As lenders have clamped down on issuing credit, your credit score now has a more significant impact on loans available to you, the interest rate and fees you'll pay, and other terms of the loan. Thus, it is more important than ever to understand your credit score and how you can improve it.
When lenders evaluate a credit application, they usually request both your credit report and your credit score, which is a mathematical calculation based on the information on your credit report. The score is intended to rate your credit risk, although other factors, such as your income, length of employment, and years in your home, are also considered.
Credit scores are often referred to as FICO scores, since they are produced from software developed by Fair, Isaac and Company (FICO). While all of the major credit reporting agencies use FICO scores, your score from each agency can differ because information on your credit report differs by agency. Your FICO score is used in more than 75% of mortgage lending decisions and by 90% of the largest lenders (Source: MSN Money, December 29, 2008).
FICO scores range from 300 to 850, with higher scores indicating lower levels of credit risk. The major factors affecting your FICO score include:
- How you pay your bills - A significant portion of your FICO score is based on how you pay your bills. How consistently do you make your payments on time? If you've paid bills late, how many times were you late? How late were you? How much money did you owe? Have you ever had a debt in collection? What was the size of the debt? Have you ever filed for bankruptcy?
- Your total outstanding debt - Outstanding debt is debt of all kinds, including mortgages, car loans, credit cards, home-equity lines of credit, and any other loans that are reported to a credit agency. Another important factor here is how much unused but available credit you have on your credit cards. The absolute amount of available credit you have is less important than how close you are to maxing out the credit you've been granted. The highest scores go to people who use credit sparingly and keep balances low. Ideally, you should use no more than 30% of your available limit, with 10% being even better.
- Length of your credit history - The longer you've had and used credit, the higher your score. You get even more points if you have established long-term credit with the same lenders - a reason why you might not want to close long-term credit cards, even if you don't use them very much.
- Mix of credit types - Your score is higher if you have a variety of fixed payment loans and revolving credit.
- Recent applications for credit - A number of applications for credit over a short period of time raises a red flag for lenders, as it is often a sign that a person is in a cash-flow crunch. The FICO formula takes points away for this. Multiple applications for a specific type of credit in a concentrated time frame - when you're rate shopping for a mortgage, for example - won't count against your credit score.
Typically, scores of 720 and above receive the best deals on interest rates. Based on the way the FICO score is calculated, there are strategies to improve your score if you're not at that level:
- Review your credit report. Your FICO score is based on your credit report, so you should get copies of your report from each of the three main reporting agencies and make sure there are no errors. You are entitled to one free report every year from each of the agencies. Your information can vary by agency, so don't just look at one. Contact the agency if you find any mistakes.
- Make sure all your bills are paid on time. Check your credit report to see if there are any late notices. If so and you have a good credit rating, ask the lender to remove the notice.
- Reduce your credit utilization ratio. You receive a better score when your outstanding debt as a percentage of your available debt is lower. Make sure your credit utilization never goes over 50%. If you can't pay down your debt, ask your lender to increase your available credit. This will have the same result as paying down your debt, but make sure you aren't tempted to use that additional credit.
- Don't close credit cards you don't use. This has the result of increasing your credit utilization ratio because you have less available debt. However, if you have too many credit cards, typically over five, close the newest ones. Too many credit cards make lenders uneasy.
- Consider an installment loan. FICO scores reward people who use both revolving credit accounts and installment loans. Thus, using an installment loan, such as a car loan or mortgage, can increase your score.
- Minimize requests for additional credit. Inquiries regarding additional debt appear in your credit file and hurt your credit score.Â
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Coldwell Banker Residential Real Estate