A credit score is a statistic used by financial institutions and lenders to measure your ability to manage debt and estimate the probability of you repaying a loan. These two factors combined are a strong indicator of your creditworthiness. Your creditworthiness is analyzed by reviewing your credit history; you receive a three-digit score based on that evaluation.
While there are quite a few credit-scoring systems, the FICO score is the most commonly used one. FICO stands for the Fair Isaac Corporation, the institution that came up with the scoring model. The FICO score ranges from 300-850, and a higher score indicates that you are more trustworthy financially.
Why is your credit score important?
Your credit score is an important overall metric that allows lenders to categorize you in terms of financial risk amongst a pool of other borrowers in the financial system. Your credit score is primarily based on your payment history and ability to manage credit responsibly. It is considered that past record is the most reliable precursor of future behavior, and a good credit history helps convince lending institutions that you are creditworthy and safe to be extended a line of credit.
This means that a credit score plays an important role in managing your personal finances. You may not be considered eligible for loans with a low credit score because banks perceive you to be a risky borrower. Borrowers with a score of less than 640 are categorized as “subprime borrowers” on FICO, for instance. On the other hand, you may find yourself in the position to negotiate favorable interest rates and terms with the help of a high credit score. Your chances of getting a big loan approved become higher and insurance premiums may be low as well. You can even get a new phone on a contract without having to pay a security deposit.
How is your credit score calculated?
Your credit score is calculated by applying an algorithm to information from one of the credit reports compiled by each of the three credit agencies: Experian, TransUnion, and Equifax. Though there is no uniform way of calculating credit scores, most algorithms used by various lenders are based on similar factors. These factors include the types of credit accounts you have, the current balance and duration of these accounts, how much revolving credit you use, payment history, and how frequently you apply for new credit.
The rule of thumb is that factors that make your score in one credit scoring model go up or down usually impact the score in other models in a similar fashion – they may just vary on the degree of impact.
Certain credit score factors have a prominent weighting in comparison to other factors. Payment history and credit utilization rates can collectively represent nearly 70% of your credit score.
So if you have seen your credit score recently and are worried that it is too low, fear not. By persistently working towards improving the factors that are most detrimental to your score, you can make steady increases to your credit score.
The following are the 10 actions that you must focus on to improve your credit score:
1. Review your credit report and check for errors.
You are entitled under federal law to a free credit report annually from all three credit reporting agencies, namely Experian, TransUnion, and Equifax. Your credit report contains financial information that determines your credit score and is used by lenders to measure your creditworthiness. This includes credit accounts, current balances, payment history, and potentially negative items. You can also get your credit score without having to pay using an existing credit card account. Bank of America, Citi, HSBC, and American Express are a few banks that provide free credit scores.
Checking your own credit score or credit report does not count as a hard inquiry (more on this, later) and has no impact on your credit score.
Check your credit report immediately for errors. Credit report errors are fairly common and definitely worth looking into. As per a 2012 report by the Federal Trade Commission, nearly 25% of Americans found errors in their credit report. If you find inaccuracies in your credit report, they can be reported to your lenders and the credit reporting agencies to be corrected or removed by a process called a dispute.
Credit report errors can reduce your credit score, the impact depending on the severity of the discrepancy. There can be minor errors, such an incorrect address or a misspelled name, that are easily verified and fixed. Then there are serious errors, such as fraudulent account activity or inaccurate account information. Serious errors like these can act as a red flag against you and stop you from getting a utility account, a new line of credit, mortgage, or even pose difficulty in getting a job.
As per studies, around 20% of consumers who had their credit reports corrected for an error reported an increase in their credit score and a subsequent movement to a lower credit risk tier.
2. Pay your bills on time.
Making timely payments to your lenders and creditors account for a significant portion of your credit score – 35% of your score in the FICO scoring model. Lenders typically want to know how reliably you pay your bills, and it is in your best interest to strengthen this scoring factor by paying the owed amount on your bills punctually every month.
To maintain a high credit score, do the following:
Set up payment reminders.
Make a note of your billing cycles and payment deadlines to avoid late payments. You can set up calendar reminders online or auto-payments to be debited from your bank account to facilitate on-time payments. Making payments on time consistently can increase your credit score in a few months.
Get current on missed payments and stay on course.
Though missed or late payments stay on your credit report for a while, their negative impact can be mitigated by cultivating the habit to pay your bills punctually. The longer the history of on-time payments, the higher your credit score goes.
Pay other monthly bills on time.
In addition to debt payment, there other bills that are typically not reported to credit bureaus, but whose late payment can affect your credit score. Non-payment of services, such as rent, utility, cable, cell phone, and internet bills can result in them being sent to collections. Bills being sent to collections will lower your credit score substantially.
Improve your credit utilization rate.
Credit scoring models often use your credit utilization rate to calculate your credit score. The credit utilization rate can comprise of 30% of your score, making it a very important credit scoring factor. Credit utilization is impacted directly by revolving credit — the amounts owed on credit cards that carry over (revolve) from month to month. Credit utilization rate is your currently used revolving credit divided by the total available credit limit. It is generally expressed as a percentage. High credit utilization might indicate to lenders that you have a tendency to overspend and have trouble managing your finances. Typically, a credit utilization rate of 30% and below is recommended by FICO. A low credit utilization rate indicates that you take on less credit for purchases and spend responsibly.
You can maintain a low credit utilization rate by doing the following:
- Paying out “maxed out” credit card bills first: If you have multiple credit cards and one is close to its credit limit, pay off that card on priority to lower your credit utilization rate and also avoid higher interest rates.
- Paying your credit card bills more than once in a billing cycle to reduce your revolving balance: Making payments every two weeks rather than once monthly will bring down your credit utilization rate and improve your credit score.
- Requesting your credit issuer to increase your credit limit: This allows you to stay within that 30% more easily.
4. Become an authorized user with a responsible cardholder.
Becoming an authorized user of a credit card offers you all the benefits of the credit system with none of the responsibility. Someone else makes payments on your spending, and your credit history improves. This sort of a one-sided arrangement works usually with a parent, spouse, a close relative, or a friend. It just takes a phone call from the cardholder to the credit issuer for you to be added as an authorized user.
There are benefits in addition to purchasing power: an increase in the credit limit available across all your credit card; increase in the duration of using credit; and an increase in the average age of your credit cards. A combination of these factors can increase your credit score by nearly 100 points.
It goes without saying that if either party, whether it is you or the cardholder, has a tendency to utilize credit irresponsibly, then both will end up with poor credit history.
5. Reduce debt and revolving balance.
Keep revolving balances down to a minimum. Having a credit balance that is close to your credit limit month after month will establish a pattern of high credit utilization. A consistently high credit utilization rate will drive down your credit score significantly.
The ideal thing to do would be to pay your credit card bills in full each month. That would reset your credit utilization rate to 0% every month. However, if you do not have the funds to nullify your debt every month-end, try to keep your carried-over balance as low as possible to reduce your credit utilization rate. As discussed before, FICO considers 30% to be a safe credit utilization rate.
For example, let’s say that you have a credit card with a limit of $10,000, and your credit balance is $6,000, which equates to a credit utilization rate of 60%. If you consistently maintain this balance over a few months, your credit score will fall because of the high rate of credit utilization. However, if you make payments of $1,600 every month without spending more on your credit card, your balance will reduce to $2,800 after two months. That will reduce your credit utilization rate to 28% – a much more acceptable rate for a higher credit score.
6. Don’t close unused credit cards.
A lot of consumers become apprehensive about credit card usage after getting spiraling debt under control. Getting their credit balance finally down to zero involves paying off debt and high interest imposed by the lending institution. This can naturally create a tendency to do away with the credit card with zero balance and close it down for good. Though this may seem like good common sense to you intuitively, it may not be the best course of action to improve your credit score.
A credit card with zero balance has a credit utilization rate of 0%. That is not going to change if you close the account. Your total available credit, however, will reduce. This can have an adverse effect on your credit utilization rate if you have revolving balances on other credit cards.
For example, say you have total credit of $20,000 available on two credit cards, with a credit limit of $10,000 on each. If the credit balance on one card is $0 and $5,000 on the other, your total credit utilization rate is 25%. If you choose to close the zero-balance account, your total available credit reduces to $10,000. Suddenly, your credit utilization rate is 50%.
An increase in your credit utilization rate will bring down your credit score. Keeping zero-balance credit accounts in hand can be effective protection against incidents that can reduce your credit score.
7. Reduce hard inquiries on your credit report.
Hard inquiries occur when lending institutions such as banks and credit card issuers check your credit report before extending you a line of credit. Applying for a loan, mortgage, or new credit cards will result in a hard inquiry. Hard inquiries stay on your credit report for up to 24 months and can reduce your credit scores by nearly 10 points.
You can avoid drops in your credit score from hard inquiries by:
Doing rate shopping for a loan quickly.
You need to check with various lenders to find the best terms for your loan. Your credit score, though, drops every time a hard inquiry is made on your credit history by a lender. To mitigate the effects of multiple hard inquiries on your credit score, it is advisable to do your rate shopping in a focused period of time. You get a grace period of 30 days with FICO before hard inquiries are reflected in your report. Multiple hard inquiries for a similar kind of loan can be treated as a single inquiry if done in this window. By doing your loan shopping in this window, your credit score is impacted only once.
Not applying for new credit cards at once.
It can be tempting to apply for new lines of credit if you have accumulated too much debt or want to increase your available credit when in need. Multiple credit card applications in a small window will result in too many hard inquiries on your credit and impact your credit score negatively. It is a good practice to not make multiple credit card applications in a short period of time.
8. Diversify your credit mix.
Your credit mix accounts for nearly 10% of your credit score. Your credit mix includes various kinds of installment credit, such as your student loans, mortgage, and auto loans. Accumulating a healthy mix of installment and revolving credit can improve your credit score over time. These credit accounts, when managed responsibly, can impact your credit history positively by increasing the age of your credit, the average age of your credit accounts, and good payment history.
It is very important, however, to ensure timely bill payment of all your credit. Seeking a loan to increase your credit score makes a lot less sense than maintaining regular payment of debt and keeping your credit utilization low. Irregular or partial payment of your monthly debt obligations will cause more harm than good to your credit score.
9. Contact your creditors.
If you are struggling to make payments on your bills, it is a good idea to contact your creditors. Setting up a payment plan will help assure your creditor that you intend to honor your debt obligations.
Late and missed payments can create high outstanding balances, which in turn can result in penalties and high interest on the unpaid bills. They can also have your debt transferred to collections. Debt in a collection account can reflect on your credit report for nearly seven years. Even paying off a collection account in full doesn’t remove it from your credit report.
It is imperative that lines of communication stay open between you and your creditors to avoid this situation. A payment plan in agreement with your lender will ease the effect of delinquencies and negative information on your credit report. Regular payments on a revised payment plan may not only reduce potential harm to your credi,t but also help you increase your credit score over time.
10. Check if you qualify for a 0% interest credit card.
Several banks and credit lenders offer credit cards with 0% interest. This annual percentage rate (APR) of 0% is usually applicable for the introductory period of 12 – 18 months. Though most credit card companies charge a fee for transferring your balance from another account, this fee can be waived off during the introductory period by some lenders. A 0% interest card can help you reduce your credit utilization immensely by removing interest on the revolving credit balance.
Maintaining a high credit score to effectively manage your personal finances is easier said than done. It requires attention and control over expenses and dealing with financial incidents that may be out of your control. The most effective way to gain a high credit score is by maintaining a consistent payment history and low credit utilization. All this may seem rather overwhelming and daunting, but the task is manageable if you are patient and persistent. By following the 10 must-do things in our list, you will be able to steadily increase your credit score and mitigate damages from financial mishaps.