Your credit score is one of the most important numbers in your life. It signals to the financial world how reliable you are. Post high marks and lenders will vie to loan you money at the best rates. Make some mistakes – such as paying bills late or not at all — and you can expect to pay thousands or even tens of thousands of dollars in additional borrowing costs. And if you fail the test with chronic late payments or bankruptcies, you might not be able to borrow at all.
Nearly 40 percent of U.S. consumers are graded “exceptional” or “very dependable” by Fair Isaac Corp. (FICO), the largest provider of credit scores. But don’t worry if you are not part of this group. You can improve your credit score over time – although doing so requires discipline and focus. We will walk you through the calculus behind credit scores and show you some strategies for improving and maintaining your score.
How Your Actions Ding Your Credit Score
You may wonder how much impact your actions will have on your credit score. Below you can see some of the most common scenarios you will encounter and how they would affect your score.
Shopping for a Mortgage
Drops your score by about 20 points for a few months because the “hard inquiries” for more credit signal more borrowing.
If you need a home loan, you should still shop for mortgages, and in the long run the money you save should matter more than the temporary hit to your credit. Cluster these inquiries in a short time span — two or three weeks, says Financial writer Lita Epstein, author of The Complete Idiot’s Guide to Improving Your Credit Score. FICO interprets multiple inquiries for one type of credit in a short time as just one span.
Applying for New Credit Accounts
Dings your score because you’ve suddenly added to your borrowing capacity.
If you’re planning a major purchase and you’re on the credit score cusp, don’t open new credit cards or even buy a new phone for about six months before you apply for the big-ticket loan.
Closing an Old Credit Card Account You No Longer Use
Lowers your score because your credit history looks shorter.
Maybe you have an old credit card that you don’t use because it doesn’t dish out the flashy rewards offered by newer cards. It’s fine to put the card in the back of your wallet, but don’t cut it up, Epstein says. Instead, use the card once a year so you can keep the account open. Intriguingly, VantageScore says closing an old account has no effect. “Closing accounts will not result in a reduction in your credit scores as a result of the loss of the value of the account’s age,” the company says on its website.
Filing for Bankruptcy
Your score will plummet to 400 after a bankruptcy, Epstein says.
Within six months of filing for a Chapter 7 bankruptcy, expect to start receiving offers for secured credit cards, which require a cash deposit. “They usually cost a lot, but they can be used to re-establish credit,” Epstein says. “If you pay on time, you can get a regular credit card in six months to a year.” With diligence, you can boost your score back up into the 600s in two years.
Losing Your Home to Foreclosure
Your score will plummet to the 400s after a foreclosure, Epstein says.
If you can’t avoid foreclosure, you’ll face a long slog to rebuild your credit score. The good news is that as time passes, the bad event will recede into the background of your credit history. To rehabilitate your credit score, stay current on any other credit accounts you have.
Carrying a High Balance on Your Credit Card
Dings your score because you appear risky. Credit-scoring models like to see you use no more than 10 percent to 20 percent of your available credit.
Say you have two credit cards, each with a $10,000 limit, and you need to spend $3,000 this month. You could spread the charges over the two cards. Or, Epstein says, you could load up one card but pay your bill early. That way, you get the protections and rewards of using your card, but you make the balance disappear before the credit bureaus get a glimpse of it.
Missing a Payment
Lowers your score because payment history is the most important part of the credit-scoring calculation.
Contact your lender immediately. If you have a good track record, the lender might not report the infraction. Or, if you have a hardship such as medical bills, a divorce, or a job loss, the lender might work with you. Mortgage lenders can cut you a break by tacking a payment onto the end of the loan, Epstein says.
Credit Score Basics
In an era of mass lending, credit scores give lenders a quick-and-easy way to determine how much risk you pose. As you go about your daily business as a modern consumer, you are creating and reinforcing a credit history, whether you know it or not.
FICO by the Numbers
Fair Isaac Corp.’s FICO score is the main metric used by lenders. Fair Isaac says 90% of banks, credit card issuers and auto lenders rely on FICO Credit Scores.
The FICO score scale ranges from300 to 850
Qualifying for the best mortgage rate can require a score of: 740
Average Credit Score in the U.S.:695
The best deals on auto loans go to borrowers with scores higher than:720
Experian, Equifax and TransUnion, the three main credit reporting agencies, track a variety of transactions, including student loans, credit cards, car loans, mortgages and medical payments. Your credit history shows whether you’ve paid on time and, in the case of credit cards and other lines of credit, how much of your available credit you use. This history also compiles bankruptcies, foreclosures and legal judgments. Credit score providers use software to analyze your credit history and generate a credit score. The three credit reporting agencies created a competitor to the FICO score known as the VantageScore. It, too, grades consumers on a scale of 300 to 850.
How to Review Your Credit
It might seem a bit unfair that lenders all know your credit score whjle that same number can be a mystery to you. Fortunately for consumers, credit scores and how they are calculated are becoming a bit more transparent. For instance, many credit card issuers now tell you your FICO score for free as part of their normal services. If you have a credit card with one of these companies, problem solved.
Meanwhile, you can get VantageScores for free from six sources:
You can use these sites to check your credit score, and to monitor how it changes over time. Or you could pay FICO for access to your score. The company’s myFICO.com site will reveal your score; prices start at $19.95 a month.
If your score seems low, it’s time to examine the credit reports that are used to create your score. The reports are lists of what you’ve paid and when.
You can get a free credit reports from each credit reporting agency once a year at www.AnnualCreditReport.com. Financial writer Epstein suggests spacing out your requests to see your reports throughout the year so that you get the reports for free but look at a different time period from each bureau. Start by examining the names and addresses on your report. “If there’s anything you do not recognize, it’s possible that your credit report is tied to someone else’s,” Epstein says. Then check to make sure that everything on your report is being reported accurately. If you have accounts you don’t recognize, it could be a sign of fraud.
If you find mistakes on your credit report, tell the credit reporting company and the lender that provided the information to the credit agency, in writing, what information you think is inaccurate. The Federal Trade Commission offers sample dispute letters that consumers can use as templates. If you file your dispute by mail, include copies, not originals, of documents that support your position. Enclose a copy of your report with the items in dispute circled. Send your letter by certified mail, “return receipt requested,” so you can document what the credit reporting company received. Keep copies of your dispute letter. Credit reporting companies must investigate the items in question — usually within 30 days — unless they consider your dispute frivolous. While the FTC suggests filing complaints by mail, the three credit reporting agencies urge consumers to file disputes online.Additional Resources on How to Investigate Your Credit Score:
Tackle the Root of the Problem
Once you know your score is accurate, it’s time to get to the root of the problem. Why is your score low? If you are making payments late or not at all, are you struggling with matching your income and your cash outflow?
Budgeting If you’re living beyond your means, it’s time to take charge of your financial life. Start by tracking your expenses so you can figure out where your money goes. Financial experts suggest writing down every expense for a week, or a month. The results could be eye-opening. Or, if that’s too tedious a task, use a budgeting website such as Mint.com. Then figure out what’s going wrong. Are you spending too much on lattes and cocktails? Is there a way to create some room in your budget by cutting expenses, or by earning more? Budgeting is especially important if you’ve lost your job or gone through a divorce, two prime reasons consumers run into financial trouble. If either scenario applies to you, it’s important to rein in your spending immediately, rather than waiting for your finances to spiral out of control.
Managing Your Bills Maybe you can afford to pay your bills, but you’re just disorganized. If you’re juggling responsibilities, it can be a challenge to remember to mail every check every month, or to go online and make your payment. To avoid late payments, automate your responsibilities as much as possible. Mortgage lenders, auto lenders, credit card companies, utilities and mobile phone companies allow you to have your monthly balance automatically withdrawn from a checking account. This set-it-and-forget-it plan lets you put your payments on autopilot.
Negotiating With Creditors
If you run into trouble, contact your creditors immediately, Epstein says. Perhaps you simply forgot to make a monthly payment or were caught in a relocation that disrupted delivery of mail, including bills. If that’s the case, and if you’ve been a reliable borrower in the past, your creditor is likely to give you a pass without reporting the transgression to the credit bureaus. If the problem is more serious – if you’ve lost your job or face a costly divorce – contact your creditors immediately. “Tell them the truth,” Epstein says. “Let them know what’s going on, and see if they’ll work with you. Sometimes they’ll agree to add the amount due onto the end of the loan. You’ll still have to pay it, but that could get you through.” If you face medical bills, contact the hospital. “There’s a possibility you could work out a payment plan so you don’t have to put it on your credit card,” Epstein says. The payment plan can stay out of your credit history. And if your situation has deteriorated, contact a branch of the nonprofit Consumer Credit Counseling Service. These debt counselors can negotiate on your behalf with creditors, and perhaps persuade your credit card issuer to reduce your interest rate to zero.
Not All Credit Scores Are the Same
The FICO score remains the king of the credit world, but the upstart VantageScore aims to gain traction. Both scores rely on the same credit histories for their raw data, but each uses a slightly different formula to arrive at a final score. FICO breaks down its scoring this way:
VantageScore weighs your credit this way:
Meanwhile, it’s important to know that there’s not a single FICO score. The New York Times reports that there are nearly 50 different versions of the FICO score, with distinct versions used by mortgage lenders, auto lenders and credit card issuers.
9 Common Credit Score Mistakes
Payment history is the biggest ingredient of your score; it’s 35 percent of FICO’s formula, 40 percent of VantageScore’s.
If you owe more than $2,000 on your credit card with a $10,000 limit, FICO sees a red flag.
The length of your credit history is 15 percent of your FICO score, and ending an old account might remove an impressive track record.
Credit scores reward responsible use of credit – while punishing an absence of credit.
Shopping mortgage rates with three lenders in a week is no big deal, but shopping mortgage rates once a month will take a toll.
Either devastates your credit score. However, don’t avoid bankruptcy or strategic foreclosure simply for credit score reasons — just understand both result in heavy credit score damage.
Once your FICO score rises above 760, relax. There’s not much benefit in pushing it higher.
Ignorance isn’t bliss – it could cost you thousands of dollars.
Expect to get slapped each time you open a new line of credit, even if it’s just for a store credit card with a low limit.
Why Good Credit Matters
Say you’re buying a new car and you want to borrow $20,000 for five years. Your FICO score will determine how much interest you pay. Here’s how the rates broke down as of late November 2015, according to myFICO, the consumer calculator provided by Fair Isaac:$20,000 Auto Loan
|Annual Percentage Rate (APR)||3.27%||4.58%||6.67%||9.36%||13.64%||14.75%|
|Total Interest Paid||$1,708||$2,416||$3,575||$5,121||$7,697||$8,393|
For mortgage borrowers, the FICO calculus is even more stark. The best rates go to buyers with near-perfect credit scores. Borrowers with scores below 620 are unlikely to be approved. These examples, provided by myFICO as of late November 2015, are based on a 30-year fixed-rate mortgage for $200,000 – and they show that a borrower with stellar credit would save nearly $100,000 in interest over the life of the loan compared to someone with spotty credit:$200,000 Mortgage
|Annual Percentage Rate (APR)||3.66%||3.88%||4.06%||4.27%||4.7%||5.25%|
|Total interest paid||$129,858||$138,941||$146,276||$155,251||$176,636||$197,631|
When Credit Counts
Mortgages and car loans are the most obvious items affected by your credit score, but there are many other ways you can take a hit if you don’t have a decent score:
Finding a job
If an employer asks for your Social Security number during the application, chances are the company will run a credit check. A low score might mean no offer.
Getting a personal loan
As with private student loans, lenders check your credit. A low score means a higher rate or no loan at all.
Many carriers base premiums in part on your credit score.
Getting a phone
Mobile phone carriers want to know that you’ll make your monthly payments.
Renting an apartment or house
Nearly every landlord will check your credit before letting you sign a lease.
Renting a car
Don’t have a credit card? Good luck persuading a rental agency to loan you a vehicle.
Getting a private student loan
Lenders check your credit score before extending credit.