This is the 2nd post, in a five part series on raising your credit score.
Insurance carriers take into account your credit score, to determine the cost of your policy. The better your score, the more you can save on home and auto insurance.
Not only does your score impact how much you pay in premiums each year, but good credit can save you thousands over your lifetime on your mortgage, car loans, and apartment rentals as well.
I recommend reading part 1, How Does Your Credit Score Work, before today’s post.
In order to optimize your score, you must know how to optimize each of the five factors. The five factors are:
photo from: MyFico.com
- Your Payment History = 35%
- Amounts Owed = 30%
- Length of Credit History = 15%
- New Credit = 10%
- Types of Credit Used = 10%
That’s the purpose of today’s post—to know the best practices for each of the five categories.
Your Payment History = 35%
The first, and most important, factor (35%) that makes up your credit score is your payment history.
Your payment history takes into account the timing of your past payments on accounts such as your credit card, retail accounts, mortgage, etc…as well as bills sent to collections.
If you miss just one payment, your credit score can potentially drop 100 points!
There is no secret behind optimizing your payment history, pay your bills on time! If you can’t pay the bill in full, just make the minimum payment. It’s the #1 thing you can do to improve your score.
A quality financial habit is to automate your bills. Many bills can be charged directly to your credit/debit card or withdrawn from your bank account. Not only does this save a lot of time each month and allows you to avoid late fees, but you’re less likely to never miss a payment.
Amounts Owed = 30%
The amounts owed category refers to the ratio of outstanding debt to the amount of credit you have available. You might have also heard this called credit utilization rate. If you only have one loan, which is a credit card with a balance of $500 and a limit of $5,000, your credit utilization rate would be 10%.
Since FICO doesn’t release the formula, no one knows what the optimal credit utilization rate is. However, there are some basic guidelines to follow:
- Don’t max or come close to maxing out available credit.
- You want to use at least some credit. Therefore, a utilization rate of 0% could actually hurt your credit score.
Shoot for the lowest percentage you can, with a reasonable credit limit.
Another fact is that lenders report your balances to the credit bureaus randomly. Some lenders report your balance on a certain day every month, some lenders might report your balance on a certain day of the week, and some lenders report quarterly. This explains why even if you never carry a balance on your credit card you can still have a high credit utilization rate.
Therefore, keep balances on revolving debt (debt that is open-ended like credit cards) way below your credit limit at all times.
For people who are responsible with paying your bills on time, a good tactic to increase your utilization rate is to call up your credit card company and ask for a limit increase.
Length of Credit History – 15%
15% of your credit score is based on how long you’ve had credit. Your credit score considers both the age of your oldest account and the average age of all your accounts in the equation.
The longer your credit history, the better.
This is why it’s a good idea to apply for a card when you’re young and keep that card for life. It’s also why it’s a bad idea to cancel your oldest card.
You always want at least one transaction every month on your oldest card. Credit card companies are now cancelling cards that are not being used without notice.
A tip for keeping cards alive is to have small monthly subscriptions charged directly to the card. Then, automate your payment of that card each month.
New Credit – 10%
Would you lend $100 to a friend who borrowed $100 from three other friends yesterday? Of course not. This is why lenders don’t like to see a lot of new activity, such as applying for multiple new lines of credit in a short period of time on your credit history.
New Credit, which is 10% of the credit score formula, takes into account
- New accounts applied for (Note: Even if you’re denied, this negatively effects your credit score)
- Accounts opened
- Length of time since you last applied for credit
- Length of time since you opened a new credit account
You might notice a problem here. How are you supposed to shop around for the best rate on a loan if every time you apply your credit score goes down?
For example, say you’re shopping for a car loan and want a low rate. Therefore, you go to a local bank, a local credit union, and fill out an online application.
Consequently, you now have three new credit inquiries on your credit report. Which all hurt your score, right?
Thankfully, FICO does recognize this as a common way people shop for loans today. That’s why the FICO score formula lumps together auto and mortgage related loans inside 30 days of each other.
As long as you applied for the above three loans inside of 30 days, it just goes as one inquiry on your credit report.
Types of Credit Used – 10%
Lenders prefer to see different types of credit on your credit score. For example, it’s better to have a student loan, a credit card, and a car loan than three credit cards.
The reason FICO likes to see a variety here is due to different types of lenders underwriting requirements. Generally, the larger a loan, the more underwriting the lender goes through.
Therefore, if FICO sees that you have a mortgage; it assumes that the lender saw that you were qualified enough to secure a large loan.
Knowing this, you don’t have to go out and buy a car or house to please FICO here. The most important thing is to have at least one credit card from a major bank such as Chase, Bank of America, Citibank, Capital One, etc…
What Effects Your Credit Score?
Many people try to crack the FICO equation, to determine their exact credit score. FICO has never and will never release the exact equation.
It all comes down to common sense. Don’t use all of your credit available, don’t close your oldest account, and most importantly, pay your bills on time!
If you have any questions, please let me know in the comments. I will incorporate them into the following posts.
Don’t forget to come back tomorrow, as I will talk about the best way to get your credit report.
