What Your Credit Score Means and How You Can Improve It
November 16, 2016
Your credit score is one of the most important parts of your financial identity. A bad score can prevent you from buying the home of your dreams, saddle you with tens of thousands of dollars in additional interest expense over your lifetime, keep you from being hired for the job you want, or prevent you from being approved for a life insurance policy. On the other hand, a good score can open many doors and with smart debt management, help you live a happier life.
What you need to know is how to keep or get a good credit score; but before that, you need to know what a credit score looks like and what it means.
Your credit score is a number between 0 and 850 that banks and credit card companies use to determine how likely it is that you’re going to repay a loan on time and in full. The higher your score, the more confident lenders are that you’re a good risk and the lower your score the higher the risk they might lose money on your loan. The lower the score, the greater the statistical likelihood that a lender is either going to fail to make the profit they expect or, worse yet, lose money.
You may have heard of your “FICO” score. This is another term for your credit score. It’s an acronym for the first company to compile consumer credit scores back in the 1950s, when credit cards started to become popular. It’s the Fair, Isaac & Company, based in California and named not for its “fairness” or any Biblical connection, but after its founders, William Fair, a mathematician, and Earl Isaac, an electrical engineer.
Ten years ago, a competitor to the FICO score – the “VantageScore” (one word) was created jointly by the three major U.S. credit rating agencies (Equifax, Experian and TransUnion). Originally, it used a different scale, but has since been changed to be almost identical in number and meaning as the FICO score (although there are some differences in the data they use and how heavily they weigh certain negative factors, like late payments).
How Credit Score is Broken Down
The table below gives you a rough idea as to how potential lenders view credit scores and their effects on your application for a loan and, if you’re approved, the interest rate you’ll have to pay on mortgage:
|What It Means
|No Credit Established
|You haven’t established any credit history yet, and won’t be approved for a mortgage.
|You’ve done a very bad job repaying your loans and may have what lenders fear is too much credit available compared to your income. Some experts say a score of 500 is the absolute minimum to be approved for a mortgage. If so, you’re likely to be saddled with an extremely high “sub-prime” interest rate.
|You’ve shown some serious problems with making payments. If approved for a mortgage, you’ll pay 2 to 4 points above the best interest rates.
|You’ve been late with payments a number of times and may have maxed out on some credit cards. Your mortgage interest rate may be 1.5 points above the lowest available.
|You’ve been fairly punctual with your payments, but your record shows a few problems. You are very likely to be approved for a mortgage, and the rate may be up to a half a point (0.5%) above the best available.
|You have very few blemishes on your payment record and have enough or more than enough income to handle your debt burden. You may be offered an interest rate just one-quarter point (0.25) above the lowest available.
|You have a perfect or nearly perfect payment history and plenty of income to take on additional debt. You are likely to be offered the lowest mortgage interest rate available.
Where are you on this scale? As of April 2015, the average FICO score was 695, at the upper end of the “Good” range. About 22% of Americans had scores below 600, 23% were between 600 and 699, and 55% were at 700 or higher. Not where you want to be? Here’s what you need to do:
How to Improve Credit Score
1) Check your credit report for errors. Get a copy of your reports from the three major credit bureaus and dispute any errors. Removing them is one of the fastest ways to boost your score.
2) Pay on time. How you fare against your payment due dates is the single biggest factor – 35% – in determining your credit score. One way to help: set up payment reminders or automate payments them to be made out of a bank account. But if you’re having trouble keeping up with your payments, seek help from a legitimate credit counselor to negotiating with your lenders for lower payments; it won’t raise your credit score quickly – and it won’t hurt it, either – but resuming timely payments will pay off over time.
3) Manage your debt to income ratio. How much you owe, compared to your income, accounts for 30% of your credit score. Ideally, required mortgage debt payments shouldn’t exceed 28% of your gross monthly income, and your total debt payments shouldn’t add more than another 8%. Combined debt payments above 43% of your gross monthly income puts you in high-risk territory. Look for ways to make higher payments, either by cutting expenses or dipping into savings.
4) Stay well under your credit limits. Maxing out one or more credit cards will pull your score down. Keeping your use on each card or line of credit below 30% of the limit is recommended by most credit counselors, and around 10% is stellar. Asking a creditor to raise your limit can help, but not if it puts you outside the desired debt to income ratio.
5) Pay down debt instead of shifting it to another creditor. If you have relatively small balances on a number of credit card accounts, pay them down rather than consolidating them with another credit card and closing them. Having the same amount of debt but to fewer lenders can actually lower your score.
6) Avoid closing unused credit card accounts. Your credit score will go down if you do this, because your successful repayment history will come off your credit history.
7) Use different types of credit. You can bump up your score a bit by taking out a small personal loan from a credit union or buy a piece of furniture or appliance on an installment loan – as long as you are sure you can make the payments on time.
8) For a new loan – like for a new car – keep your rate shopping with a very short period of time. Each credit inquiry from a new lender lowers you credit score, but not as much if they’re all within the space of a few days.