Note: For basic information on how FICO scores are calculated, see http://www.bestcredit.com/credit-ratings-understanding-fico-scores/
Real world strategies for improving credit scores.
Let's dissect each of the five scoring elements and consider them in terms of their relative connection to practical, real-world actions you can take to improve your score.
As explained, payment history is the most heavily weighted factor, comprising 35 percent of the total credit score for the average person.
- The last 12 months of payment history carries the most significant weight, so recent late payments are the worst. One recent late payment on a single account can lower a score by 15 to 40 points, and missing one payment cycle for all accounts in the same month can cause a score to tank by 150 points or more! This puts a score well below loan-eligibility range overnight. Those 150 points won't come back overnight, though, I assure you. Bills must be paid on time.
- It's estimated that each judgment and collection account entry can reduce a FICO score from 15 to 40 points. The severest detrimental effects come from entries that involve public records, such as judgments, and information from an original creditor, such as tradeline information. That is, an entry such as collection account (an account past due 90 days or more) from an original creditor (the issuing bank of a credit card, for example) will carry more weight than a collection account from a third-party debt collector that is collecting on behalf of an original creditor. Collection accounts and judgments— even paid judgments—are worse than a bankruptcy that's two years old (assuming a good track record since the bankruptcy), so it's important to avoid or remove judgments and collection accounts at all costs. You can still get approved for a home mortgage at the very best rates within two years after bankruptcy. The road to a good credit score is very similar after bankruptcy but a bit trickier. This is explained in far greater detail in Chapter 12.
- The number of tradelines that are “paid as agreed” will raise a credit score, though not by very much (unless they're adding to an average of the total credit history, explained shortly). It's important to make sure at least three accounts in good standing appear on your credit report, since the more accounts in good standing, especially open, the better.
- Public records are factored into the FICO payment history category, including such things as judgments and liens. As such, all adverse public record information must be removed from your credit report.
- Consecutive late payments hurt your score exponentially. In other words, the first late payment isn't weighted as heavily as the second, the second as heavily as the third, and so on. This is particularly true for lateness occurring in the 12 months prior to scoring. Keep this in mind when prioritizing the removal of adverse information, as you may want to first remove items of recent and multiple lateness (especially from the same furnisher), which may yield the greatest benefit in the shortest amount of time.
- Lofty scores are more volatile and will be impacted more by recent lateness. For example, for someone with a score over 800, one 30-days-late entry can reduce it by 100 points, whereas someone with a score of 650 may see a change of only 25 points for the same entry. This is another reason to place recent lateness at the head of the pack when prioritizing bad credit removal.
- FICO does not include adverse payment history when an account is shown as in dispute by a consumer. For information on how to have credit bureaus show an account as in dispute, see “Four Times When Furnishing Is Limited” in Chapter 4.
- Although participating in a credit counseling or debt repayment plan with a creditor can get you denied by most lenders, it is neutral to a FICO score.
Again, the 35 percent weight that the FICO scoring model gives to payment history is for a typical person. This weight can rise substantially if the credit report contains recent delinquent tradelines, collection accounts, or public record entries. For example, with the other factors (amounts owed, length of credit history, types of credit used, and new credit) in a very good state where FICO is concerned, I've seen recent delinquent accounts with a recent bankruptcy take a score down to 450 in weeks! This would put the weight of payment history at more like 70 percent; such a score is only 30 percent of the range theoretical maximum of 850 (150 points of the 550 range, 300–850, is 27.27 percent, leaving roughly 70 percent affected by the payment history).
This knowledge is helpful in understanding how recent lateness can be a huge detriment, and certainly should be prioritized accordingly when removing bad credit.
Few people understand the enormous impact their balances can have on their FICO scores. Yet this is the second most weighted factor in the credit score, at 30 percent.
- The more owed relative to the credit card limit (cap), the lower a FICO score. And there are cutoffs or segments, meaning that within certain ranges of a balance percentage there's no effect, and then a change when a balance hits a cutoff. The cutoffs are as follows: 0–19 percent, 20–39 percent, 40–59 percent, 60–79 percent, 80–99 percent, and 100+ percent. Each increasing cutoff harms a score the same amount as the previous (e.g., if a balance goes from 39–40 percent, it will harm a score at the same rate as its going from 79–80 percent would). (Many “experts” claim 50 percent of the credit limit is a magic number. But as you can see, this is wrong.) Keep all balances on your revolving (credit card) accounts below 40 percent of the credit limit, and never exceed that amount. If possible, never exceed 19 percent.
- The “amounts owed” factor not only takes into consideration all accounts, but each individual account as well. The FICO model will first look at the revolving account with the highest balance relative to the limit and weight this heavily. It will then look at all the accounts (including installment loans, which are fixed payments, such as on an auto) relative to the cumulative limits. If you carry a balance, try to keep it to only one account if it can be below 20 percent. Otherwise, spread the debt around to all the accounts, keeping each one below 40 percent. And if you know when your creditor is reporting, time your payments accordingly; the balance will be lower during the reporting period. Unfortunately, the bureaus only report the date and month, not the day on which an account is reported. But if you are serious about finding out when a creditor reports to the bureaus, you can subscribe to a credit monitoring service (see Chapter 11), which permits unlimited new credit report access over a period of time. You may check this daily to discover when creditors report to any of the Big Three (though a separate subscription for each individual bureau is required for unlimited access to each of their reports).
- As a top negative factor, FICO will often report, “You have no recent revolving balance information being reported.” In general, moderate and responsible use of revolving credit accounts will boost the score slightly. Research shows that consumers with very moderate usage of revolving credit accounts (charging low balances and repaying them on time) have slightly better repayment risk than those who do not use revolving credit at all. Responsible, frequent use of credit increases a score, so use your credit cards regularly (as long as you keep the balances below 20 percent of the credit limit), since not using them will hurt a score.
- Mortgages and other installment loans (e.g., auto loans) are also considered in terms of “gap” (that is, balance relative to amount originally borrowed), though not to the same degree as revolving debt. However, Fair Isaac will not say how much of a role this plays. Paying down installment loans below 40 percent will help.
- Those holding second mortgages may technically have a “line of credit.” It has been generally assumed that such accounts are treated as revolving accounts and can decimate a score if the balances are high. However, Craig Watts of Fair Isaac explained that the FICO model accommodates this by assuming those with very high home equity lines of credit (HELOCs) are using them as second mortgages. He says that someone with a $10,000 HELOC will have it treated as revolving debt, while someone with a $100,000 HELOC will have it treated as installment. He wouldn't say what the cutoff is, even going so far as to say it would change if the secret ever got out. (Many would simply go after a HELOC right below the cutoff, which he claims would be manipulating the system.) My wild, safe guess is that the cutoff falls between $30,000 and $60,000. The best bet is to dump the HELOC if there's a large balance relative to the limit and get a second mortgage if practicable. (Of course, someone who is serious about scoring could check his or her score, close the HELOC, make sure it's reported closed with the credit bureaus, and then check the score again. HELOCs can usually be reopened within a couple of months of closing. Ask your lender.)
Weighted at 15 percent, credit history is no small thing. For a FICO score to be calculated, your credit report must contain at least one account that has been open for six months or more and at least one account that has been updated in the past six months. The older your credit accounts, the better your score.
- FICO scoring takes into account both the oldest credit account and the average age of all open accounts, so it makes sense to keep accounts that are in good standing open (unless they are of the subpar variety; see “Types of Credit” below). Closing accounts not only lowers your score by reducing open account history, but it may also affect the “amounts owed” portion of the pie by lowering the total credit available so that remaining balances weigh more in terms of a percentage of the total available credit. If you've already closed some very old accounts, some creditors will permit you to open them back up (under the same account number). Reopening an account that's far older than anything currently open or reopening a couple of old accounts may be worth a try if doing so will increase the average age of all open accounts. Just bear in mind that before reopening your accounts creditors will perform an inquiry, which will put a small downward pressure on your FICO score. Yet the benefit of adding an aged account should override this, especially for those with a sparse or short credit history.
- Recent activity helps your score, so use your accounts. If you have several revolving accounts, rotate using them every couple of months or so while keeping the balances below 40 percent of the cap or paying them off in full every month.
Are you beginning to see how one of the five scoring elements can affect one or more of the other four?
Types of Credit
The types of credit and creditors account for 10 percent of your credit score. The best scenario is to have a mix of secured and unsecured credit and installment and revolving accounts Secured credit is simply when collateral is used, such as a house or car, while unsecured credit is when no collateral is used, and the credit extended is guaranteed with a simple signature or promise. The ideal mix appears to be a couple of credit cards and a mortgage or an installment loan on a car.
The quality of the lender also matters. There are captive and general lenders. Auto manufacturers are captive lenders—they loan money on their product only; the FICO scoring model treats them the same as a bank, which is good. Credit from auto manufacturing companies such as Toyota Motor Credit and General Motors is fine. But be wary of outside dealer financing; it's often from a finance company. Finance companies, unlike banks, are general lenders; they loan money on anything and are to be avoided because they will hurt your FICO score.
FICO's scoring algorithm attempts to detect if a consumer is making poor credit decisions—that is, getting poor credit terms such as paying a higher interest rate. It's assumed, with some merit, that consumers who use general lenders are making bad credit decisions, and thus any lender that has “Banc” or “Finance” in its name will lower your credit score.
Appliance and electronics stores are always offering “90 days same as cash,” or “no payments for two years.” That type of credit is almost always provided by outside finance companies and is harmful to a FICO score. The exceptions are department stores such as Sears and Macy's, which provide branded credit cards using Citibank and Chase Manhattan, respectively.
Though it's weighted at only 10 percent, obtaining new credit impacts a score far more than most people realize.
- Anytime you apply for credit of any kind, the potential lender performs an inquiry. These are then compounded, with each successive one taking more points off your score. Inquiries have a greater impact on those with a shorter credit history and/or fewer accounts because FICO assumes that the newer you are to credit, the more likely you are to overindulge. FICO also claims that those with six or more inquiries in a two-year span are eight times more likely to declare bankruptcy than those with no inquiries (this claim was made prior to the Bankruptcy Reform Bill of 2005 taking effect). Many department stores try to lure you into applying for a credit card in exchange for 10 percent or more off your purchase. Don't do it! Don't apply for any credit unless you absolutely need it! (Exceptions would be the rebuilding of credit, explained later, and those needing to establish credit for the first time.)
- Some inquiries don't count against your FICO score, including those you perform yourself and those coded PRM (permissible purpose), which include preapproved credit offers, those considered to be “routine account reviews” by existing creditors, and employment-related inquiries. Further, “rate shopping” (going to multiple lenders in search of the best rate on a car or home loan) will only count as a single inquiry if the multiple inquiries were made in the same 45-day period (though each inquiry will still show up on the report). In addition, the FICO score will ignore all inquiries made in the 30 days prior to scoring, so it will be completely unaffected by rate shopping.
- In 2001, FICO developed a new scoring model called Nexgen. Also known as also known as FICO 8, it is supposed to be a more accurate predictor of consumer behavior. FICO 8 does a few things better, like permitting 45-day rate shopping verses 14 for the old version. This is excellent, as it allows those in search of a home or auto to take up to six weeks as opposed to two when deciding on what lender to do business with and not be penalized for multiple inquiries during that period.
- Each time you actually obtain new credit, it will affect your FICO score, most likely in a negative way. The more new accounts you have relative to the total number of accounts reported, the worse the effect on your score. New credit will be most detrimental to someone with a shorter credit history. If you've had past credit problems, getting new credit will harm your score in the short term, but it will help you in the long run if you get the right type of credit and pay on time. In the best-case scenario, someone who has a stellar record and hasn't applied for new credit in many years (say 10 or 15) can actually boost his or her score by opening up a new account.
- Unsecured new credit will do more harm than secured new credit. Be cognizant of this, and obtain unsecured credit judiciously.
- FICO scores both secured and unsecured cards the same way.
People often ask if auto insurers may perform an inquiry on a credit report. They may, unless state law specifically precludes it.2
2 Many states have adopted laws that regulate the practice, such as the score not being the sole determinant, as well as disclosure rules. See the National Association of Mutual Insurance Commissioners Web site (www.namic.org) for more information.