Your FICO score is a numerical measure of your creditworthiness that ranges from 300 to 850. There are three different credit repositories – Experian, Transunion and Equifax. Each has a different calculation for their distinct credit score, but they are all similar in the areas that will affect the score.
They generally focus on five categories when calculating your score: How much debt you have, your payment history, your debt utilization ratio (how much you owe in relation to your credit limits), how far back your credit history goes and your mix of various types of credit.
Here are a few things that can wreak havoc on your score and wreck your chances of getting an affordable loan:
Making late payments
A single late payment on a credit card or other loan could ding your score by as much as 110 points if you already had a great score and 80 points for someone with an average score. So the best thing you can do to improve your score is make payments on time.
This continues to be the number one reason scores are lower. In addition to being a heavily weighted part of your score, if you’re late on a payment, it’s going to continue to appear on your credit report for about seven years.
If you’ve made mistakes in the past, you can’t change them, but you can outlive them. The longer it’s been since you were late on a payment, the less of an impact it will have on your score. Typically if it’s been at least 36 months since your last 30-day late payment, it doesn’t affect your score.
Since payment history accounts for about 35% of your total score, it’s really important to start paying on time.
Carrying a big balance
Your debt utilization ratio accounts for almost 30% of your score. So carrying too much debt will not only cost you a fortune in interest, it can also destroy your credit rating.
For example, if you have a credit card with a $5,000 credit limit and you owe $4,000, you owe 80% of your limit. That will more negatively affect your score than if you only owed $3,000 or $2,000. The ideal credit card situation is to have a very high credit limit and have a balance of less than 10% of that limit.
There are two ways to improve your debt utilization ratio. The first obvious way is to pay down your balance. The second is to ask for and always accept an increase limit from your bank or credit card company. This will lower the debt utilization ratio without paying down your balance.
Closing a credit line
As credit card companies jack up interest rates and add inactivity fees to compensate for lost revenues, it’s tempting to just close your accounts. But closing a line of credit could impact your debt to utilization ratio.
For example, if you have two credit cards with a limit of $1,000 each and a $400 balance on each card, your current debt utilization ratio is 40%. If you close one of the credit cards and transfer the $400, giving you an $800 balance on one card, your debt utilization ratio will immediately double to 80%.
The negative effect varies greatly depending on how many cards you have and/or how high your credit limits are on your cards. Closing one card could have a very small impact if you have lots of other high-limit cards. This is another reason to ask for and accept any limit increases.
You can counteract some of the impact by opening up a new line of credit. But beware: that can also impact your score. (see the next Killer)
Opening a credit line
When you open a new account, you’ll knock some points off your score but not a significant amount. The reason why is that according the data collected by the credit repositories, the people who open new accounts tend to be of a higher risk level immediately after opening a new account. Hence, opening a new line of credit typically will decrease your credit score from five to 15 points.
However, the temporary ding only lasts about six months, so if you’re in a stable financial situation, the score reduction could be worth it in the long run.
Defaulting on a loan is the single worst thing you can do for your credit. And unfortunately, more people are damaging their credit scores through foreclosures, credit card charge offs and bankruptcies.
A home foreclosure, for example, might dock about 200 points off your score and a short sale could cost you around 100 to 150 points. Declaring bankruptcy could lower a good score of 750 by up to about 250 points. Charge offs, like auto repossessions or credit card write-offs, will also drop a credit score by 100 to 150 points.
Most negative information stays on your report for seven years. However, bankruptcies can stay on for 10 years. But it’s never too late to start rebuilding your credit.
“I need to close all my old accounts to improve my credit score.”
Closing an account will NEVER increase your credit score. Many people want to “clean up” their credit by closing all old accounts they are not using. This is understandable so as to assure an old account that is still open does not get used fraudulently. However, simply closing an account will not do anything to positively affect your score. In fact, it could negatively affect your score because of the debt utilization ratio.
As we learned above, 30% of your score is determined by how much you owe (your balances) versus how much you could owe (your balances). This ratio is not only calculated per tradeline, it is also a cumulative calculation of all your balances and limits. By closing an account with a $2,000 limit and a zero balance, you have just reduced the amount of your cumulative credit limits but your balances stayed the same.
“Don’t pull my credit – it will drop my credit score!”
Many people are worried that someone pulling their credit will drop their score. It will, but usually only 3 or 4 points. And if you only have 1 or 2 inquiries in a month, by the next month the score rebounds back the same amount the score dropped.
Additionally, the credit repositories can determine if multiple credit inquiries are for the same reason. For example, if you are shopping for a car loan and 8 different lending institutions need to pull your credit to determine the terms they can offer you, this will only count as one inquiry on your credit. The rule of thumb is if you have multiple inquiries on your credit for the same reason within a 2 week period, these will all be counted only once.
Also, All inquiries after 10 in a 12-month period will have no effect. In other words, ten inquiries in 12 months is a cap on the negative impact.
“I need to pay off my collections to improve my credit score.”
This one is true and false depending on your goals. If your goal is to improve your scores for something more than a year in the future and to completely clean up your credit report, then you want to pay off all your collections. However, if your goal is to get the best score you can for something in the next few months, you may not want to pay off all of your collections.
There are two aspects of a collection that negatively affect your credit score – the balance and recency of the collection. Simply having a collection account with a balance will drop your credit score. However, a more recent collection will drop your score more than an older collection will, even if the more recent collection is for a smaller amount.
For example, if you have a collection that was just filed last month with a $200 balance, and you have a collection that was filed 3 years ago for $2,000, the more recent collection will drop your credit score more than the older one will. In this instance, paying off the $200 collection will help your credit but paying off the older collection could actually drop your score. If you pay off the $2,000 collection, then the balance will report as paid, but the credit report will update the date of the collection to the month you paid if off, thus making it appear as though it is a recent collection.
So what is the rule of thumb? Pay off all collections if you don’t plan on needing credit in the next 1 to 2 years or more. If you need to buy something on credit within the year, only pay off collections with recent reporting dates (those with dates within 6 months of the date of the credit report).
“It doesn’t matter what my credit score is as long as I have great collateral for the loan.”
Having a lot of equity in the car or house being purchased or refinanced does not discount the importance of proving to the lending institution you have a good history of paying back loans. Believe it or not, financial institutions are not in the business of repossessing cars or foreclosing on homes. This is a very expensive and time consuming activity. Anytime they make a loan, they want to be paid back. Lending institutions make their money on the interest they earn, not through re-selling collateral. They are not risk takers.
“My loan will be approved or denied solely based on my credit score.”
Your credit score is just one piece of the overall approval decision. Lenders look at many different factors when making loan decisions, including, but not limited to the equity (Loan To Value) ratio of the collateral, the income of the borrower, the items within the credit report that are used to calculate the score and the net tangible benefit to the borrower. There are many times a borrower can have a very high credit score but cannot be approved for a loan, such as when a lender is unable to verify a borrower’s income.