Improving Your Credit Score

Credit scores are designed to measure the risk of default by taking into account various factors in a person’s financial history. Credit scoring is often used in determining prices for auto and homeowner insurance as well. Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers and to mitigate losses due to bad debt. Using credit scores, lenders determine who qualifies for a loan, at what interest rate, and to what credit limits. In the United States, a credit score is a number that is based on a statistical analysis of a person’s credit report, and is used to represent the creditworthiness of that person—the likelihood that the person will pay his or her debts. In the case of insurance companies, the likelihood that the person will pay his or her debts directly correlates with their likelihood of filing a claim against their insurance policy. People with lower credit scores have a greater history of filing claims according to an overwhelming amount of research and statistics done over the past 15 years or so. The theory is that when times are tough smaller less relevant claims are now getting submitted to the insurance company, also claims are padded to look bigger so people can get a little extra cash from their company.

A credit score is primarily based on credit report information, typically from the three major credit bureaus. Although the Fair Isaac Corporation develops these credit score versions for the different agencies (known as FICO scores), they are different numbers, and are periodically updated to reflect current consumer loan repayment rates. Recently, some of the agencies that generate credit scores have also been generating more specialized insurance scores, which insurance companies then use to rate the quality of potential customers as I mentioned before.

Understanding your credit score is the first step to improving it and making it work in your favor instead of against you. With an improved credit score, lower expenses,proper asset and identity protection, and maybe some extra income on the side; all of which I will discuss in future posts, you can eliminate your debt completely in a few years (not a joke) and live a less stressful life. Here are some tips on improving your credit score relatively quickly:

Payment History - Your monthly bills consist of expenses and debt. The debt is loans such as credit cards, car payments, mortgages, etc. You must make sure your debt is paid on time every month. Any history of late payments (including missed payments and derogatory payment statuses) is a negative factor. No reported history of payments on any account is also negative because lenders cannot tell whether you paid on time or were late. Some cases of late payments are worse than others. If you have not been late with any payments recently, lenders may think you are responsible and do not (or will no longer) miss payments. Lenders realize that many people occasionally pay late. Therefore, being late with a single payment is typically not as harmful as being late with two or more consecutive payments. Similarly, being late on many accounts is typically worse than being late on one. Also, lenders may view late payments as a more serious problem if you have collection accounts or negative public records such as bankruptcies or court judgments. These types of credit records indicate a pattern of credit problems.

Debt To Credit Limit Ratio - Having accounts with a high credit limit or loan amount is a positive factor, because it indicates to a lender that other lenders have trusted you with a lot of credit in the past. On the other hand, having accounts with low credit limits or loan amounts is a negative factor. It may suggest that your credit reports contained information that was of concern to lenders at the time they determined your credit limits or loan amounts. Finally, having no accounts with a reported credit limit or loan amount is a negative factor because lenders cannot evaluate how much other lenders have trusted you with credit so far. It might be beneficial to close the lower limit accounts and ask for higher limits on your preferred accounts.

Activity - Having accounts listed in your credit reports is a positive factor because the payment history of these accounts shows lenders how well you pay your bills. Therefore, having too few accounts or too few open accounts may be considered negative. However, having too many accounts or adding new accounts too quickly may also be considered negative because lenders worry that you are spending (or preparing to spend) beyond your means, even if you have never been late with any payments. Note that closing accounts will not change this. Also, if you do not currently have credit, getting your first few credit cards may be difficult and may involve high fees, high interest rates, and low credit limits. Note that accounts from personal finance companies (which specialize in lending to people with credit problems) may be considered negative.

Revolving Credit Balances - High balances are a negative factor because lenders worry that you are living beyond your means and may not be able to repay them. This is particularly true for credit cards. For installment loans such as mortgages and auto loans, lenders often use the proportion of the loan that is still unpaid to judge your ability to take on new debt. If very little of your installment loan balances have been repaid, lenders may not give you more credit that could add to your debt. In general, lenders evaluate how much you owe (your debt) in relation to how much you earn (your income). However, no matter how high your income, having a lot of debt may lower your credit scores because lenders know that adverse changes in your employment and life events such as divorce or illness may make it hard to pay your bills. Low balances, on the other hand, are a positive factor because lenders do not stand to lose as much if you become unable to repay them. However, not using your credit accounts may be considered a negative factor, because it does not provide lenders with information about how you typically use credit and repay your debts.

Applying For Credit - Applying for credit many times within a short period can lower your credit scores. When you apply for any type of credit (such as an auto loan, credit card, department store card, or mortgage), the lender considering your credit application checks your credit history. This is recorded in your credit reports as a “hard inquiry.” Although inquiries are an unavoidable result of applying for credit, lenders dislike seeing many inquiries within a short period (such as 6 months). This is because they cannot tell whether you are “shopping” for the best offer or if you are desperately trying to get credit because of financial trouble. Therefore, try to limit your comparison to a small number of lenders when “shopping” for the best offer.

In summary, it is quite easy to improve your credit score by 30-50 points in just a three month period. This could be difference between paying 25% more or less on your car insurance, or getting a credit card or mortgage with rates of 3-5% higher or lower. These little differences will most definitely affect your ability to get ahead of the game. People that pay more for insurances and have higher interest rates on their loans will never become debt free or get out from under it all.