Pragmatic Finance

These days your credit history is becoming an inseparable part of our financial lives. Want a loan for a car or house? That lender is going to check your credit before he decides to loan to you and how much interest to charge. And of course if you’re going to apply for a credit card they are going to check it to help them make their decision. Even car insurance companies are starting to use it to help determine the rates they will give you.

In addition to looking over your history, potential lenders will also look at your FICO score, which is a measure of your credit worthiness. The higher the score the more willing they are to give you loans with lower rates. The score ranges from 300 to 850 with most in the 600 to 800 range. A score over 720 is usually needed for the best rates. If you’re curious about your current score you could pay to get an official one. Everyone is entitled to a free report from each credit bureau once a year. I would recommend pulling it for free and using a FICO score estimator.

If you wanna beat a game you gotta know the rules first. Unfortunately the exact equation is a secret but there are some vague guidelines about how the score is calculated. There are five main categories looked at and each has several factors inside it.

35% Payment History - This is the largest chunk of your score. The more on time payments the better. If you are late 30 or more days your score is going to get dinged. The longer you are late the worse it gets. If the debt is charged off and sent to a collection agency it’s really going to hurt. If you have to declare bankruptcy, well let’s just say companies will be very hesitant to lend to you for awhile. Of course, if you pay your bills on time then this category will only help you.

30% Amounts Owed - A close second in importance is how much money you owe. There are several things to consider here. First is the total you owe. The higher it is the more cautious people are to lend to you. Also, how much of your credit you are using is extremely important. Someone who $5,000 of debt on a card with a limit of $6,000 is much worse off than someone with $5,000 on a card with a $25,000 limit. Not only is each individual card or tradeline looked at, but your total available credit over all cards is compared to how much you’ve used.

15% Length of Credit History - Pretty self explanatory. The older your credit history the better. Not much you can do here. If you already have some credit cards avoid closing them, especially the oldest ones.

10% Types of Credit Used - The three main types of credit are revolving, installment, and mortgage. A good mixture of these is best. However, avoid finance company accounts if possible. These look bad because they tend to be used by people who can’t get normal loans. Also, major credit cards are preferred to department store ones.

10% New Credit - When you apply for credit a hard inquiry is made and can be seen by others who view your credit report. These stay on for 2 years but after 6 months they are much less important. Mortgage inquiries within a 30 day period are counted as one so you don’t have to worry about that if you’re shopping for a home loan. If you check your own credit report it is simply recorded as a soft inquiry that only you can view so that doesn’t hurt your score.

That’s it. The first thing that’s obviously missing from here is income. Also, if you’ve applied for any credit cards you’ve undoubtedly been asked for work information, how long you’ve lived at your residence, etc. These are factors that lenders will individually consider but they are not factored into your FICO score.

So what is the best way to improve my score?

The easiest way to get a good score is to open several cards from major issuers, use them, and pay the bills on time. This will give you a good history and you will probably get credit limit increases as time goes on. This will help out your credit utilization if you get significant balances on them. Never close your oldest cards and your credit age will increase with time.

If you are going to apply for a loan soon make sure not to apply for many cards or other forms of credit within 6 months. Also, try to pay off your cards several months beforehand, starting with the ones that are closest to being maxed out first.

Having mortgage, auto, student loans, etc on your report will greatly help your score but I can’t thing of any situation where I would benefit more by opening up a loan to increase my score.