Why do you keep hearing about credit ratings and how important those scores are? In the same way that companies and even governments are rated on how likely they are to pay back money loaned to them, individuals are also rated by their risk to lenders. In corporations, the rating goes from AAA (almost no risk) to BB+ and below (the so-called “junk bonds”). For individuals, it is that magic credit score that goes from 300 to 850 (FICO). There are other scales based on other risk models, but in general the higher the value, the better your risk.
Why is Improving You Credit Rating Important?
Just like corporations, when money is loaned to you, the higher the risk of not paying it back, the more it will cost you to get that loan in the form of the loan’s interest rate. More risky people will get charged a higher interest rate for the loan. So, how do you raise your FICO score if it isn’t very good?
A friend and I discussed that there is a tool that mortgage lenders use that can tell you exactly what to do to attain a particular credit rating. Of course, this tool is not available to the general public, so we cannot just go on the internet and have it spit out a list of things to change.
While we don’t know exactly how credit risk models are built, according to MyFico they take into account a number of factors with general weightings: Payment History (35%), Debt Burden (30%), Length of History (15%), Types of Credit (10%), and Recent Credit Searches (10%)
Where to Start: Paying On-Time
If you look at the percentages, you can see that the highest weighting of the credit rating score goes to Payment History and Debt Burden. That means that one good way to raise your score is to make sure you pay on time. Payment History is based on on-time payment and not the amount of the payment. So even if you have a credit card that has a low amount due, make sure it is paid on-time. Note, I said on-time payment and not payment in full.
Obviously, if you don’t pay in full, the company is going to charge you interest for the amount not yet paid, but it should not affect the payment history. Keep in mind that if you’ve missed payments and are starting to pay on-time it will take some time to see a change in score. This is because the scores are based on the most recent 12-36 months of history, so it may take a year or more for those missed payment months to roll off the history.
Next: Reduce Your Debt Burden
The other high-weight item, Debt Burden, takes into account a number of things, but one of them is the ratio of the amount of credit you have available compared with the amount of credit you are using. To find that ratio, add up the balances on all of your cards. Then add up the credit limits for all your cards. Finally, divide the total balance by the total credit limit. You will get a number between 0 and 1. You want a number closer to 0 than 1.
There are a few things you can do to improve the Debt Burden ratio of your credit score. First, don’t max out your cards. Second, if you aren’t using a card, don’t necessarily close it if it has a high credit limit. A higher credit limit will help lower the ratio.
Opening new cards and not charging on them, while they would improve that ratio, isn’t all that useful if your score is low to start with. This new card will likely have a high interest rate and you aren’t likely going to get a high credit limit, so this isn’t very helpful. In addition, opening a number of new credit cards is going to cause a credit search for each one, which will lower the Recent Credit Searches portion of the FICO score.
Umm… so Why is it Low to Start With?
Of course, the major credit rating question is why the score is low to start with. What habits around money do you have that caused the lower score? If that is something you might need help with, contact us and we can help you determine how best to get back on the right track.