Want a Better Credit Score?
Your credit score gets checked a lot more often than you realize. In today's world, employers are checking new hires' credit scores before signing them onboard and landlords regularly check potential tenant's scores before allowing them to sign a lease. A low score can prevent you from buying a car, applying for a new credit card, or even buying a house. Even if you can buy these things, a low score can cause you to pay a higher interest rate which can add hundreds (or, in the case of a house, tens of thousands) of dollars to the eventual cost of the item. It's like you're paying two or three times as much for the item than the price advertised!
But, having a poor credit score isn't the end of the world and it isn't something you need to live with forever. While improving your credit score isn't a quick fix, it can be done over time when you use the right tools and develop the right spending habits.
So, here's the basics of how your credit score works, how your score ranks with others' scores, and how you can improve your score over time. Remember, ignorance is expensive so let's get you educated and empowered!
Credit Score Basics
Before you can improve your credit score, it's a good idea to understand where it comes from. A credit score is a number that represents (based on your past payment history and other criteria) the likelihood that you'll pay back your debts. Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending you money. Using credit scores, they determine if you qualify for a loan, at what interest rate, and how much credit they're willing to extend to you.
Here are the five different things credit agencies look at when they're calculating your credit score:
15% Length of credit history - As your credit history ages, it can have a positive impact on your FICO (credit) score. The longer you've had credit accounts available and open, the better. Never close accounts you have if they've been open a long time. Use them once in a while just to keep them active.
10% Recent searches for credit and/or amount of credit obtained recently – When you try to open a lot of credit lines in a short period of time like credit cards, retail store accounts, and personal loans, it can hurt your score. It's viewed as risky behavior because it looks like you may be hard up for cash and will run the account balances up quickly once you get them. The exception to this is when you're shopping for a mortgage or auto loan. Frequent credit inquiries like these over a short period of time probably won't hurt your scores since it's expected for these types of transactions.
10% Types of Credit Used – Not many people realize that there are different types of credit that go into calculating their credit score. These include installment loans like mortgages, revolving debts like credit cards, and consumer finance loans like car notes. Lenders like to see a variety of credit types on your credit report because it shows you have a history of managing different types of credit instead of being a one-trick-pony who only has credit cards.
35% Payment History - This is the biggest part of your credit score and the most important piece you can have control over. Late payment of bills, such as mortgages, credit cards, or automobile loans, can cause your score to drop ... FAST! Paying your bills on time and as agreed over time is one of the fastest and best ways you can improve your credit score.
30% Credit Utilization - The second largest impact you can have on your credit score is the ratio of how much credit you have available to how much you're actually using. You can improve your credit score by paying off debt and lowering your (utilization) ratio. As I mentioned earlier, closing your existing accounts will almost always result in your score dropping since you have less credit available compared to the amount you're using.
How Do You Rank?
How good is your credit score compared to other people? Here's a quick chart showing the five different credit score levels you can have.
For those in the poor category, it can often be impossible for them to get any form of credit. If they can get someone to extend them credit, it often comes with a high interest rate and exorbitant fees. Many people who find themselves in this category are forced to use cash advance outlets as their main form of credit and struggle to dig themselves out of debt.
For those with fair credit, it often still difficult to get any form of mainstream credit cards. They're often still stuck with cards with high interest rates and exorbitant fees. Sometimes, however, they can get decent secured credit cards (see below) which can help them build their credit.
If you find yourself with good and very good credit, you can usually obtain new lines of credit without much difficulty and the interest rates you pay will be much lower than those with poor or fair credit scores. In fact, you'll probably find yourself bombarded by credit card offers in the mail weekly as lenders seek to gain you as a valuable, financially responsible customer.
If you have exceptional credit, congratulations! You're the top dog when it comes to credit scores. You'll pay the lowest interest rates of any category and the trust lenders put in your ability to pay will often allow you to negotiate your interest rate, payment terms, and other perks!
So, What Does a Perfect Credit Score Look Like?
A lot of people wonder what a perfect credit score looks like. Here's the 'Holy Grail' of credit scores.
- You have ten or more open lines of credit which include at least three credit types.
- Those lines of credit have been open for at least five years each.
- You're using less than 10% of your total available credit.
- You've had zero credit inquiries within the past year.
- You've had zero late payments within the past seven years.
- You have zero collections, tax liens, bankruptcies, and/or judgments.
What are Some of the Best Ways to Improve Your Credit Score
So, now that you know what you need to shoot for, how do you get there? Well, here are some of the best things you can work on to improve your credit score.
First, one good opportunity people with poor credit have to improve their score is through the use of secured credit cards. These lines of credit act as normal credit cards except that how much credit they offer is tied to a deposit (a.k.a. collateral). Usually, once the card has been active for a period of time (usually 1-2 years), it can be converted to a regular unsecured credit card after the cardholder's credit score has improved enough.
What if you're thinking about buying a home? Well, your options are extremely limited but you do still have a few routes you can take. One is by getting a land contract. This is when you arrange for a portion of your rent payments to go toward the purchase of the home. After a set period of time (usually two to three years), you can go to a mortgage company with your proof of on-time rent payments and get a mortgage on the home, transferring it to your ownership. If done right, it can be a great way to purchase a home when you have bad credit. But be very, very careful when it comes time to draft the contract with the owner. I had a client who got burned with one when their landlord (who they had a land contract with) didn't give them receipts for their rent payments for over two years since they preferred to pay him in cash. When it came time for them to apply for a mortgage, they couldn't find any mortgage company to work with since they didn't have proof that they'd paid their rent on time for the past two years. Although they're now paying by check each month and creating that paper trail, they have to wait for another two years to get the proof they need for the mortgage company.
Thinking about buying a car? Did you know that those big new car lots actually have two lots? One for those with good credit and one for those with … let's say less than perfect credit. When you go in and see all those fabulous new cars with the incredibly low monthly payment offers … well, unfortunately, they're not going to be offered to you. Once the salesman checks your credit and finds out what you can pay monthly, he'll walk you around the building to the pre-owned (a.k.a. used) car lot. These cars have a good amount of mileage and wear and tear on them and you'll be paying a higher monthly payment with a lot higher interest rate. Unless you're willing to pay cash for one of the newer cars, you'll probably be stuck with this situation at least until you can improve your score. On the plus side, the bigger car dealerships report to all three credit agencies and, as long as you make your payments on time, you'll be improving your credit score over time.
One last thing about cars. Thinking about shopping at a Buy Here-Pay Here car lot? Before you do, make sure that they report to all three credit bureaus and that they don't have any complaints against them with the Better Business Bureau. If they don't report to the credit bureaus or have a bad reputation, keep looking. A legitimate business will still want you as a customer if you have bad credit. It'll just cost you more money in the short term to deal with them.
The Four Rules of Credit Score Improvement
What it boils down to is following these four rules:
- Pay your bills on time by using automated payment tools and due date alerts. You can set up automated payments for most of your bills either directly through your lender or through your bank. As they say, out of sight, out of mind. It's hard to forget to pay your bills on time when they're getting paid on time every month this way. If there's a bill you aren't able to automate a payment for, set up a monthly reminder on your phone to let you know that your payment is coming up.
- Keep your utilization low. Only use your credit cards once a month by filling up the gas tank or buying groceries. This will keep them active while also keeping the balances low. Then, when the bill comes due every month, pay it in full. This way it won't be a burden and you'll avoid paying interest on an outstanding balance.
- Apply for new credit sparingly. More isn't always better. Remember, each time you apply for new credit, your score gets dinged and it takes a while for your score to rebound. Once you get one or two credit cards in your wallet that have the options and rewards you need while avoiding high fees and interest rates, stop applying for more.
- Be patient. Time heals all wounds. It probably took a while for you to get into the credit troubles you're in now and they aren't going to disappear tomorrow. Repairing your credit score is going to take some time but if you follow these rules, you'll be on track to having a much better credit score within a year or two.
What to Do If you have a Good, Very Good, or Exceptional Credit Score
If you already have an above average credit score, good for you! You're probably already financially stable and on the way to financial independence. Keep up the good work by following the above four rules for improving your credit score (They actually apply to everyone, not just those with poor credit scores.) and you'll see your score improve over time as well.
Having a low credit score is something that happens to most people when they're just not paying attention to their spending habits on a daily basis. They probably didn't wake up one day and say to themselves “Wow! Today is the day I screw up my credit score!”
Developing good spending habits by creating a monthly budget you can live with is one of the best steps you can take to prevent yourself from falling into the debt trap and to get out of it if you're already there. We have a great budgeting tool you can use to help you stay on track financially while living a life that doesn't feel like you're unable to spend money on the things that matter most to you.
Remember, having a good credit score isn't just something you stumble into. It requires focus, patience, and the will to see the job through. But if you're willing to put in the work, the rewards can be amazing!