Credit is a funny thing. When you need it the most, you often don’t qualify. When you don’t need it at all, everyone wants to give it to you. Nevertheless, you can’t blame lenders for scrutinizing your creditworthiness before extending you credit: They simply want some sort of guarantee that you won’t take their money and run. And the best indication of creditworthiness is a credit score.
Having a perfect credit score will make you eligible for some of the best interest rates offered. In turn, you could potentially save hundreds of thousands of dollars on loan payments. You’re probably thinking, “Sounds great, but how do I manage to get a perfect credit score?” Well, we’ll show you!
Before you can improve your credit score, it’s important to first make sure you have a good understanding of exactly what a credit score is and how it impacts your financial situation. In a nutshell, your credit score is a number from your credit report that represents how likely you are to repay a loan on time. The higher your credit score, the more confident a lender can feel about doing business with you, and thus, the more likely you are to get approved for a line of credit.
Besides using it to decide whether or not to grant you a loan, banks and other lenders use your credit score to determine what interest rates to charge you. In order to mitigate their risk, a lender will typically charge a higher-than-average interest rate to someone with a below-average credit score. Simply put, this means that borrowing money is more expensive for people with a bad credit history.
Figure 1: 30-Year fixed loan interest rates as of October 2011 (national average).
For major loans such as a mortgage, your credit score and resultant interest rates can produce a huge impact on both your monthly payments and on the total amount you have to repay the bank over the years. For example, based on current national averages as of October 2011, on a $250,000 30-year fixed mortgage, a person with an “excellent” credit score will pay about $169,000 in total interest by the time the loan is paid off, whereas someone with a “fair” credit score will pay roughly $254,000 in interest (See Figure 1).
Unfortunately, a bad credit score can have a vicious-circle effect, as high monthly payments make it even more difficult for you to pay your bills on time, ultimately causing your credit score to drop even further.
It’s also important to note that your credit score impacts you differently for different types of loans. This means that while your below-average credit score may not be high enough to qualify you for a real estate loan, it may qualify you for lower-quality loans like an installment loan or credit card. Conversely, the type and quality of your existing credits also affects your credit score. But we’ll look more closely at the factors that affect your credit score later on.[/nextpage] [nextpage title=”Next Page” ]
You are probably familiar with the term “FICO score” as it is often used interchangeably with “credit score.” Indeed, the FICO (Fair Isaac Corporation) credit scoring model is the most widely-used of its kind in the United States, and your FICO score is the number most lenders reference as your credit score to determine your creditworthiness.
FICO scores range between 300 and 850, with a median score of 723. A score of 599 or lower is typically considered “bad,” whereas a score of 750 or above is considered “excellent.” (See Figure 3). The higher your FICO score, the lower your perceived risk to creditors. For example, a “good” score ranging from 700 to 749 indicates you have a low, five percent risk of developing serious credit problems (See Figure 4).
Figure 3: About 40 percent of Americans have FICO scores of 750 or greater.
When it comes to qualifying for a mortgage loan, a FICO score of 620 is typically the cut-off – at least, such is the case since the post-2008 financial collapse. If you do manage to qualify for a mortgage with a sub-620 FICO score, expect to pay very high interest rates.
You actually have three FICO scores, as the three national credit reporting companies (CRCs) that collect the credit report information which determines your credit score – Equifax, Experian and TransUnion – each have their own databases. Depending on the CRC, FICO scores are also marketed under different names, such as Beacon (Equifax) and Empirica (TransUnion). The three CRCs won’t necessarily show identical FICO scores for any individual, since they may all pull from slightly different sets of data. However, credit scores based on the FICO algorithm will rarely deviate significantly for the same individual, unless of course there is incorrect information being reported.
There are also specialized FICO scoring versions which only lenders see. For example, the auto-enhanced FICO score, which emphasizes auto loan history, is used to determine your auto loan-worthiness and interest rates, while many credit card companies use a bankcard-enhanced FICO score when reviewing a credit card application.
Further complicating the matter, the three major CRCs introduced their own credit scoring system to compete with FICO in 2006. The CRCs’ competing credit scoring model, VantageScore, produces credit score values ranging from 501 to 990. FICO has filed a federal lawsuit against VantageScore, which is ongoing. As a consumer, you don’t really need to worry about your VantageScore as it isn’t widely used by lenders – according to court documents filed for the federal case, VantageScore’s market share is only six percent.
VantageScore and other non-FICO credit scores are also sometimes called “FAKO” or “Fake-O” scores – a derogatory play on FICO. As their nickname implies, you’d be wise not to bother with FAKO scores — and you certainly shouldn’t pay for one. As a consumer, the most meaningful credit score number you need to know is your FICO score provided by one of the authorized CRCs – or even better, the average of your three FICO scores.[/nextpage] [nextpage title=”Next Page” ]
Your FICO score is calculated using various credit-related data from your credit report. The credit information that determines your FICO score can be grouped in to five categories: payment history, credit utilization, length of credit history, new credit, and types of credit used.
Figure 5: The importance of various factors in determining your FICO score.
Length of Credit History
Types of Credit Used
When your credit history information is accessed, this is called an inquiry. Soft and hard inquiries affect your credit score differently, so it’s essential that you know the difference between them.
A soft inquiry, or soft pull, is a credit check that doesn’t affect your credit score. When a third party pulls your credit report without the intention of issuing you new credit, this is a soft inquiry. Oftentimes, you, the consumer, is unaware that a soft pull is taking place. Soft pulls may occur when a lender that you currently have a line of credit with checks your credit information to make sure you aren’t defaulting on other accounts.
Lenders also conduct soft pulls in order to make you those pesky, unsolicited, “pre-approved” offers (also called “Firm Offers”) for lines of credit. (If you take them up on the offer, however, the lender will then conduct a hard inquiry before actually loaning you the money). When you pull your own credit report to monitor your credit, this can also be considered a soft inquiry.
A hard inquiry is a pull that adversely affects credit score. This kind of credit check occurs when you apply for a new line of credit, such as a credit card, auto loan, student loan or mortgage. While they can be tempting, new credit applications should be avoided unless necessary. For example, applying for a new retail credit card to receive a 10 percent discount on a single purchase can cause you to lose more money – via higher interest rates – in the long run than you gained with the one-time discount.
Hard inquiries remain on your credit report for 2 years. However, they only affect your credit score for one year, and their impact on your score lessens after 6 months. Having some inquiries on your report is not necessarily a big deal, but too many inquiries may give the impression to lenders that you are overextending yourself or trying to take on new debt.
Examples of Hard Inquiries vs. Soft Inquiries
Note: When shopping for auto or mortgage loans, multiple hard inquiries made within a thirty-day period will only count as one hard inquiry on your credit report. Banks understand that you’re shopping around to find the best rates. It is not a good idea, however, to apply for other types of credit, such as credit cards or car loans, in the months prior to applying for a mortgage loan. These hard inquiries will result in a lower credit score when it comes time to make that larger, more substantial purchase.[/nextpage] [nextpage title=”Next Page” ]
While your credit score is the primary piece of information lenders consider to determine your loan eligibility and/or interest rate, they may also consider other factors. For example, while your credit score doesn’t reflect your salary, assets, or employment history, lenders may take these items into account. In addition to your debt ratio and other data from your credit report, banks and financial institutions may also take into account the following lifestyle factors when calculating your interest rate:
Depending on the type of loan you’re applying for, lenders may also consider:
As with credit scoring agencies, lenders are legally prohibited from taking into account your age, race, gender, national origin or marital status when considering your credit application.
In November 2011, FICO and data provider CoreLogic announced the joint creation of a new type of score for mortgage lenders. This score will incorporate additional consumer information not included in FICO scores, such as payday loans, child support payments and evictions. Status of rent, utility and cellphone payments may also eventually be included in this score. Keep in mind however that it’s still unknown whether or not this new score will be embraced by lenders.[/nextpage] [nextpage title=”Next Page” ]
If you’ve been paying attention, we’ve already dispelled some myths about credit scores. You should now know that not all of your credit scores will be the same (you have three different FICO scores as each credit bureau may pull from different data), that neither your salary nor your level of education affects your credit score (though lenders may consider this information), and that checking your own credit report doesn’t hurt your credit score. Here are a few more credit score myths we thought were in need of debunking.
Myth: I can’t have any negatives on my report.
Truth: If you have a missed payment in the past, or even if you have a far more serious skeleton in your credit closet such as a personal bankruptcy, don’t sweat it too much. In fact, it’s entirely possible to have a score of over 700 even with a bankruptcy on your report. More recent credit data is actually weighted more heavily in calculating your credit score, so the longer it’s been since a past negative event occurred, the less it will affect your score. If you’ve made credit mistakes in the past, just do your best to rectify them and work on re-establishing a good credit history from here on out.
Myth: Opting out of pre-approved offers will benefit my credit score.
Truth: This is a common misconception. As previously mentioned, “soft pulls” that banks conduct to make you pre-approved offers of credit don’t negatively impact your credit score; thus, opting out of these offers won’t benefit your credit score. However, opting out of pre-approved offers will cut down on your junk mail and decrease your risk of identity fraud.
Myth: If I correct an error on a credit file with one credit reporting agency, the correction will be picked up by all of them.
Truth: You might have guessed that this one is false, since you now know that each credit bureau maintains its own separate database. When you find an error on your credit report from one of the three major CCRs, you need to check if it also appears on the credit reports from the other two. You’ll need to individually contact each agency which has an error on file for you; correcting your file with one agency won’t fix your records with the other two.
Myth: Paying or settling a negative account such as a judgment, lien, or charge-off will remove that item from my credit reports.
Truth: Unfortunately, this is also false. However, time does heal all wounds. Most resolved negative events will disappear from your report and stop weighing down your score after seven years, although bankruptcies are an exception – these can linger on your record for up to ten years. Nevertheless, it’s important to settle any negative account standings, since lenders will take outstanding delinquencies into account when considering whether to offer you a new line of credit.
Myth: Asking for lower limits will benefit my credit score.
Truth: Depending on your personal spending behavior, it may be a good idea to request that a lender lower a high limit on your credit card if this will help you stay out of debt. But if you can control your spending, there’s no need to ask for a lower credit limit; this will not benefit your credit score whatsoever. In fact, it could potentially hurt your score by increasing your debt to available credit ratio.
Myth: My credit score is merged with my spouse’s.
Truth: Unlike your assets, your credit score is yours and yours alone and is not affected by husband’s or wife’s score. But even though getting married does not cause your credit information to merge with your spouse’s, your spouse’s credit history can affect your ability to qualify for credit together — for better or for worse. Also, when you open a joint account with a spouse or another person, that information will appear on both of your credit reports.
Myth: A divorce decree will release me from financial responsibility for an account.
Truth: Regardless of what a judge determines in regards to division of credit card payments, mortgage payments and other joint debts between you and your ex, these decisions carry no weight with the creditors, themselves. Therefore, if your ex-spouse misses payments for a car, house or another account that your name is connected to, this can still negatively impact your credit score. To close a line of credit or remove one of your names from a loan you share with your ex, both divorcing parties must contact the creditor or have the other party sign a letter of consent to remove their name. If your credit score is too low, a creditor may not agree to remove the other person from the account, however.
Myth: Receiving credit counseling services will lower my score.
Truth: This is untrue. Seeking debt help from a credit counselor will not, by itself, impact your credit history or score. However, if you sign off on a debt management program, bankruptcy or debt settlement as a result of contracting a credit counselor, it will show up in your credit history. A debt management program (DMP) should not affect your credit score but a bankruptcy or debt settlement involving only partial debt repayment may lower your credit score.
Myth: Using debit or check cards can help rebuild my credit score.
Truth: Debit/check cards have no bearing on your credit score. However, if you overdraw your account using a check card and fail to repay the negative balance, this may harm your credit score if the bank files for collection.
Myth: The higher my credit score, the lower interest rate I’ll get.
Truth: While this is generally true, it is not always the case. Lenders typically use a grading system to calculate interest rates wherein scores falling within a specified range will be assigned a certain grade corresponding to a particular interest rate; a score at the top of this range won’t receive a better rate than a score at the bottom of the range. For example, depending on the lender’s grading system, all scores between 760 and 850 might be graded “A” and receive the lender’s lowest offered interest rate. In such a scenario, raising your score from 760 to 800 would not affect your interest rate.
Myth: My credit score is locked-in for a certain amount of time.
Truth: Actually, your FICO score changes as soon your credit report information changes, and your score is recalculated each time your credit information is accessed. It is entirely possible for your credit score to change in the course of a day.
Myth: As long I pay my bills on time, I don’t need to bother checking my credit report or score.
Truth: Credit reports commonly contain erroneous information ranging from an incorrect date of birth, to missing accounts in good standing, to fraudulent accounts opened in your name. Even if you have good credit habits, it’s important to check your report at least once yearly to make sure the credit information on file for you is accurate.
Myth: I can raise my credit score by hiring a stranger to add me as an authorized user to a credit card account in good standing.
Truth: FICO recently changed its scoring rules to prevent credit repair companies from paying strangers to add clients to their accounts. However, this strategy may still work if the credit card account to which you are added belongs to a spouse, parent, or another close relative.
Myth: My credit report will show a zero balance for any credit cards I pay off before the due date.
Truth: Lenders usually report to the credit bureaus on the statement closing date, not the due date. The closing date appears on your statement and is usually about 20 to 25 days before the due date. Thus, if you want your credit report to show zero balance for a particular card, you need to pay it off before your statement closing date. To play it extra safe when you’re applying for a major loan such as a mortgage, you may want to avoid using your cards altogether for a month in advance so that your debt-to-credit ratio is as low as possible.
Myth: All lenders have the same impact on my credit score.
Truth: Consumer finance accounts are considered a negative by the credit bureaus. Consumer finance companies provide credit to customers who may not qualify for bank or credit union loans, and the credit bureaus know that these customers generally have higher rates of default. Consumer finance companies also charge higher interest rates than traditional lenders, which further increases their clients’ default risk.[/nextpage] [nextpage title=”Next Page” ]
In addition to obvious things like paying your bills on time and not racking up huge balances, the following tips can help you build and maintain a healthy credit score.
Apply for credit
Not having enough recent credit history may negatively impact your credit score.If you lack sufficient credit history,you’ll need to apply for credit to improve your score. Before opening a new account, however,it’s important to ask yourself if you’ll be able to use this card on at least a semi-regular basis, and to make sure a lack of credit is the reason your credit score is low – applying for new lines of credit when you already have sufficient credit history can, as previously mentioned,harm your credit.
Don’t apply for more credit cards than you actually need. Also make sure you’re aware of any annual fees associated with a new credit card and that the lender will report your timely payments and credit limit to the three major credit bureaus (not all creditors supply information to the credit bureaus).
Prune your credit
After your first couple years of building credit, it may be a good idea to cancel any cards with low credit limits (less than $1,000). Low credit limits are a sign that lenders can’t trust you to manage too much credit. Additionally, a higher average credit limit for all your accounts results in a higher credit score. Also keep in mind that while it is good to have more than one credit card, you don’t need more than a few. Having more accounts won’t necessarily equate to a better score. While lenders like to see a variety of credit sources, ten credit cards isn’t better than three (although three is better than one).
Get your credit reports and FICO score every year
You are entitled to one free annual credit report from each of the CCRs, although you aren’t entitled to receive your actual credit score for free. However, if you pay a small fee when you get your free credit report, you can also see your FICO score. Take advantage of the opportunity to get your FICO score from at least one of the CCRs, and make sure you also examine each of your three annual credit reports carefully. Be sure to notify the CCRs if there are any errors on your reports.
Dispute inaccuracies on your credit report
If there are blemishes on your credit report that shouldn’t be there, take action to have them removed. Start by sending letters to the lenders themselves and follow-up with letters to all of the credit bureaus that are reporting the erroneous information. Be sure to keep copies of everything you send, and send your letters via certified mail with return receipt requested. This will come in handy if you ever need to prove that the document was received. For sample letters and templates, refer to the resources at the end of this eBook.
Open savings and checking accounts (one each)
Although these don’t directly impact your score, banks like to see that you have these accounts when applying for credit.
Ask for a “goodwill correction”
Lenders will sometimes remove a negative mark from your account if you simply request its removal. Creditors won’t always consent to do this, but it doesn’t hurt to ask. So, make sure you give it a shot, particularly if you have a long-standing account with the creditor and you only have one negative on an otherwise unblemished payment record. FICO does not track changes to your credit history, so if a creditor removes a bad mark from your account today, FICO won’t know it ever existed next time it pulls your file.
Beware of consumer credit scams
There are a number of services that claim they’ll repair your credit or provide other credit related services for “a small fee” – which often adds up to hundreds of dollars. Just about all of these services are misleading and/or overpriced, and some of them are downright fraudulent.
Credit repair services commonly claim that they can remove liens, judgments, or other negatives from your credit record, but such claims are false. Keep in mind that anything a credit repair service can legally do for you, you can also do yourself at little or no cost.
Other common credit-related services that pose risk to uninformed consumers include advance-fee loans, home equity lines of credit, and file segregation – an illegal scheme employed by credit repair companies that helps consumers fraudulently obtain new taxpayer identification numbers from the IRS to hide from creditors. Beware that if you participate in file segregation, you are committing a felony.
Some credit-related services, such as credit monitoring services, may be legitimate, but such services are generally unnecessary.
Besides encouraging you to participate in exploitative and/or illegal actions, consumer credit scams may also collect your information under false pretenses to commit identity theft. If you do decide to pay for any kind of credit service, it is of utmost importance that you do your research to make sure the company is legitimate.
Keep oldest accounts open
Even if you don’t use them anymore, it’s a good idea to keep your oldest credit card accounts open. This will help your credit score by increasing the average age of your accounts, as well as increasing your amount of available credit.
Look into debt consolidation
Consider consolidating your debts if you have difficulty paying your bills on time. Debt consolidation can help lower the total amount of your monthly payments and simplify your debts by consolidating them into one monthly payment. There are various approaches to debt consolidation so make sure you do your due diligence and research the matter thoroughly before taking this step. As with other credit-related services, there are fraudulent debt consolidation companies out there, so be careful.
Keep balances in check
You know that carrying high balances is a no-no. But exactly how low should your balances be? Well, credit experts recommend that your balances not exceed 10-30% of your total credit limit. If you have several cards with balances, pay down the card that’s closest to reaching the credit limit first. Keep in mind however, what’s best for your credit score isn’t always what’s best for you. If you’re carrying a balance on a credit card with a much higher APR than the rest of your cards, it may be in your best interest to pay down the card with the highest APR first.
Choose which payment to miss
If you absolutely must miss a payment, choose carefully. Missing an auto loan or mortgage payment will hurt your credit more than skipping a credit card payment will.
Protect your identity
We can’t stress enough the importance of protecting your identity, as identity theft can have devastating effects on your credit score. The Federal Trade Commission (FTC) recommends the following tips in order to minimize your risk of identity theft:
FICO High Achievers are people who have a FICO score of 760 or higher. The following are characteristics of these High Achievers, as reported by consumers who received the information in their myFICO credit reports.
Length of Credit History:
Types of Credit Used:
In this section you may find resources including sample letter templates to address credit score problems as well as important credit repair-related contact information.
TransUnion: Mail | Online
P.O. Box 105169
Atlanta, GA 30348
P.O. Box 9554
Allen, TX 75013
P.O. Box 6790
Fullerton, CA 92834
Federal Trade Commission*
600 Pennsylvania Ave. NW
Washington DC 20580
*Note: While they may be able to give you useful advice, the FTC does not resolve individual credit complaints.[/nextpage]