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What are credit scores and how to get started improving them

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Your credit score is simply a number that lenders assign to you to determine your capacity to repay a loan, or any line of credit.

So, if you want to get a better loan, with better interest rates, you need to have a better credit score.

To do this, it helps to know what your credit score is in the first place.

Don’t worry if you don’t know your credit score.

According to the CFPB, only 20% of the US population actively manage their credit scores.

To understand your credit scores, you should use each of the three main bureaus (Equifax, Experian and TransUnion) for several months before you apply for credit:

Get Your Credit Score From Each of the Major Bureaus:

What Makes Up Your Credit Scores?

Credit scores are made up of:

  • 35% – Payment History
  • 30% – Amounts Owed
  • 15% –  History Length
  • 10% –  New Credit
  • 10% –  Types Of Credit

1. Payment History

Payment history makes up more of your credit score than anything else. Payment history is making your monthly credit card or loan payments on time.

This is considered for:

  • Credit cards
  • Retail accounts (store cards)
  • Loans where you make regular monthly payments (auto loans)
  • Mortgage loans

If you are over 30 days late with any credit account payment, this will stay on your record. This will negatively affect you credit scores. The amount it affects your rating depends upon:

  • How late the payment was
  • How recently the late payments occurred
  • How many late payments there were

2. Amounts Owed | Credit Utilization

30% of your credit scores is based upon the amount of debt that you owe. If you owe a lot of debt, it doesn’t necessarily mean that you have a poor credit rating.

What the bureaus analyze and score is the percentage of the available credit that is being used, or the balances that you carry. For example, if you have credit of $10,000 available to you, and you have used $9,000 of this, you’re unlikely to get an additional credit card or loan because you are using 90% of your available credit.

This suggests that you may be overextended and struggle to pay back what you owe.

The percentage of your available credit you are using is known as your Credit Utilization Ratio.

3. History Length | Credit Age

The length of your credit history makes up 15% of credit scores.

This is simply the average age of all of your accounts as measured using the date opened. For example, if you have 2 accounts that are 4 years old and 6 years old respectively your “average age of credit” will be 5 years. This item is constantly changing and if any credit account goes off of your credit report, it simply vanishes from your credit report and its history cannot be calculated here.

4. New Credit

How regularly you open new credit accounts makes up 10% of your credit score.

Lenders believe opening several accounts within in a short period of time can be an indicator of risk. This is especially true if the applicant doesn’t have a long credit history.

As such, simply making an enquiry can have an impact on your credit score. Although, this impact is not too great, as the ratings agencies understand people do this to find out which cards and loans can offer the best possible rates.

You really just need to be sure you are leaving space between opening multiple accounts.

5. Account Mix

Account Mix or Total Accounts make up 10% of credit scores and this is the different types of credit accounts you have and the total number of accounts you have open.

Lenders like to see that you have experience with having multiple accounts and in a variety of credit forms.

What Effect Does Poor Credit Have on Interest Payments?

As you can see from the image below, the better your credit is, the lower your interest rates are.

Just by looking at the interest rates on auto-loans, you can see the difference having excellent credit makes, when compared to poor credit.

So, on a 5-year auto-loan of $25,000:

  • Poor credit pays a total of $13,828
  • Excellent credit pays a total of $3,375

That’s a difference of over $10,000. Or, over $2,000 per year.

Now, imagine this in the context of a mortgage loan worth $160,000. The difference in the example is 9.5% for poor credit vs. 3.9% for Excellent credit! This is $89,000 in interest paid for excellent vs. $259,000 interest paid for poor credit, a difference of $170,000 in just interest! 

When you have good and excellent credit scores, you can get better access to credit cards that offer cutting edge rewards programs.

Some Simple Steps to Improve Your Credit Score

1. Pay All Accounts on Time

When you charge something to your credit card, there is a grace period where you can pay off the amount you owe without being charged any interest. This grace period usually lasts 30-60 days.

Almost all credit cards have a minimum required payment. Paying these accounts on time and not going past being “30 days late” makes up 35% of your credit scores. On time payments is the most significant factor of all factors in determining your credit scores. 

If you make purchases on your credit cards you don’t need to pay off the full amount owed every month, but, you must make the “minimum payment due” each month if you want to get and maintain high credit scores.

Credit Cards and Bank’s give consumers a 30 day window to make their “minimum amount due” and If you don’t pay at least this “minimum amount due” each month this will be marked as a late payment on your credit report. If you miss this 30 day grace period this will be recorded on your credit report as “30 days late” and negatively affect your credit score. 

2. Review and Dispute all Adverse Items

If there are adverse items on your credit report do what you can to remove them.

This might mean disputing the item and working with the individual lenders to come to an agreement to remove the adverse item. You can also with directly with the lender or bank on the item without disputing the item. 

Under the Fair Credit Reporting Act, creditors have 30 days to respond to your dispute. If you don’t get a response within 30 days the credit bureaus need to remove the disputed item from your credit report.

3. Don’t Apply For Loans or Credit Until You Know Your Credit Scores

Applying for additional credit multiple times in a short period of time can lower your credit scores. This is because hard inquiries will show up on your credit report. So, it’s important to know your credit scores before you apply.

Make sure you sign up with each of the three major credit bureaus (Experian, Equifax and TransUnion.)

Lenders typically use the middle credit score of the three FICO scores when making a lending decision. Or they may use a single bureau to make their decision. Pay attention to your credit scores for three months before you apply for any credit.

Know the minimum required credit score for any credit line you are going to apply for. Make sure your score is comfortably above this minimum limit.

4. Pay Your Credit Utilization Ratio Down to 30% or Less

Credit Utilization Ratio is the percentage of your credit card or revolving credit balance compared with the total credit available to you.

Say you have $5,000 credit limit combined across all your credit cards. If you have used all $5,000, your credit utilization ratio would be 100%.

If you have used $500, your credit utilization ratio would be 10%.

Ideally, you want to have your overall credit utilization ratio at or below 30%. This indicates that you have the capacity to pay back the debt that you owe. If your ratio is in the 70%+ bracket, it suggests to lenders you have over extended yourself, and might struggle to pay back any additional credit.

If you do have a high credit utilization ratio and want to reduce it, it can make sense to take out a personal loan to pay down your credit card debt and lower your credit utilization. These are considered installment loans and can often be taken at lower interest rates, and don’t apply to your credit utilization rate. 

So, if you transfer credit card balances to this personal loan you can increase your credit scores by lowering your credit utilization ratio.

5. Request Credit Line Increases

Provided your credit scores reach Fair(FICO range of 630 to 689), request increases to your existing credit limits.

If you have demonstrated that you can make your payments on time and have the proper income, this increase request is typically easy to get acceptance with at least a few of the banks. Here, it is ideal to have a few credit cards with different banks when applying for a credit line increase so that at least one bank will accept your request. This credit line increase will decrease your credit utilization ratio by increasing your overall credit limit.

This decrease in utilization will improve your credit scores as “credit utilization” accounts for 30% of your overall credit scores.

You can usually request credit line increases on your bank’s website within a couple of minutes.

Change your credit, change your life!