The Ultimate 10-Step Guide to Improving Your Credit Score

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The Ultimate 10-Step Guide to Improving Your Credit Score

Dec, 16th 2016

Most American adults have a credit score attached to their name. The score directly impacts each consumer's cost of obtaining credit. Lower scores mean higher interest rates for credit cards, auto loans, mortgages, and so on.  Many consumers use the terms “credit score” and “credit report” interchangeably, but that's a mistake. Credit reports are detailed records of a consumers' financial lives.  Credit scores are 3-digit numbers designed to boil someone's financial prospects down into a single numeric calculation. Consumers have the right to see their credit report for free each year. They don’t have the right to see their credit scores, but increasingly, scores are given away for free by financial institutions to their customers.

1. Why should I care about my credit score?

The number matters -- a lot. Borrowers with great credit typically pay 3.6 percent an auto loans right now, but can get rates as low as 1 or 2 percent. Subprime borrowers are paying 10.4 percent interest.  On a $16,000 loan. On a typical 60-month loan, that’s a $2,000 penalty.  We’re talking about real money.

2. What is a credit score, really?

There is much confusion about what a credit really is and what it really represents.  So let's clear that up.  The score is merely an attempt to predict the likelihood that a borrower will pay back a loan in a timely fashion, based on that borrower’s past bill-paying habits and a few other factors. It does not evaluate someone entire financial situation. It does not take into account the size of someone's bank account.  So -- a person with $1 million in the bank who misses credit card payments out of laziness would have a terrible score.  

3. Not one score, scores

You don't have one credit score, you have many. Dozens. Maybe a hundred or more.  When people say "credit score," they tend to mean the scores generated using the FICO formula developed by the formerly named Fair Isaac Corp. That score is used in about 90 percent of lending decisions, FICO says.  But even "that" score is really three scores: The data in each of the three credit reports -- Experian, Equifax, and Trans Union --is used to generate separate FICO scores. They might be similar, but they are different. Then, many lending institutions generate their own scores -- many are derived from a FICO score, but emphasize different parts of your payment history. An auto lender might give greater weight to your past auto loan payment history, for example.  Finally, there are other scores that are related to your credit score but predict different things. An insurance score, for example, attempts to predict the likelihood that you'll make a claim.  Generally speaking, consumers aren't entitled to see these scores until they are used as part of an "adverse action." If you are denied a loan or a policy because of a score, you have the right to see the score used. But not before.

4. What's a good score?

This question doesn't really have a satisfying answer.  Why? There are dozens of scores, as we just discussed, and each can have different scales.  Also, lenders really decide what a good and a bad score is, and their "opinions" can change. A 690 might get you approved with a good rate at one lender but denied at another.  However, FICO now publishes a good-enough guide to give you an idea where you fit in.  FICO scores range from 300-850 (that's a super-helpful range1).  In April 2016, FICO said the largest group of US consumers (20 percent) had scores over 800; this is the so-called "super-prime" group. The *average" credit score was 699, FICO said. Some 17 percent have scores from 700-749, and 18 have scores between 750 and 799.  Most of the folks in that group would get a bank's best rate, and are known as "prime" borrowers.  You'll get disagreement over where the prime line is, and it can vary from bank to bank, but 720 is often cited as the cutoff.

Some 21 percent of consumers have scores below 600, which would generally be called subprime or deep-subprime. Another 23 percent sits in the 600s. Some of them will also have to pay subprime rates to borrow money; some will get 'near' prime rates instead.  It just depends on the lender, and of course, the economic environment.

Please note, however, that the FICOs scale and the slots I've mentioned don't hold true for other kinds of scores. VantageScore, FICOs chief competitor, used a scale of 501 to 990 until recently. (It has newly changed to 300-850 to make life easier for consumers).

5. It's simple. Pay your bills.

The world of secret credit score formulas and subprime loans is murky and complicated. Like teachers' pets, many consumers become fixated on the idea that they are being "graded" in this way and want to do all they can to have a perfect score. They sign up for services, check their scores daily, and obsess over small ups and downs. This is silly and counterproductive.  So let me simplify things for you.  Pay your bills on time, all the time, and you'll have a great credit score. If you haven't done so in the past, start today! It'll take 7 years to rid your report of your dark past, but it won't take nearly that long to dramatically improve your score.

6. No it's not that simple. 

I didn't lie to you. For many people, it really is as simple as paying your bills. But it's not that simple for everyone.  A stunning number of consumers (about 15 million) see their scores weighed down heavily by a single unpaid medical bill. Given how complex the medical insurance claims process is, it's easy to see how this happens accidentally.  In fact it's so common that FICO has announced it will downgrade the importance of unpaid medical bills in its credit score formula.

For others, identity theft causes a scoring nightmare. If a criminal opens an account in your name, your score can suffer mightily. The only way to find out is to pull your credit report, or see a change in your score. Fixing such issues is supposed to be easy; often, it's not. That's why it's so critical to check your credit report a few months before any major borrowing decision.

7. What's in a score?

How is a credit score calculated, anyway? Well, I can't tell you. It's a secret, like the Colonel's Secret Recipe. But through the years, enough information has been released that we generally know what's in the math.

FICO says there are 5 factors included:  Payment history (35%), amounts owed (30%), length of history (15%), credit mix (10%) and new credit (10%). But the precise weighting of each factor can vary, FICO says.  (New credit, by the way, dings borrowers who have recently applied for several new credit accounts).  And remember, other scores use other formulas.

8. How much do mistakes hurt?

Again, we're reading tea leaves here. The folks at FICO have spoken very little about how much an unpaid bill or flurry of credit applications hurts your credit score. But one chart released by FICO not long ago gives a good picture of "damage points." Here's the headline: a single missed payment can hurt a lot especially if you have very good credit.

A consumer with a great 780 score who missed a mortgage payment would see their score drop by about 100 points, FICO says.  And it would take three years to recover. On the other hand, a consumer with an on-the-edge 680 score would drop about 60 points, and could recover in 9 months, from the same mistake.

9. Lots of free scores now

Despite all the mystery still shrouding credit scores, there is good news for consumers.  So-called "educational" scores are available for free now from many banks.  You should take advantage of these scores. As already mentioned, often these scores are different from the scores lender use, but they will provide a good snapshot of how you are doing. And critically, if you spot a big drop in an educational score, you will know you have to take action to fix the problem, be it ID theft or a late payment.

10. Can I improve my score quickly?

Yes and no. In the section above, we've already shown that rehabbing a great score dinged by an unpaid bill can take three years.  On the other hand, if your score is low because of mistakes or ID theft, removing these erroneous items from your credit report could help your score improve very quickly.  There are numerous services offering to help consumers with low scores; be careful paying for such a service.  It's perfectly legitimate to clean inaccuracies off your report, and it might make sense to hire someone to help you. On the other hand, some firms simply file frivolous disputes over negative entries on your credit report; that can do more harm than good.

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