How to understand and improve your credit score

Todd Ballenger, Founder, National Institute of Financial Education

Does your credit score make the grade?

Your FICO^® credit score can be your single most important asset or opposing barrier when securing a loan or other form of credit. Even though most credit providers also look at your income, assets and job history to determine your ability to borrow, your credit history often makes up as much as 75% of the decision to extend credit in the end.

Essentially, your credit score tells lenders what they most want to know: "What is the likelihood that you will repay us if we give you the money?" The higher your score, the easier it is for a lender to approve your credit and offer you their lowest rate. On the other hand, the lower your score, the more difficult it is to obtain credit and competitive terms.

In today's environment, it's especially important to keep your credit score in tip-top shape. That means playing the game of credit to maximize your score. How? First, understand the five primary rules that make up the ever-changing game of credit.

1. Payment history – 35% of your score. This is the history of your payments weighted to the most recent activity. You lose more points for recent negative payment history than for older negative history. Over time, older late payments have less of an impact as creditors pay more attention to what’s happening with your more recent payment history.

   Key to maximize score: Pay each bill within 30 days of the due date.

2. Utilization rate – 30% of your score. This is the percentage of available credit that you use based on your credit limit. You may earn points when you use less than 30% of your credit limit on revolving accounts, and you may lose points when you exceed 30% of your limit.

   Key to maximize score: Know your credit balances and avoid exceeding 30% of your limit. If you consistently exceed 30%, call the card issuer and ask them to raise your limit. This will reduce your utilization rate.

3. Length of history – 15% of your score. This is the length of time your accounts are open. The overall age for your accounts goes up and down over time. Any time you open a new account, it reduces the overall age (and your score) until you build a history of making payments on the new debt. Closing an older account often negatively impacts your credit for the same reason. New accounts tend to subtract points for the first 12 months, are neutral for the next 12 months and add points after 24 months of on-time payments.

   Key to maximize score: Don't close that old credit card account – even if you've achieved a zero balance. Your oldest accounts make the biggest impact on your credit score, so closing them could bring your score down. Also, with today's challenging economy, it's important to have a credit cushion to fall back on. But remember: You'll need to use the card at least every six months to keep it active and to ensure it's adding valuable points to your credit score. Just don't rack up any debt you can't pay off the following month.

   

4. Type of credit – 10% of your score. There are varying types of credit, including installment loans and revolving credit. It's important to have both to achieve a high credit score. Specifically, you should have at least one major installment loan (mortgage), one additional installment loan (auto) and three revolving accounts (credit cards) to ensure the potential for the highest score.

   Too few accounts, or none that are currently active, will negatively affect your credit score. A good mix of credit types shows that you have the ability and willingness to manage your borrowing. Keep in mind that ATM and debit cards don’t really impact your credit score.

   Key to maximize score: Keep accounts open and active. If you've paid off your mortgage, open a home equity line of credit (HELOC) and use it for occasional expenses that you'll pay off the following month. And keep at least three credit cards open that you pay off monthly – even in retirement.

5. Inquiries – 10% of your score. These are generally shown in two categories: soft and hard. The first, or soft inquiry, is when you pull your own credit report or an employer pulls your report with your permission. This has no direct impact on your credit score.

   The second, or hard inquiry, is when a lender pulls your credit. This can have varying degrees of impact on your credit score. For example, if multiple lenders pull your credit report for a single new account (e.g., a mortgage), all of these inquiries are counted as one hard inquiry on your credit report. But if multiple lenders pull your credit report for multiple accounts (e.g., a Sears Card^® and an American Express^® Card), each instance counts as a hard inquiry, which can negatively impact your credit score.

   Key to maximize score: There is a difference in staying power when it comes to the long-term impact of certain credit activities on your score. While a bankruptcy will stay on your credit report for 10 years, debts, collections and judgments that are paid off will remain for seven. And although inquiries stay on your report for two years, they only reduce your score for the first 12 months. Still, to ensure minimal negative impact on your credit score, make sure you share your personal information only when necessary and/or you anticipate a borrowing transaction.

Take these steps now to improve your credit score

A. Review your credit report
In general, 80% of all credit reports have one or more errors in them. Errors on your report could be costing you valuable points.

1. Order your report by visiting annualcreditreport.com, where you can obtain a free copy of your credit report from the three credit reporting agencies – Experian^®, Equifax^® and TransUnion^® – once each year.
2. Review your report to make sure all personal and employment information, account statuses, credit limits and payment history are correct.
3. All errors – even those that seem harmless such as the wrong address or multiple employers – need to be corrected. This can also help improve your credit score. If you spot an error on your report, contact Equifax, Experian or TransUnion (based on where the error appears) to begin the dispute process. Note that this process varies by credit reporting agency, so contact the specific bureau for details.
   • a. Equifax: equifax.com – (800) 685-1111
   • b. Experian: experian.com – (888) 397-3742
   • c. TransUnion: transunion.com – (800) 888-4213
4. Once you get the errors corrected, keep a copy of any correspondence and review your old report against a new one to make sure old errors have not resurfaced on your report.

B. Obtain your credit score
Although you can order your credit report each year at no charge, your credit score is not available for free. One option is to request your score from any creditor you are working with to obtain a new loan. Otherwise, you can order your FICO score for a fee through numerous online services, including myfico.com and credit.com.

Once you have your score, see how it stacks up against these general guidelines, as posted on credit.com:

Above 800 = Excellent
You qualify for the best available deals.

750-800 = Very good
You qualify for some of the lowest rates available.

700-750 = Good
You qualify for very competitive interest rates and terms, but maybe not the best that a lender has to offer.

650-700 = Fair
You are considered a moderate credit risk.

600-650 = Bad
You may find it difficult to be approved for standard credit products at competitive rates and terms. You also could be denied credit.

Below 600 = Very bad
You are a very high credit risk. It will be difficult for you to obtain new credit without the help of a co-signer or a large down payment.

No credit
Lenders and insurers cannot accurately predict your credit risk and by default they consider you to be a high risk. You can establish your credit by opening a new credit card and using it responsibly. After a few months of use, your credit report should be able to be scored.

Source: Understanding Your Credit Score, Emily Davidson and John Ulzheimer for credit.com (2009)

C. Conduct an annual review of your credit report.
Establish an annual date, such as April 15, when you order your report through annualcreditreport.com. Then, review your report and monitor any changes. Once you're more familiar with your report, it will be easier to identify theft or other errors that could create problems for you later.

Of course, your score is not the only factor considered by creditors when determining your eligibility for financing. Other factors include your income and the loan-to-value ratio on your home. But by increasing your score – and keeping it there – you'll have a better chance of getting the credit you need when you need it, with the best possible terms.

Todd Ballenger is author of Borrow Smart, Retire Rich. He is also the founder of the National Institute of Financial Education (www.niofe.org).