Your credit score is the arguably single most important number that affects your financial health. No wonder that it’s one of the most asked about topics on the interwebs! If you’re a young adult or a new immigrant with little to no credit history, one of the most impactful steps you can take is getting your credit going. This is even truer as your creditworthiness is probably the last thing on your mind at that stage.
So What Are Credit Scores and Why Are They Important?
Your credit score is a single 3 digit number that summarizes your credit risk. It helps lenders evaluate the risk that you will default on a loan or line of credit that may be made available to you. Higher the score, lower the risk and lower the possibility that you will not fulfill your financial obligations.
This means that with high credit scores, you have access to:
- Better rates & terms on car loans
- Better rates & terms on mortgages
- Access to better credit cards with higher credit limits
- Using credit card signup offers to collect enough points to travel hack to your dream destination
Other benefits include:
- Landlords may use your credit score to determine if you’re financially responsible
- Potential employers are likely to review your credit report
Credit Scoring Models
FICO® is the big daddy of the bunch, with a majority of the lenders using that to qualify their borrowers. It uses data from the 3 biggest credit reporting agencies – Experian, Equifax and TransUnion to create a software model. This model is then used to calculate your FICO® Score ranging from 300-850.
You’ll be surprised to know that at the time of writing, there are 19 different versions of FICO® scores used by lenders. This depends on the type of loan you’re looking to get and where the lender pulls your scores.
Don’t worry, you won’t need to track all the versions – just concentrate on boosting your score and it’ll be high enough in all versions. However, keep in mind that the FICO® score provided by your credit card company may not be the exact version used when you’re shopping around for a mortgage.
VantageScore was created by the three national credit reporting companies: Equifax, Experian, and TransUnion in 2006. This is the second most widely used credit scoring model in the United States.
Older versions of VantageScore went from 501-990 but VantageScore 3.0 now ranges from 300-850 as well. VantageScore 4.0 is expected to debut in Fall 2017. This will also use the 300-850 range and is expected to be more predictive than prior versions.
If you’re used to FAKO credit scores from sites like Credit Karma, Credit Sesame, Quizzle and the like they all use VantageScore from one or more bureaus.
Factors That Affect Your Score
Lenders are naturally very interested in how reliably you pay your bills. If you have missed payments in the past – even by a day – it will show up on your credit report. This, in turn, will negatively impact your credit score.
What you need to do:
- Pay all bills on time. Not just your credit card bills or any loans, but also your rent, utilities etc. Set up payment reminders or automatic payments to make it easy for yourself.
- Try not to let an account go to collections.
- Even if you pay it off, it won’t come off your report for seven years.
- If you’re behind on any payments, catch up as soon as you can, even if it is just the minimum payments, to begin with. Note that just making the minimum payments isn’t going to help you get control over your debt, but it’s a start.
There was this one credit card payment that reached my credit union a day late two months in a row. Each time they promptly reported it to the credit bureaus, with not so much as notification to me. I was using Fidelity’s online bill pay service and the payments were arriving a day after the due date. Realizing my mistake a couple of months later, I fixed it promptly, but by then it was too late. Four years later, it still shows up on my report and has dinged my score a few points!
Amounts Owed / Credit Utilization
This is also called as the Credit Utilization Ratio i.e. how much of the credit available to you do you actually use? Are you running spending $2,000 on a card with a $2,500 credit limit even though you pay it off in full? If so, that’s going to hurt your score.
What you need to do:
- Use your cards but keep the balances on the lower side. Do not max out your credit cards.
- Once you’ve had a card and been paying it long enough, you can always try calling your card provider and asking for an increase in your credit limit.
- If you have control over your spending, get additional credit cards but continue to spend the same amount that you do currently. This will reduce your utilization as you’ll be using a lower percentage of all the credit available to you. That said, you need to be very careful with this strategy as it could negatively impact your scores very easily.
Age/Length of Credit History
The length of your credit history allows FICO to determine how long you’ve managed credit, and whether it was in a responsible way or not. The longer your average history, the higher your score.
If you have a short credit history, opening additional cards in a short amount of time will lower your average credit history length.
What you need to do:
- Don’t close older, unused cards. If you’re afraid the bank/credit union might cancel them due to non-usage, get them out of the sock drawer 1-2x a year and buy some groceries.
- Don’t sign up for a lot of cards in a short time, unless you’ve already had access to credit for a decent number of years
Credit Mix / Types Of Credit
This is a mix of the types of you credit that you have – auto loans, credit cards, store cards, mortgages, installment loans etc. To have a good score, you need to have a good mix of some of them. Keep in mind that some types of loans e.g. store credit cards carry less weight than say a bank credit card or mortgage.
It’s funny how this works in that the banks want you to demonstrate you can manage different types of credit responsibly. I remember that when we sold our home and moved cross-country, the mortgage naturally showed up as being ‘paid’ on my report. This caused my score to go down a few points as I was only using a single type of credit i.e. credit cards.
What you need to do:
- Despite the allure, only get other types of credit if you really need it and will use it. Don’t go off buying new cars financed by the dealership just because you want to diversify your credit mix!
New Credit / Recent Behavior
This covers the frequency of credit inquiries and new accounts you may have opened. It has a smaller impact on your score but an impact nevertheless.
What you need to do:
- Don’t take on too much new credit
- If you’re shopping around for a new mortgage, auto loan etc do your rate shopping in a short period of time, say 10-14 days. This lets the credit scoring models know that these multiple inquiries should be bundled together as they’re likely for a single loan.
Boosting Your Score
Now that you’ve understood the credit scoring models and what goes into them, it’s time to figure out how to boost your score!
1. Check Your Credit Report
Request a free copy of your credit report from AnnualCreditReport.com. You can request it from all three bureaus at the same time but I personally prefer to request from a different bureau every 4 months. This will allow you to check it 3x a year and catch any discrepancies. You are entitled to one report from each bureau every 12 months.
Be careful to check all three reports as some lenders report to only some of the agencies and not all three.
If you catch any errors, dispute them online for free:
I had an old auto loan that was never parked as paid from one of the 3 agencies. I filed a dispute online and a few months later it was marked correctly. They kept me updated with notifications every time an action was taken on their behalf which definitely helped me to understand where my file was at any given time.
2. Get a Credit Card
If you have too few, or none at all, getting a card will help boost your score. It affects multiple factors that you’ve already seen above. Needless to say, manage it responsibly and pay off your bill each month.
If you’re a new immigrant and gainfully employed (which you should be), look into local credit unions near your place of work or residence. Some may have tie ups with your employer allowing you to get an unsecured credit card relatively easily. This was actually the step I took when I first arrived in the US almost two decades ago. I was able to get a card from a local union and used that to start building my credit history.
3. Become an Authorized User
If you’re just starting out, or have bad credit yourself, see if you can become an authorized user on your parent’s or spouse’s credit card. This will help increase your score over time as the card is paid off in full.
If you’ve not been financially responsible in the past, there may be convincing in your future to let them add you on as any negative actions you take will impact their credit as well.
4. Pay Your Bills on Time and Don’t Max Out Your Cards
Simply put, both factors will make or break your credit, as discussed above.
5. Pay Down Your Balances
Moving credit around from one card to another via balance transfer or borrowing from Peter to pay Paul isn’t going to help your credit, likely the opposite.
Reduce your expenses, save enough and make additional payments to pay down your balances. This will reduce your credit utilization and you’ll notice a difference in your scores in a matter of months. Rule of thumb is to use only 30% or so of the credit available to you across all cards and loans.
If by chance you’ve made some bad decisions in the past and they show up on your report, try and negotiate. Call up the banks from where you got your cards and see if they’ll let you reduce your interest if you agree to pay it off in a lump sum or via installments by a certain time frame. Get the agreement in writing.
- CFPB – What is the best way to negotiate a settlement with a debt collector?
- Dummies Cheat Sheet
- Debt Settlement & Negotiating With Creditors
7. Ask For Help
If you feel you’re drowning in debt and can’t manage to pay your bills, then please ask for help. Find a legitimate credit counselor who can help you consolidate your debt. They will hold your hand and get you on the right path to fixing your credit.
Be wary, as there are a lot of unscrupulous agencies and folks out there looking to take advantage.
- US Dept of Justice: Approved credit counseling agencies
- FTC: Choosing a Credit Counselor
- NFCC: Locate an NFCC Certified Credit Counselor
Does It Work?
Understand the factors that affect your credit score and follow the steps above to improve your credit score. You have to be patient and work at it constantly and you’ll be in the 700s pretty quick. Stick with it, and an 800+ score is easily doable.
Header photo by CafeCredit under CC 2.0