Credit scores. Mysterious numbers that mean so much when you’re trying to get a loan, say for a house or a car, but numbers that a lot of us don’t understand. There are a lot of tips out there about how to improve your credit score, and a lot of them are very bad, in my opinion.
But first off, what is a credit score?
A credit score is a number that analyzes a consumer’s credit risk. The higher your score, the less risky it is to loan to you. If you are a high risk, you are likely to get a higher interest rate, because if a company’s going to take a risk on you, they want to be sure that they get more money out of you, especially if you end up only paying off part of the loan. The most commonly used score is the FICO score. FICO is actually a software analytics company that created a piece of software that calculates a credit score.
There are five elements that make up your credit score.
- Payment History
- Debt Amounts
- Length of Credit History
- New Credit
- Credit Mix
Some of these are confusing, so let’s break it down.
Payment History
This one’s pretty simple. Historically, do you pay your bills on time?
Debt Amounts
This is one you’ll hear a lot about. How much of your available credit are you using? For example, let’s say you have a card with a $10,000 limit. Is your balance usually around $2000? Or is it closer to $9500? It’s better to keep that number low so the percentage of your credit that you’re using is good. But this doesn’t mean that you should open a bunch of new accounts. We’ll discuss this later.
Length of Credit History
How long have you had your credit cards? This is one reason that it’s good for college students to get a credit card – so they can start their credit history early. Unfortunately, that can also lead to them getting into trouble. My oldest card is one that I opened in college. I never use it, but I refuse to close it. The longer you’ve had credit, the better. This is also why you should never close your oldest credit card, even if you don’t use it.
New Credit
Similar to the above, do you have a bunch of new credit cards? If you’ve suddenly gone from no credit cards or loans to a whole bunch of them, creditors are going to wonder what you’re doing. This is also where “hits” to your credit show up. Every time you apply for a loan or credit card, the company pulls your credit. This shows up on your credit report. (Note – if you get credit card offers in the mail and don’t respond to them, those aren’t hits on your report.) If you’re just rate shopping for a mortgage, that’s no big deal, because a bunch of hits in one short period of time for the same type of loan are treated as one, but a hit every few months will be viewed very differently.
Credit Mix
Essentially, this one means what types of credit do you have? Revolving accounts like credit cards? Installment accounts like mortgages and car loans? This one isn’t very practical to alter, so it’s less of a concern.
Now that you have all this information, what should you do to improve your credit score?
First, check your credit reports. Make sure that the information that is indicated is correct and actually belongs to you. While it’s not common, mistakes do happen, and you don’t want someone else’s poor money management affecting your ability to get a loan.
The easiest thing to do is to start paying down your credit card debt. Reduce the percentage outstanding on your credit cards. People choose to tackle this in different ways. Some people like to pay off the cards starting with the smallest balance so they get a quicker win. Others like to start with the highest interest rate. Both of these methods have benefits, so it’s about what works best for you.
Pay your bills on time. Set up reminders or put a sticker on your calendar. Set up automatic payments if that’s something your finances can handle. My credit card company texts me ten days before my payment is due. I typically already have it scheduled, but better safe than sorry.
You will hear some people say that you should open more accounts so that your available credit is higher. Don’t do this! Why? Because of that new credit category. A bunch of new accounts is not going to look good, and potential lenders are going to wonder what you’re doing.
If you search, you will see tips on how to improve your credit in 30 days. These tips are typically a terrible idea and won’t work, and may even hurt your credit score. It’s a slow process, but with time, you can get that score up to where you want it to be.
Megan is a 40-something government employee in the Washington, DC area. She got interested in Personal Finance when she got out of college and realized that her paycheck wasn’t going to go as far as she had hoped. Since starting this blog, she has managed to buy a house and make a solid start on her retirement goals, and hopes to help others do the same. Here is her story:
In 2007, I was a gainfully employed 20-something with no debt but not a lot of knowledge about personal finance. It was a co-worker’s comment about Roth IRAs that sent me to the internet, searching for information. It was then that I realized that I really didn’t know a whole lot about personal finance and that my current financial situation was due a lot to inherent frugal tendencies, generous family members, a fear of debt, and good luck. While that was working for me, clearly I needed a better plan.
While I had no debt, I was also pretty much living paycheck to paycheck and not worrying about going over budget (I say this as if I had a real budget) because I had an emergency fund set aside to cover any overages.
Except that’s not what an emergency fund is for.
So I did a lot of research, read a lot of blogs, and decided that I needed a plan. I needed to budget. I needed to know what I was spending my money on. I needed to prepare for the future.
I decided to create a blog not only to make myself accountable to others but also to share the knowledge that I gained along the way. I’ve learned so much from my fellow bloggers, and I hope that my readers can find something useful in what I have to share as well.
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