If you don’t understand your credit score and how it’s calculated then you’re in the dark regarding one of the most important aspects of your financial life. Here’s a look at how credit scores work, how they’re calculated, and ten steps you can take to start improving your score today.
Not convinced your credit score can have a serious impact? Look at the chart below, which shows your expected interest rate on a 30-year fixed rate mortgage, depending on your current credit score:
So with a credit score of 620, your interest rate could be as much as 1.6 percent points higher than if you had a score of 760. Now, you might think it doesn’t matter because, really, there’s not much difference between 3.9% and 5.5 %.
Wrong. For big purchases, like houses and cars, such a seemingly small difference can result in almost unimaginable extra costs over the life of the loan. Let’s take the 30-year fixed rate mortgage loan above as an example, on a home-loan of $200,000. Here is what you can expect to pay, based on your interest rate:
I’ll let that sink in for a moment…Yes, you read that right. A lower credit score can cost you an extra $68,000on a 30-year home loan. And you’ll see similar (though not as drastic) effects on auto loans and other large purchases.
Now that we’re all in agreement about the importance of understanding your credit score, we can dive into the details…
Credit scores are compiled by the Fair Isaac Corporation (FICO), and for that reason they’re often called FICO scores. Lenders rely on these scores and the accompanying credit reports to determine your likelihood of defaulting on a loan. When you apply for a loan, the bank or lender will pay one of the three main credit bureaus (Transunion, Experian, and Equifax) to obtain your report.
The question is, how can you easily improve your credit score to save yourself money in the long run?
According to FICO, there are 5 factors that make up your credit score. They’re each weighted somewhat differently in terms of their effect on your total score. Let’s go through these one by one and describe specific actions to help you improve your score in each area.
Payment History (35% of Total Score)
This is pretty obvious at first glance: your history of making payments (or not, as the case may be) on loans and credit cards plays a big role in determining your credit score. Duh!
But digging a little deeper we start to see more nuance. The size of the late payment and the length of time it has been overdue matters. A $55 credit card payment that is 90 days late will usually have a smaller impact on your score than a $500 auto loan payment that’s six months late.
And remember, almost any type of late payment can affect your score. Cell phone bills, child support payments, medical bills… if you pay any of these late your score could pay the price. There have even been instances where overdue library fees were handed over to a collections agency and hurt people’s credit scores!
Furthermore, you need to have concrete evidence of on-time payments (not just the lack of late payments). Check out this sample credit report from Equifax. It says that the make-believe borrower has too few credit accounts open. Believe it or not, your credit score will be higher if you have 6-10 credit accounts than if you have just one or two.
Here are action items to consider to improve this section of your credit report:
- Pay on time. Credit cards. Utility bills. Library dues. Parking tickets. No matter what it is, pay it on time. If there’s ever a time when you can’t pay a bill on time (or you forget), do the following:
- If you ever get a phone call or a letter from a collections agency, respond immediately and — it’s impossible to emphasize this enough — attempt to negotiate a removal of the collection from your credit file on the condition that you pay the amount in full.
- If you can only pay off certain past due amounts, be strategic about which ones to pay off first. Focus on the ones you can fully pay (so they won’t damage your credit score any more than they already have). Also focus on paying off the ones that have been overdue for the longest time.
- Open and then close a credit account. I’m serious. (But only if you’re sure you can handle it and if you DO NOT plan on taking out a loan in the next year) One of the best ways to do this is when you’re making purchases at a department store and the clerk mentions a special discount if you apply for their credit card (i.e. at Macy’s, JC Penney, etc.). Say yes, but also politely ask the clerk how to close the card if necessary. Later that day, close the account. Pay the first bill as soon as it arrives. You’ve now added another “on-time account” to your credit report.
Amounts Owed (30% of Total Score)
Many people don’t realize that what matters most here is not the total amount you owe but the proportion of your available credit that you are using. For example, a balance of $5,000 on a credit card with a $20,000 credit limit (25% used) is better than a balance of $1,500 on a card with a $3,000 limit (50% used).
This is true for auto loans as well. One that is 20% paid off will hurt your credit score more than one that is 90% paid off, regardless of the total amount.
Actions you can take:
- Don’t take on loans or expenses that you can’t afford. And as much as possible, reduce the revolving amount on your credit cards (i.e. the balance that carries over from month to month). If you need help with this, use one of the available online tools for eradicating credit card debt.
- Only for the very disciplined: Call your credit card company and ask them to increase your credit limit OR apply for another credit card. Increasing your total credit limit will decrease the proportion that you’re using. But this will backfire if you don’t have the willpower to hold your spending steady. So proceed with caution.
Length of Credit History (15% of Total Score)
This is pretty straightforward. The longer your credit history, the better. Here are actions you can take to lengthen your history:
- Start developing a credit history as soon as you’re responsible enough to do so. Many people get their first credit card while in high school. As long as you start off with a very low credit limit to prevent yourself from making any rash or foolish spending choices, this can be a good way to kick off your credit history.
- Don’t close an account in good standing unless you have to. It turns out, that credit card you’ve had for 10 years might be your credit score’s best friend (if you’ve used it wisely). Why? Because it’s the most tangible proof that you’ve consistently paid on time. Once the account has been closed, you won’t benefit as much from it.
New Credit (10% of Total Score)
Opening new credit accounts or having your credit checked will hurt your credit score, at least temporarily. Above, we described certain scenarios where opening accounts can help you in the long term, but it will always hurt you a little in the short term. To fully understand the different types of credit checks and how they can affect you, take a look at this previous Lifehacker post.
The solution? Don’t apply for a whole bunch of credit cards at once. In fact, don’t apply for a whole bunch of credit cards at all. Use credit (and applications for credit) very strategically and very sparingly.
Types of Credit (10% of Total Score)
There are many types of credit — auto loans, mortgages, credit cards, retail accounts, etc. — and having several different types can sometimes help your credit. However, there is no need to take on many types of credit simply to help your credit score.
Now you understand the basics of the credit score and have some actions to help improve your score. Still, there’s one more thing that can help you, and luckily it’s not too hard to do:
- Check your credit report for free once a year viaAnnualCreditReport.com. That site was mandated by the government to allow people to access their report. When you see your report, look over it carefully to make sure there are no errors on it. Occasionally, your credit can get dinged based on false or inaccurate information. By checking over the report yourself, you can make sure that doesn’t happen.
- Beware of signing up for services that promise to monitor your credit report on a monthly basis — usually for a fee of up to $15 or $20 per month. These are usually no more effective than simply checking the report yourself for free once a year or even paying a one-time fee to see your report and score when necessary.
Remember, credit scores can be anywhere from 300-850 but most are within the 650-750 range. In 2006, FICO said the median score was 723. That may not be true after the disastrous economic events of the past five years, but it’s still an interesting reference point for you to keep in mind.
Hopefully, if you follow the advice given here, you will have a robust credit score for years to come. While getting a better score can be a bit of a game to be played, taking an active role in improving it is important. Who knows, maybe the ten minutes you just spent reading this will someday save you $68,000 on a 30-year mortgage!