Personal Finance: How to Achieve Optimal Credit Score

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