Credit scores are important, and can be improved. Image: Flickr / pyxopatamus / CC-BY-SA

A credit score is a number intended to indicate how risky a financial gamble a person may be. There are three big credit reporting agencies in the United States, and each one reports its own score. There are numerous factors that affect your credit score, and you can control your credit score by taking specific actions.

The history of credit scores

Credit score reporting, in its current form, has been around since 1841. Store owner Lewis Tappan started keeping files on customers and their payment history. Tappan hired thousands of correspondents to report on the credit worthiness of individuals in their communities. These reports on individuals soon had hundreds of customers, and the modern credit reporting system was born.

How credit scores are used

Credit scores were originally intended for informing decisions about extending credit to customers. Credit scores are used much more extensively now. Many lenders check credit reports on individuals applying for a credit card or loan. Landlords, potential employers and insurers may run credit reports in order to inform their decisions. There is controversy over the use of credit scores to make decisions that do not deal directly with the issuing of credit or providing of financial services, but the practice is legal and widespread.

What goes into a credit score

Each of the three credit reporting agencies has a different formula for creating a single credit score. The FICO score, developed by the Fair Isaac Corporation, is the most widely used measure of credit in the United States. The general information included in these reports has been determined to be:

• 35 percent payment history – how often you make payments on time
• 30 percent debt – what type of debt and how much debt you have
• 15 percent length of credit history – how long you have used credit
• 10 percent credit diversity – how many different types of credit you make use of
• 10 percent hard inquires – when a creditor checks your credit report

Defining good credit

The FICO credit score ranges from 300 to 850. What is considered a good credit score depends on the creditor doing the checking. However, the relative risk factor associated with each score can be estimated. In general:

• A FICO score of 770 to 850 is considered “choice”
• A FICO score of 710 to 770 is considered “good”
• A FICO score of 600 to 710 is “average” or “medium” credit
• A FICO score below 600 is considered “bad” credit or “high risk”

Taking control of your credit score

The federal government mandates that every credit reporting agency provide a free copy of its credit report on an individual once a year. These free federal reports generally do not include the numerical credit score, but they do include all the information on your report. The government-supported AnnualCreditReport.com provides access to these free reports. There are also numerous services that provide a “free” copy of a credit report in exchange for subscription to services. Once you have a copy of your credit report, check it for accuracy. Credit report errors must be disputed in writing, with a copy of any relevant documents included. The agency has 30 days to investigate the dispute and inform you of the outcome.

Improving your credit score

Once you determine the information on your credit report is accurate, you can improve your credit score by taking a few simple steps. First, pay your bills on time. Second, take a close look at the debt you are carrying and how it is being used. If your credit card balances are close to their limit, pay down that debt. You should also try to keep your debt to income ratio – the ratio that compares your total monthly debt payments to your total monthly income – below 30 percent. For an income of $2,000 per month, a 30 percent debt-to-income ratio is $600. Rebuilding your credit really is simple – make payments on what you owe on time and in full. Once you are doing that, it simply takes time.

Sources

MyFICO.com
PBS.org
FTC.gov
Investopedia
CreditScoring.com

These days, it seems like you need your credit score for just about everything, whether it’s a mortgage or a car loan, or even a seemingly unrelated purchase, like utility service or a new cell phone plan. But this magic three-digit number doesn’t just affect your ability to get these loans or services – it also impacts how much you pay for them. If your score is low, you’ll pay more in interest rates and fees than someone with a higher score.

Three easy steps to a higher credit score

Even if you’ve made mistakes in the past, you can start improving your credit score today by taking these three easy steps.

1. Make your payments on time. As much as 35% of your credit score is determined by your history of past payments, so it’s the first thing you should look at if you need to improve your score. Fortunately, this is an easy problem to correct. Most lenders offer automatic payment programs that will simply deduct an amount you specify – either the minimum payment or a larger amount – on the credit’s payment due date. These programs can be extremely helpful if you find yourself missing your payment deadlines consistently, as they take all the work out of the equation for you.

In addition, paying on time has another exciting advantage – saving you money. Although late payments aren’t typically noted on your credit report unless they’re 30 days or more late, your lenders may increase your interest rates substantially if you’re even one day late. Enrolling in an automatic payment program will help keep your interest rates in check, meaning that you’ll save money over the life of the debt.
2. Pay down your account balances.  Another major factor in determining your credit score is what’s known as your credit utilization rate – basically, the balances you carry versus the credit lines you’ve been extended. For example, if you have one credit card with a $10,000 line of credit and you carry a $2,000 balance on it, you have a utilization rate of 20%.

This rate – which accounts for roughly 30% of your credit score – shows lenders how much you’ve extended yourself. A high utilization rate, for example, tells lenders that you may not be able to cover all of your monthly payment obligations should your income change unexpectedly, making them more reticent to offer you additional credit. For this reason, most financial gurus recommend maintaining a utilization rate of no more than 35%. If your rate is higher than this, do your best to pay down your balances until your rate reaches 35% or less and you’ll see a dramatic change in your credit score.

3. Maintain a balanced debt portfolio. When investing, you don’t want to put all of your eggs in one basket, and the same is true for your debt portfolio. Factors like the length of your credit history and the types of credit you’ve been extended also have an impact on your overall credit score. Lenders like to see that you’ve successfully managed your debt for a long period of time and that you’ve managed to balance several different kinds of debt – such as mortgages, auto loans, student loans and credit cards.

To score points in this area, keep your accounts open as long as possible, even if you’ve paid them off entirely. Closing your older accounts will shorten the length of your credit history, bringing down your score by a few points. In addition, it’s a good idea to maintain a few different types of credit (depending on your situation), as well as credit cards from more than one major lender (such as Visa, Mastercard or Discover) to demonstrate to potential lenders that you’re capable of managing several different kinds of debt.

We’re in the middle of a credit crunch, and getting an installment loan – whether it’s an auto loan, a home loan, or a personal loan – requires better credit than ever before. Creditors have their guards up and lending standards are becoming increasingly strict.

The most common credit-scoring model used by lenders is the FICO score. The FICO model (originally Fair Isaac) was established in 1956 by an engineer named Bill Fair and a mathematician named Earl Isaac. A FICO score can range from a very risky 200 to a perfect 900.

In a recent CNNMoney.com report, John Ulzheimer, president of consumer education at Credit.com, stated that FICO requirements are on the rise: “You need a 750 or better today to have the same treatment you got with a 700 two years ago,” he says. John D’Onofrio, CEO of Autoloandaily.com, concurred: “Two years ago a 680 was enough to get a great car loan rate. Today it’s often the minimum to qualify at all.”

How to maximize your FICO score

If you’re thinking of borrowing money (other than hard money loans like small payday loans or emergency cash loans that don’t require credit checks) you need to do everything you can to boost your FICO score before you apply. Here are some things you can do to maximize your credit score:

Find your score

You can get free estimates of your credit score at any number of websites (like Creditkarma.com). But if you’re serious about getting an installment loan on the best available terms, you need to see what your lender will see. Lenders will be looking at your actual FICO score, based on credit reports from three credit bureaus: Experian, Equifax, and TransUnion. To get a better sense of what lenders will actually see, for a small fee you can get one representative FICO score at myfico.com.

Look for mistakes

According to a Zogby International poll, one-third of people who pull their credit reports find errors, so check yours closely. When you get your FICO score at myfico.com, you’ll get a copy of the report it was based on. You’re entitled to one free report from each of the three credit bureaus every 12 months. So once you have your score and the report it was based on, you can get the other two reports for free at annualcreditreport.com

If you find errors, request corrections, following the instructions on each credit bureau’s website. Inaccurate delinquent marks are common. Fixing just one of those can improve your FICO score dramatically.

Never be late on payments

Your payment history is the most important part of your credit score. Lenders can’t report late payments to the bureaus until they’re 30 days past due. But keep track of your payment due dates and take precautions not to be late at all.

If you know you can’t pay a bill on time, think about getting a quick payday loan to pay the bill. If you will be able to get by on your next paycheck after paying the loan back, a cash advance can save your credit score, but don’t let payday loans become a habit. If you make a late payment, getting right back on track will eventually improve your score, but if you fall more than 30 days behind, the damage to your FICO score can haunt you for years.

Don’t use more than 20% of your total available credit

Another important factor in calculating your score is how much you owe compared to how much credit is available to you. According to Ulzheimer, 10% is ideal, but a ratio as high as 20% is acceptable. Unfortunately, banks are scurrying right now to raise interest rates before new regulations go into effect (read Credit Card Company Comeuppance), and they’re also rushing to lower credit limits and cancel unused accounts, all of which make it more difficult to maintain an ideal ratio.

Be aware of the limits on your credit accounts, watch closely for changes on your monthly statements, and don’t use more than 20% of your available credit on any card or in total. If you’re thinking about getting a home or auto loan, try to reduce your account balances even farther before you apply.  If you’re working to pay down your debts before applying for new credit, remember that it may take a couple of months before reduced balances will appear on your credit report.

Preserve old accounts

A long credit history without late payments is the most important part of your FICO score. Closing old accounts not only increases your credit utilization ratio, it shortens your credit history.  So don’t cancel your oldest cards. You can avoid having lenders close old accounts by transferring recurring charges to them from the accounts you use more regularly.

Don’t try to out-smart the credit bureaus

Other, less important factors are involved in calculating your FICO score, but they are more difficult to manipulate. For example, part of your score is based on your mix of credit types, such as mortgages, car loans, and credit cards. But don’t buy a car or apply for new credit cards just to boost your score. The effects of new credit on a FICO score are complicated, and it is much easier to improve your score by carefully tending a few long-standing credit accounts and making your payments on time.

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