Smart
consumers always keep their eyes on their credit scores. Ideally, checking your
credit score annually is important for one reason: you can know if you are
healthy enough to support, say, a new mortgage or a car loan. Of course you
already know that the score tops out at 850: typically your credit score(also
called FICO score, named after the company that developed it – Fair Isaac &
Company) is a number between 300 and 850, which is calculated by using a
mathematical equation to evaluate the information from your credit report. In a
broader sense, your FICO score is an estimate of your level of future
credit risk, implying that the higher your number the better the chance you
will make your loan payments on time, and vice versa. Because lenders use FICO
scores to make lending decisions, that simple 3-digit number can stand between
you and a car loan or a mortgage(Morales, 2009).
The
only sensible question you need to ask is what credit score is actually good
enough for you. From a realistic perspective, it may be impossible for you to
go all the way to a score of 850. So what is the optimal number – the number
beyond which lenders see you as a safe risk and hence give you low interest
loans? Broadly speaking, the best number to have – the tipping point – is 720
and above. If you have a FICO score of 720 or above, you are going to be
getting the best rates and opportunities because lenders will view you as a
safe risk. Our next question becomes how you can reach this number. Before
discussing that, it will be necessary to explain the breakdown of the factors
that determines your FICO score(see table 1). These factors include your
payment history, the amount you owe,
length of credit history, new credit and
Table 1 – What’s in a FICO Score?
|
Factor
|
Percent of FICO Score(%)
|
|
Payment History
|
35
|
|
Amount Owed/Credit
Utilization
|
30
|
|
Length of Credit
History
|
15
|
|
New Credit
|
10
|
|
Types of Credit Used
|
10
|
the type of credit in use(Johnson, 2013).
Payment History
Having a long history of making payments on bills and
loans on time is one of the most
important things lenders look for and 35 percent of your total credit score is
calculated based on that reason alone. Given that late payments – or missed
payments – will lower your FICO score, it is important that you pay your bills
on time so as to maximize your performance in this area.
Amount Owed/Credit Utilization
Another 30 percent of your rating is based on the amount
you owe relative to the total amount of credit available to you. Hence if you
are closer to maxing out all your credit limits, it will indicate that you are
over-extended, and hence is more likely to make some payments late, or no
payment at all. This will generally give you a very poor credit utilization
score – which is calculated by dividing the total amount of debt
outstanding with your total credit card
limit. Generally speaking, part of the science of FICO scoring is determining how much is too much for a
given credit profile. As a practical
matter, if you use a little of your available credits, the balances on your credit cards and other
revolving credit will be low(credit issuers likes to see a credit utilization
rate of approximately 35 percent or less), and your FICO score will be high . The implication of
this is clear: First, you will need to keep your balances low on all credit
cards as a high balance can lower your FICO score. Second, it is sometimes not in your favor to
close credit cards without balances as a short-term strategy to raise your FICO
score. As a matter of fact, it can pay
to leave credit cards open even if you don’t use them because you will damage
your credit utilization score if you cancel your lines of credit(Fair Isaac
Corporation, 2011).
Length of Credit
History
One way to keep your credit score high is to avoid
opening lots of new accounts too rapidly. Perhaps the best way to gain an
understanding of how this happens is to state that, because 15 percent of your
rating is based on the length of credit history, new accounts will obviously
lower your average account age, which, in turn, will have a larger effect on
your FICO score – particularly if you don’t have a lot of other credit
information. In general, since FICO considers your oldest accounts and the
average age of all accounts, a longer credit history will increase your FICO score, and vice versa(Fair Isaac
Corporation, 2011).
New Credit
Academic research showed that opening several new credit
accounts in a short period of time represents greater risk because it will
lower your credit score, particularly if you do not have a long established
credit history. In addition, multiple credit requests can hurt your credit
rating for the simple reason that the many recent requests for credits you have
made will remain on your credit report for two years – a factor that can impact
on your FICO score. Note that multiple credit requests excludes
those made by lenders who sends unsolicited, “pre-approved” credit offer
because FICO Scores have been carefully
designed to count only those inquiries that truly impact credit risks, such as
the requests a lender makes for your credit report or score when you apply for
credit. Note also that 10 percent of your credit score is based on how often
you open a new account and hence have your credit checked.
Types of Credits
Used
Approximately 10 percent of your FICO Score is based on
the types of credit in use: That is, on whether your mix of credit cards, mortgage loans, retail accounts,
and so on is a “healthy mix.” The unspoken message here is that it is not
necessary to have one of each since it is not a smart move to open credit
accounts you don’t intend to use. Generally speaking, your FICO Score takes into account two key
factors under this category. First, the kind of credit accounts you have. Here, FICO
conduct checks to ascertain if your credit experience is limited to only
one type of account, and if you have experience with both revolving and
installment type accounts. Second, it looks at the total number of accounts you
have(Fair Isaac Corporation, 2011). The bottom line: As long as you stay
current on all your accounts, having a healthy mix of different types of
credits, such as credit cards, a car loan and a mortgage improves your FICO
score.
With all the above items in mind, it is obvious that,
although you cannot achieve the optimal FICO Score(that is, 720 and above) overnight, you can do so fairly
quickly, since the factors governing credit score are simple. Even 7 months of
good behavior – avoiding late payments, minimizing your credit utilization,
nurturing your credit history and avoiding opening new credit accounts – will have
a significant positive impact on the score, since it will demonstrate to the
lender that you have cleaned up your act.
Here
are Few FICO Tips for Boosting Credit Score
1.
Pay your bills on time
2.
If you are having trouble making ends meet,
contact your creditors or see a legitimate credit counselor
3.
Keep balances low on credit cards and other
revolving credit
4.
Pay off debts rather than moving it around
5.
Don’t open a number of new credit cards that you
don’t need just to increase your available credit
6.
Avoid credit repair agencies that charge a fee to
improve your FICO Score by removing negative, but accurate, information from
your credit report: No one can force credit reporting agencies or lenders to
remove accurate information from a credit report
7.
If you have been managing credit for a short time,
don’t open a lot of new accounts too rapidly
8.
Be careful about opening new accounts that you
don’t need
9.
Have credit cards – but use them responsibly
10.
Note that closing an account doesn’t make it go
away.
References
Fair Isaac
Corporation(2011): Understanding Your
FICO Score. Retrieved August 9, 2013
from http://www.myfico.com/Downloads/Files/myFICO_UYFS_Booklet.pdf
Morales T.(2009):
Understanding Your Credit Score. CBS News. Retrieved August 9, 2013 from http://www.cbsnews.com/2100-500200_162-551521.html
Johnson D. (2013):
Achieve the Optimal – Not Highest – Credit Score. Yahoo
Finance. Retrieved August 9, 2013
from http://finance.yahoo.com/news/achieve-the-optimal-%E2%80%94-not-highest-%E2%80%94-credit-score-171836679.html
