Frugalnomics

The FICO credit score has become a centerpiece in American business. Not only does it help creditors determine whether they will finance your new car or house, but many employers are also using it to help evaluate potential employees, especially when the job requires some sort of security clearance.

It is thus essential to achieve a “good” credit rating and maintain that rating once you get it. There are three basic tenets of improving your credit score: pay well, pay long, and don’t borrow more than you can pay. All three parts will take time, but you can do it!

Before we get into how to improve your score, let’s first define what a good score is. There is much debate about this, involving words like “prime”, “sub-prime”, and other terms that really do not mean a lot to the layperson, especially now that the big movers, like Fannie Mae, are in financial straits themselves.

As a general rule, however, having a score under 620 (out of a possible 850) means you are a risky borrower and lenders will either decline you or charge you exorbitant interest rates. On the upper end, 720 will get you most anything you want, and once you get above 780 it no longer matters how high you go. By law you are allowed to receive one credit report from each of the three credit reporting bureaus annually, make sure you review them at least that often, though quarterly is certainly better.

Pay Well

The key term used to determine your FICO credit score is “payment history,” and how well you pay your debts is the first half of your payment history. Here’s how to show that you can pay well:

Make every payment, and make it on time. When you look at your credit report, it only shows whether or not you made the payments as agreed, it does not indicate whether you paid more than required or if you only paid the minimum amount owed. Getting behind on payments or paying less than the minimum amount owed is the quickest way to start losing points, though.
1. Maintain a low average monthly balance on unsecured debt. Unsecured debt is dangerous debt; it is debt like credit cards which is not backed by collateral. Managing your unsecured debt well shows creditors that you are capable of managing secure, fixed-rate loans like auto and home loans. The best way to handle your unsecured debt is to pay off the amount owed each month, or, at a minimum, to always pay more than you charge. If your monthly balance increases each month it shows lenders that you are spiraling into deeper debt.
2. Keep your debt to available credit ratio low. If you have $3,000 in available credit and maintain a debt of $1,500 or more it looks bad. Get that ratio down to at least 50%, though less than 30% is best.
3. Settle delinquent accounts. If you are behind on payments get caught up! No lender will borrow fairly to a person who is already behind in payments. They may borrow to you, but they will charge very high interest rates to make sure they get their cut before you declare bankruptcy. Once you get your accounts into “good standing” keep them that way: it will take time before the credit agencies will determine that you are no longer in trouble.

Pay Long

The other half of payment history is how long you have held and managed credit. Lenders, especially those who might give you a loan for a long-term purchase like a mortgage, want to see that you are capable of the commitment. Here’s how to make this part better:

1. Start with a small, secured, fixed-rate loan. This type of loan is called an installment loan. It is backed by collateral, exists for a specified term, and usually has a fixed monthly payment. Your auto loan and mortgage are both installment loans, but if your credit score is low you’ll have to start with something smaller. If you can get a loan for a cheap car, that is the best way to start.
2. Another option is a cash loan. Most banks will offer small loans, about $1,000, that you back with items already in your possession, like your plasma TV and expensive sound system. Take this loan and do not spend it! Place it in an interest-bearing account so you recover some of the money you’re spending to make your score better and to act as your own security, giving you the ability to pay off that loan if things become difficult. Pay off the loan over the predetermined time; do not pay it off the next month.
3. Keep credit card accounts open. The knee-jerk reaction to having bad credit is to shut off all of your cards. If you are in financial hardship just cut up the cards or lower the limit, but keep the credit line open. 10 years is the golden number. A credit line will stay on your history for ten years after the date it was closed, and credit lines that have remained open for ten years show creditors that you are capable of a 30-year mortgage. If you close your credit accounts you are basically starting all over again. Instead, pay off the balance and keep it at zero: if you never have a balance you are always in good standing.
4. A common fallacy here is that it is bad to have many accounts. No one is turned down for credit because they have a lot of accounts; they are turned down because they can’t manage their accounts. One thing that does matter, though, is if you have applied for a lot of loans recently. If you apply for multiple loans it looks like you are out of money and looking to fix the situation by borrowing.

Don’t Borrow More Than You Can Pay

There is really only one thing that matters here: keep your debt-to-income ratio low. If you work a minimum-wage job and have as much debt as a person who makes $50,000 a year, it shows that you are living beyond your means. The credit agencies really do not see how much you make, so it is the previous steps that determine this in a “show me don’t tell me” way. It actually comes up at the point you attempt to borrow more money. The lender invariably asks for your employment information, and will compute the amount of credit reported to the credit bureaus and match it to your income. If you have a low debt-to-income ratio they will be more willing to lend, and do so at lower rates.

The last piece of advice to improving your credit score is to simply be patient. Credit scores take a long time to improve because they are, by definition, scoring you over time. There are many people out there who will tell you they can fix your credit for you now, but you are the only one who can truly do it, and you do it for free. Take charge of your finances and follow these precepts develop a plan to improve your credit score.