Every day in banks across the country, people like you and me stare their loan officers in the face with confusion and anger. We stare because we just learned what our credit score was, and how we would not qualify for a loan because of that credit score. This is both embarrassing and humbling. The good news is that there are specific steps that you can take today to avoid credit score shock, and begin working your way towards improving your credit score.
A credit score is nothing more than a mathematical equation that tells lenders and banks the risk they are taking when they lend money to you. A credit score is a generalized numerical guide for banks and lenders to help them make their lending decisions. Credit scores range from 300 – 850. 850 being flawless credit, and 300 being “pull your financial life together and stop being stupid, because nobody will lend you a penny” credit. Your credit score is compiled by the Fair Isaac Corporation, or FICO. Your FICO score is a snapshot in time of your financial history. FICO creates all credit scores by compiling credit reporting information from the three major consumer credit agencies: Equifax, Experian, and Transunion.
The first step to avoiding credit score shock is to know what your credit score is (preferably before you walk into a bank and apply for a loan). To get a baseline of what your credit report looks like, you can pull a free copy of your credit report. Federal law allows you to pull one free copy of your credit report per year, from each of the 3 major credit agencies. If you schedule your pulls correctly, you will be able to pull a free copy of your report every 4 months. Your free report can be obtained at http://annualcreditreport.com. That is the only site authorized by the government to let you pull your report for free. Don’t be fooled by the snazzy commercials for their competitors (freecreditreport.dot.com).Unfortunately, you will not be able to see your actual credit score when you pull a report, but you can gauge a very accurate estimate of what your score will be based on the following 5 credit score criteria.
Payment History – 35%
The main component of a credit score is your payment history. All payments on mortgages, credit cards, auto loans, student loans, and all other debts that are reported to the credit bureaus are factored into the payment history. As soon as you are 30 days late on a payment, that information will be reported to the credit bureaus, and included in your credit score. It is important to stay on top of your payments, and never hesitate to contact one of your lenders if you believe that a late payment has been reported in error.
Credit Utilization – 30%
Only slightly less important than your payment history, is your ratio of revolving debt levels to your revolving debt limits. For instance, a person who has a $10,000 credit limit on a credit card, but maxes out their credit card each month will have a very high debt level to credit limit ratio and their score will suffer because of it. Simply paying off debt on your revolving lines of credit can immediately impact this ratio to your benefit. If you decide to cancel one of your credit cards because you have paid off the balance be aware that this could hurt your credit utilization ratio. One quick fix is to contact another of your credit card companies and ask them to increase your credit limit by the amount of the credit limit that you just cancelled. This should balance out your debt level ratio, and your credit score should not suffer.
Length of Credit History – 15%
Another factor in your credit score is the length of credit history. The longer your lines of credit have been open, the more banks perceive you as being established and stable. Banks do not want to lend to a unproved rookie; rather they like to lend to veterans. Obviously you cannot speed up time to improve your length of credit history, which is why it is a great idea to open a low credit limit, secured credit card at a young age. This will establish your credit history, and teach you valuable lessons in handling your money. Many college graduates realize that they have not established any credit by the time they leave college. By this time, it is too late. Auto loans, mortgage lenders, and even some credit card companies will scoff at extending you any credit. Avoid this humiliation by beginning your credit history as early as possible.
When canceling credit cards, it is also important to remember that if you have had a credit card for a long period of time it may be better to simply use the card once or twice a year and pay off the balance every month, rather than canceling. This would avoid your length of credit history being affected by trying to make a seemingly smart financial move.
Types of Credit Used – 10%
Lenders also want to see that you can be trusted with various forms of credit. You should have revolving credit (credit card), installment loans (student loans, auto loans), and mortgages. The more credit types you are able to successfully manage, the more lenders will be willing to work with you, and give you lower rates.
Credit Inquiries – 10%
The last factor in your credit score is the number of credit inquiries that you have on your report. There are soft inquiries and there are also hard inquiries. A hard inquiry is the only one that will actually lower a credit score. A hard inquiry is where a lender actually pulls a copy of your credit report to analyze you for a potential loan. A soft inquiry is where a company simply does an unauthorized check of a person’s general credit standing; usually for marketing purposes. A large number of credit inquiries strung closely together can indicate to a lender that you are “shopping” for credit, and this will hurt your credit score.
Never be Shocked Again!
Credit scores may seem like an enigma, and there really is no true way to know exactly what your credit score will be, but if you follow the steps above you can guarantee yourself that your credit score will be as high as it can be. You will never again have to be humiliated by being turned down for a loan after you were surprised with a low credit score!