your bills on time. I cannot overemphasize this. If you already have some late payments on your credit report, focus on paying your current bills on time. As you are able, go back and begin catching up on old bills.
- Do not use all of your credit limit. Always keep some room available on your credit limit. This has a positive effect on your credit score. A good rule of thumb is to use only 30% of your available credit on your credit cards. If you have a $15,000 credit limit on your card, do not go over $5,000 usage at any one time. Most lenders do not like to see maxed-out credit limits on credit cards.
- If you have large credit-card debt and you have several credit cards, begin paying down the debt on the card with the highest interest rate and pay extra principal payments each month to pay down the balance. As soon as possible, pay down all of your credit cards to an amount that is 30% of the credit limit on each credit card. Then, begin paying extra principal payments on the credit card with the lowest balance until it is paid off. When you have one card paid off, begin paying extra principal payments on the card with the next lowest balance until all of your credit cards are paid off. When all of your credit cards are paid off, pay each credit card off each month and do not carry unpaid credit card balances into the next month.
- Keep paid-off credit cards open with all available credit limit unused. Having ample unused credit limit will help your credit score. When people have large credit card balances, one of the first things recommended is to cut up all of your credit cards and close out the paid-off accounts as soon as they are paid down to zero. This actually hurts your credit score. Closing existing credit cards lowers your available credit and drives down your credit score. In today’s economic world, you need four to six lines of credit. This can consist of credit cards and unsecured lines of credit with a bank. It is not enough to just have the available lines of credit; you must use them to show activity and financial responsibility. It is best to use each line of credit at least twice a year. I recommend that you pay off the balance each time you use one of your credit cards.
- If you have a credit card with a large balance that also has a high interest rate, do your homework and find a card with a “teaser” no-interest rate for six months or a low interest rate for a period of time, and move the balances from the high-interest rate card to the low-interest or no-interest card; then, concentrate on paying off the balance owed on the new card. Remember, do not close out the old card – and keep it open by using it at least twice a year and paying off the balance as soon as you use it. If you have more than six credit cards, you certainly can close the excess number of credit cards.
- Many people have “back-of-the-wallet” credit cards – that is, credit cards that are carried but rarely or never used. The first thing that you should do is put these seldom-used cards in a safe place in your home. If your wallet is lost or stolen, you will not have to cancel these cards and get them reissued. You should still use these cards at least twice a year and pay off the balances immediately to keep these cards active and your credit limit on these cards valid.
According to a poll conducted by Opinion Research Corp., only 27% of consumers understand that credit scores measure credit risk. The truth is, a credit score, sometimes called a FICO score, is a number based on the information in a credit file that shows how likely that person is to pay back a loan on time. The higher the score, the less risky the person is.
A FICO score is a quick way for lenders to assess how risky a person is as a potential borrower. The higher the score, the less risk to lenders and the more likely a favorable rate will be offered.
There are three major credit bureaus: Experian, Equifax and TransUnion. The credit bureaus write credit reports based on information they receive from companies that extend credit. This information includes payment history, length of credit history, types of credit offered and amounts owed. From that report, a credit score is derived.
Scores range from 300 to a perfect 850. A “passable” score would be 620. That’s a drawing line for creditors. (The median credit score in the United States is 723.)
Consumers with scores above 700 usually are charged relatively low rates, and those with scores above 760 are charged the lowest rates. Consumers with scores below 600 typically are charged relatively high rates. If a person’s credit score is very low, he/she may not be able to borrow at all.
Any late payments will lower a credit score, but establishing or re-establishing a good track record of making payments on time will raise a credit score.
How Your FICO Credit Score is Calculated
The best way to ensure a good FICO credit score is to manage your credit responsibly. To maximize your score, it is important to understand what goes into the calculation and how each factor is weighted. Below is a rough breakdown of what comprises a credit score.
Punctuality and Payment History: 35% – Takes into account:
- Many different types of payments, including mortgages, major credit cards, department store credit cards, car loans, other installment loans such as for furniture,
- Information from public records, such as bankruptcies, liens, lawsuits, foreclosures, judgments, and wage garnishments, and
- Details of any missed or late payments, such as the amount, how long ago late payments occurred, and how late the payments were paid.
Amounts Owed: 30% – Looks at:
- The total of all the amounts owed for all accounts,
- The mix of amounts owed (credit cards versus installment loans, for example),
- The number of accounts that have balances,
- How much of the total credit available on credit cards and installment loans is being used (the closer a person is to maxing out the available credit, the more negative the impact on the credit score), and
- How much of the original balance borrowed still owed on installment loans, such as a car loan.
Length of Credit Accounts and Credit History: 15% – Having a credit card for ten or more years is a plus for a FICO score. The less negative information in your file and the longer your credit history, the higher your score.
Recent Requests for Credit and Recently Obtained Credit: 10% – Considers:
- How many new credit accounts have been opened recently,
- How long it has been since you opened a new credit account,
- How many requests you’ve made for credit recently,
- How long it has been since lenders have requested credit information on you, and
- How good your recent credit history has been.
Types of Credit Accounts in Use: 10% – Considers the number of credit accounts and the mix of credit types (credit cards, installment loans, mortgages). This is important if you don’t have a long credit history.
So, now that you know what makes up a credit score, where do you fall with regard to the factors above? Do you know your credit score?
This is a good stopping point. Over the next three articles, I will discuss the concept of a credit score in more detail and provide some helpful suggestions for improving a credit score. As always, feel free to email me directly with questions.
Thomas