Your credit score is a widely accepted indicator of your creditworthiness. Not only can a low credit score cost you more in interest charges, but it can also deprive you of financing, cause you to have to pay higher insurance rates or have an impact on your employment and housing options. Managing your credit score is a high priority personal finance task.
Credit scores are calculated based on a complex mathematical algorithm that aggregate a number of different factors reflecting the various aspects of your financial discipline and ability to be a good debtor. The most widely used credit score computed by FICO considers payment discipline, amount of outstanding debt, length of credit history, new credit utilization and types of credits used as the key factors for assessing credit risk. Each key factor is evaluated using a variety of indicators. Debtors are grouped into 10 ‘score cards’, each including people of generally similar risk profiles and the final scores are calculated based on debtors’ relative ratings within their specific ‘score card’.
Outsiders can never get a full understanding of how exactly the scores are calculated, neither can they easily assess the expected impact of the changes in their financial behavior and status on their credit scores. However, based on the high-level description of the popular credit scoring models and the experience of other debtors, you can infer what types of decisions and actions are expected to raise your credit score. In addition, some of the more advanced – and fee-based – credit reporting products provide simple, but reasonably predictive tools that you can use to simulate the impact of your projected financial actions on your credit rating.
Foundation: Review and clean up your current credit report
While there is an abundance of online services offering credit reports for free trials and sometimes expensive monthly fees, it is important to know that Consumers are entitled by law to receive one free copy of their credit reports from all 3 credit bureaus once in every 12 month period.
Understanding where your credit score stands and what the entries are on your record is critically important. First, you need to ensure that all entries on your report are accurate. You need to get all inaccurate items fixed or removed – no matter how long or cumbersome the process may be. As the three major credit bureaus use slightly different models and may have access to different databases, the score that they calculate for you can vary significantly. Since various lenders may rely on any one of the three bureaus, it is important to satisfy yourself that irrespective of the potential differences in their final score, they all display accurate and complete information on your report.
Apart from the score, your credit report will also provide a summary of the negative and positive items impacting your rating. To increase your score, you need to eliminate the ‘bad’ entries and increase the number of the good factors. A credit score is built on data points capturing long histories, so some of the levers are not easy to impact in the short term. Focus on the more immediate items first, while working towards strengthening your long-term indicators. The best strategy will depend on your specific circumstances.
Any outstanding delinquency should be immediately addressed. Ideally, you would like to pay off all delinquent debts right away. If this is not possible, you have to explore other options: negotiation of a payment plan with the creditor or raising additional funds. The latter, if done by assuming additional debt from reporting lenders, can dim the expected positive impact of the settlement of the delinquent account. Irrespective of this, taking out a new loan is still more beneficial than continuing to carry the bad debt.
If your score is negatively impacted by high outstanding loan balances, you should target this area as the primary immediate focus of improvement. Total debts owed is the second most important contributor to the overall score, carrying a 30% weight in FICO’s model. Amounts owed are measured in several different ways: total debts, liabilities by different credit type with revolving credit or credit card debt being less favorable than installment loans such as mortgages or car loans, number of open credit lines, and percentage of available credit lines used. Reducing the percentage below 30% or possibly 10% on all the different credit lines should be a short-term objective as it will have a positive impact. The benefit will be more immediate and significant if the current usage is much higher than these targets. You can use available cash or savings. If this is not possible, you can try to get a loan from friends and relatives, as this will not be captured on your records as outstanding obligations. If this is not feasible, you can try to negotiate with your lenders to increase your available credit lines for a reduction in the percentage outstanding measure. Remember, though, that this will not have an impact on your total outstanding debt – and consequently will give a smaller boost to your rating – and can also have a collateral negative impact on your score due to new inquiries and on your finances due to potentially higher interest rates and charges.
If your credit report cited a high number of recent inquiries or newly opened credit lines as a negative factor, you should consider staying away from the loan markets for a while, unless it is absolutely necessary to shop for and obtain a new loan. Tightly control new, score-reducing inquiries by not disclosing your social security number to anyone.
As a medium-term credit score remediation tool, you can also consider re-balancing your credit portfolio. Mix of credit is a significant factor with a weight of up to 15%. Over-reliance on credit card debt is considered an unfavorable factor. A healthier balance can be achieved over the medium term by obtaining a personal loan with an installment plan or – if possible at all under the current economic and credit conditions – securing a home equity line. You can use the proceeds from these more favored loans to pay off credit card debt to improve both your mix and credit card balance utilization factors.
Missed or late payments, collections and liens in your history cannot be undone any more. Although as a component of the highly weighted payment history factor, these can have a big impact, their downward pressure on the score eases over time. Consistent and accurate payments going forward can help you build towards a positive trend in payment discipline. If you ever find yourself in a situation where you are forced to miss or delay a payment, you should try to work out a solution with your lender to mitigate the hit to your score. As you continue to make payments on time, not only will you accumulate positive payment history, but you can also lower your balances faster with higher, appropriately chosen monthly payments.
Other negative factors such as length of sufficient history or lack of certain types of credit – mortgage, for example – may be more difficult to address. You should continue to track changes in these longer-term indicators and remember that your financial decisions can have an impact on your credit for many years to come.
Little tricks and gimmicks of the credit scoring system
Credit scoring is anything but fully transparent and reliable. Sometimes little tricks can have beneficial results. Some debtors try to negotiate with lenders reporting derogatory items to get the information removed. This could be ethically questionable as it attempts to erase valid information and most major lenders will refuse to cooperate.
Sometimes the score can unexpectedly move without any significant action or event. Typically this is due to the aging of older items whose impact is starting to wear off. Occasionally, you may be moved from one score card to the other, where your relative score against a new population can change.
It is a lesser known fact that non-financial factors such as your profession, length of residence, home ownership, length of employment and age also affect your credit score. While most of these are fairly objective and not directly under your control or even if they are, your career and housing choices may be driven by considerations other than credit score impact, it is important to remember that they play a significant role in your credit.
Increasing your credit score is a continuous, life-long task. Everyone can find themselves in financial difficulties potentially depressing their credit scores. Understanding how lenders view your credit risk can help you to increase your credit score by adopting and maintaining responsible financial behaviors. Through these good habits and prudent decisions you can also build a more stable and secure financial future.