How to Improve Your Credit Score
KEY POINTS
Your FICO credit score has a direct impact on the interest rates you pay
65% of your credit score is dependent upon your payment history and credit utilization
Poor credit ratings can be fixed by combining the 13 steps highlighted below
2022/23 Financial Tsunami
Many of us suffered financially throughout the pandemic. As we emerge from isolation and try to find our financial footing we are faced with a double whammy of high inflation and rising interest rates.
We may not be able to do much about inflation, but we can take steps to mitigate the impact of rising interest rates.
How?
Improve your credit score.
Why is a Credit Score Important?
Your credit score can have a major impact on your cash flows, lifestyle, and ultimate net worth. Lenders will take your score, decide if they will extend credit to you, and then adjust the interest rate they charge your accordingly. A high score translates to low interest rates and a low score equals high interest rates.
Every form of credit you access will be impacted. For example,
Mortgage
Home equity loan
Auto loan
Credit card
What is a Credit Score?
Financial institutions need to assess your degree of credit risk prior to extending any form of credit. Therefore, they review your financial history and calculate a credit score specific to your situation. There are many ways to calculate a credit score. Artificial Intelligence is becoming more prominent in this regard. However, the most popular methodology is the FICO credit score.
FICO Credit Score
In 1989, the FICO score was created. It has provided financial institutions with a systematic model from which to standardize, quantify, and compare credit risk. Your credit profile is accessible on demand by your financial institution.
The FICO model is not perfect, but you cannot avoid it when applying for credit. There are three primary national credit bureaus that extract your financial data monthly and calculate your credit score: Equifax, Experian, and TransUnion.
FICO Credit Score Ranges
This chart highlights the key scoring ranges you can achieve.
We invite you to read our posts How Can Your Credit Report Increase Your Net Worth? and Financial Literacy - Credit Scores for a more in-depth background on FICO scores and how a higher score can save you tens of thousands of dollars from lower interest rates.
Credit score management forms a crucial step in our financial literacy series that is summarized in our post Financial Literacy - A Definitive Guide.
FICO Credit Score Components
Your credit score is broken down into the following 5 components each shown with their respective weightings.
13 Ways to Improve Your Credit Score
An improved credit score will allow you to experience:
Now let’s look at opportunities for you to improve your score.
Obtain your credit report
A great first step is to simply obtain a copy of your current credit report. You should review it to ensure all the data is correct. It is not uncommon for such to contain errors related to your personal contact information or your financial accounts.
You may detect accounts you have closed but are showing as active on the report. Your accounts may also show as be delinquent when such should be in good standing.
You may detect fraud upon review of your credit report. Someone may have stolen your identity and opened up unauthorized credit facilities in your name. If so, such facilities likely have high balances that are destroying your credit rating.
We cannot stress enough how important it is to obtain and review your current credit report.
Budget
A budget is a critical tool you can use to ensure you take on a level of credit that you can afford. Your budget will also make you take a hard look at your discretionary expenditures and focus you on diligently managing your finances.
As discussed in our post How to Make a Budget That Works For You, we recommend you find a tailored approach to budgeting that is aligned with your unique style.
Your credit score should naturally benefit from a realistic budget that is tweaked to adapt to your changing circumstances.
Pay down revolving debt
Debt management is essential to maximizing your credit score. Revolving debt is a critical type of debt that refers to credit that remains available after being repaid (e.g., credit cards, and lines of credit).
Credit utilization accounts for 30% of your credit per the pie chart above. The lower the utilization, the higher your credit rating. Therefore, pay off your balances to the greatest extent possible.
Fun Fact
Many credit providers report their balances monthly. Therefore, try making weekly or bi-weekly payments to reduce your utilization rate and reduce your interest costs.
Spread purchases across multiple credit cards
Your credit utilization is calculated on an overall basis and on an individual account basis. Therefore, you may benefit from spreading out large purchases across multiple credit cards and lines of credit. You will need the discipline to manage the tracking and repayment of each account. As noted below, you never want to miss a payment.
Never miss a payment
Payment history represents 35% of your credit score.
There are 3 main reasons for missing a payment:
i) Financial distress
ii) Financial emergency
iii) Poor financial management
However, poor financial management can usually be avoided. Make sure you track all your debt obligations and develop a plan to ensure payment 100% of the time. Consider establishing automatic payments whenever possible to reduce the risk of missing a payment. You will enhance your credit rating while saving on penalties and interest.
Credit card limit increases
Available credit utilized represents 30% of your credit score.
You can decrease your utilization rate by either increasing the credit limits on existing credits cards or opening new credit card accounts. If you apply for new credit cards you should consider those with no annual fee.
The application for a new credit card may cause a temporary decline in your credit score. Be careful to maintain financial discipline as the additional credit may lead to financial temptation and create financial distress.
Negotiate with Debt Collection agencies
It can be extremely stressful if you have a creditor or debt collector pursuing you for non-payment of debts. It can be equally devastating to your credit score. It may be tempting to ignore the situation, but such only compounds the problem. The problem may trigger a lawsuit and an eventual garnishment of wages.
We recommend you meet with the representative in charge of collecting your debt. You may be able to negotiate a discounted net amount owing while agreeing to a debt settlement or payment plan.
How to apply for new forms of credit
Multiple applications for new credit can be an indication of an increased level of credit risk. Your credit score may take a temporary dip when you apply for a new line of credit. Therefore, be strategic and only apply for credit that is necessary.
Credit agencies are aware that consumers will obtain multiple quotes for a given form of credit when negotiating with creditors (e.g., mortgage, car loan). Therefore, condense your multiple quotes to 1-2 weeks as the credit agencies will consider these a single request.
Do not close old accounts
Think twice before closing a credit card or line of credit. Your credit score can benefit from the account’s length of credit history and amount of credit utilized. Ideally these accounts will not incur annual fees and you will maintain the financial discipline to only use them if necessary.
Debt consolidation loan
Credit cards charge some of the highest interest rates throughout the credit markets. Financial stress can mount quickly if you carry large balances on your credit cards.
A debt consolidation loan allows you to obtain a single loan with sufficient proceeds to pay off your high interest rate accounts. The interest rate charged on these loans are typically lower than your existing revolving debt.
The initial application for the loan may cause a temporary reduction in your credit score. Your credit score will see an increase as such loans are not considered in FICO’s available credit utilized calculation. Repayment of the loan as per the terms of the contract will also increase your credit score.
Student loans
Payment history is the largest component of your FICO score. Therefore, the repayment of your student loans as per the terms of the agreement is critical.
The pandemic has had a significant impact on student loans. Some countries temporarily suspended all payment requirements, some cancelled interest amounts accrued, others did not make any changes.
For example, the United States suspended payment requirements in March 2020 and set the interest rate at 0%. The Biden administration has attempted to forgive a portion of the student loans; however, such is being challenged at the Supreme Court at the time of this writing.
The key take away is that you need to stay well informed of your obligations related to your student loans. Such obligations may be influenced by politics and could experience significant changes. It is your responsibility to ensure you make your payments in full and on-time; otherwise, your credit score will suffer.
Secured credit card
A secured credit card may be a good step to take when trying to rebuild your credit rating. You will be required to place a deposit on account before using the card. The card’s credit limit will typically be equal to your cash deposit. In this regard, it is like a debit card.
You can use the card like a normal credit card. Over time, it will help improve your credit score and the card provider may offer you a standard credit card in due course.
Protect yourself against fraud
Fraudsters have devised an endless supply of scams and schemes to steal your money and ruin your credit rating. They will try to steal your identity, open accounts in your name, trick you into wiring them money, and steal your possessions.
We invite you to read out post Top 5 Scams and How to Protect Yourself. You can never fully protect yourself against fraud, but there are many steps you can take to mitigate much of the risk.
Bottom Line
Your credit score reflects your financial profile, spending habits, and financial management. Therefore, you have the power to take control of your credit score. The combination of multiple options noted above can put you the right track to obtaining an Excellent credit score.
