One day a few years back, I decided to shop for a car. I was still using public transportation as I transitioned from life on the East Coast to life in Southern California. You really need a car in Southern California. I didn’t think I would be able to buy a car because I hadn’t saved any money. But I got it in my head to browse and dream for at least an afternoon.
I took the bus to a car dealership after work and test drove a modest vehicle with few bells and whistles. When I told the salesman I wasn’t prepared to buy a car that day, he asked why not? I said I couldn’t afford to make any size down payment. As in zero. He said lots of people buy cars with no money down (this was news to me). Obviously, it was in his best interests to make the sale, and I knew it. Still, I decided to apply before walking back to the bus stop. What could it hurt?
Less than one hour later, I drove myself home.
To my pleasant surprise, I found out that day that I had excellent credit. My score popped up at about 780. I had no inkling what it was or what it meant, except that the number was good enough to get me a $20,000 loan at 2 percent with no money down. I was more than satisfied with that result.
The moral of my car story is that a good credit score opened the door to credit that I needed, even before I knew I needed it.
Bad versus good credit – what’s the difference?
First, you should understand why it may be worth your time and efforts to try to raise your credit score.
Every creditor decides what “good” or “bad” credit is. There is no universal cutoff point. For a mortgage lender, you might need a score of 740 or higher to get the best rate. For an auto lender, maybe 720 will get you the best loan. The only way to find out is to ask each lender.
Nonetheless, these credit score buckets or ranges (excellent, good, fair, poor, bad) matter because that’s where lenders draw their pricing lines.
The best example of how this works is in mortgage pricing. Interest rates on mortgages tend to rise gradually as credit score goes down. Some mortgage lenders have a sliding scale that includes six (or more) different rates, five of which are higher than the advertised rate. A consumer with a 625 credit score is likely to pay a higher interest rate than someone with a 665 score, who is, in turn, likely to pay more than someone with a 725 score.
Here’s what the overall interest cost to these three hypothetical consumers would look like on a $200,000 30-year fixed-rate mortgage loan:
|$200,000, 30-year fixed-rate loan||6 percent interest||5 percent interest||4 percent interest|
|Total interest over the life of the loan||$231,676||$186,512||$143,739|
|Total additional cost for less than excellent credit||$87,938||$42,774||$0 (best price)|
(Source: Amortization Schedule Calculator)
You’re reading that right. The person with a 625 score will pay nearly $88,000 in additional interest charges over the life of this loan, compared to the person with the 720 score.
In this case, the moral is that having good credit can significantly knock down the cost of the credit you need.
I’ll bet you have quite a few other things you’d rather do with $88,000. So it’s a really good idea to be thinking about this before you need that loan.
While this is a very generalized example and does not represent actual interest rates at a bank today, it really is how banks price loans. Unfortunately, the cost of bad credit tends to be even higher as interest rates rise for everyone.
What’s in your credit score and why you need to know
Credit scores are based on these five factors:
- Payment history. Late payments hurt you. Collections hurt even more.
- Utilization. This is how close you are to maxing out your credit cards.
- Age of credit. Keeping accounts open for a long time is good for your credit score.
- Credit mix. Your experience with different types of credit, such as installment loans and revolving credit, is reflected in your score.
- Inquiries. This represents the number, type, and frequency of credit checks made because you applied for new credit. Self-checks and certain other kinds of inquiries do not hurt your score.
The first two factors, payment history and utilization, are most important. The other factors have less influence on your score but if handled correctly can help you reach the next higher credit score bracket and (hopefully) become eligible for a cheaper loan.
Here are the top three actions that can potentially result in fast and dramatic credit score improvement:
1. Correct errors
Millions of people have errors on their credit reports. The most recent study by the Federal Trade Commission (2012, with a follow-up in 2015), found that one in five consumers had a credit report error corrected by the reporting agency, and one in five of those consumers saw their credit score go up as a result of the correction.
Federal law says you are entitled to a free copy of your credit report every twelve months from each of the major credit reporting agencies (Equifax, Experian, and TransUnion). There is only one place to get these free copies, and it’s AnnualCreditReport.com. Some people like to monitor their credit all year long by getting one bureau’s report every four months, but there is no wrong time to request your free copies. Additional copies of your credit reports are always available from the reporting agencies for a fee.
It’s a good idea to get your credit report at least once a year and comb it for errors. After all, you’re the only person responsible for checking it. If you find erroneous data, follow the agency’s instructions for requesting a correction. You have to do this separately with each credit reporting agency. For significant issues, you may need to write letters to both the reporting agency and the creditor reporting the data you want to be removed. Smaller issues can often be resolved just by clicking the “dispute” button while viewing your report.
Removing negative data
In addition to errors, if you find any negative data on your credit report that you think can’t be verified by the creditor, consider disputing it. The credit agencies aren’t obligated to remove negative data if it’s accurate and timely, but the debt must also be validated by the creditor on request. Otherwise, the agency must remove it from your report.
2. Pay early, and never late
If you pay a bill one day late, it probably won’t hurt your credit score (although you could be hit with a late fee). Once you hit the 30-day late mark, however, the creditor will typically report it and the negative mark is then reflected in your score.
Sixty days late is worse than 30 days late, and 90 days late is worse than 60. Collections hurt most of all, but in the newest versions of the most widely used credit scores, paid collections don’t count against you. Unpaid collections, however, are very damaging, so if you’ve made mistakes in the past, it’s a good idea to clean them up if your goal is credit score improvement.
Late payments and collections stay on your credit report for seven years, but the damage to your score diminishes over that time.
Just don’t pay late. Bill management is part of adulting. If you struggle with this, consider setting up auto payments, reminders, a bill pay app. Whatever you need to do.
3. Lower your utilization
Your utilization ratio is your credit card balance divided by your credit limit. It’s calculated for each card and overall. If your credit card has a $1,000 limit and your balance is $500, your utilization is 50 percent. If you have three cards with $1,000 limits and your balance is $900 on one card, your utilization is 90 percent on that card and 30 percent overall. Maxing out (or almost maxing out) any card or multiple cards hurts your score.
You might come across advice to keep your utilization under 50 percent or 30 percent or even 10 percent. In fact, no magic number represents a line between high and low. Just know this: People with credit scores above 800 tend to have utilization under 5 percent.
When it comes to utilization, lower is better.
Here’s a hack that can help you use an early payment strategy to reduce your utilization ratio: Most credit card issuers report utilization on or right after the statement closing date. That’s typically three weeks before your payment due date. So where your credit score is concerned, your utilization ratio might be higher than you think it is. This is especially true if you use your card but pay it off every month. If you don’t pay your bill early, your utilization is not zero.
Pay your bill before your balance is reported to get the lowest possible utilization reflected in your credit score.
Other credit score improvement strategies
The other factors that affect your credit score have less of an impact, but they still count:
The age of your oldest account and the average age of all your accounts combine to give you a credit age score. The older, the better, but there isn’t much you can do to speed the passage of time. What you can do, however, is keep old accounts open. If you’ve had a credit card for years and years, and there is no disadvantage to keeping it open, do so even if you prefer to use some other card on a more regular basis, such as for rewards or other benefits. Let that old card just keep getting older.
Any time you apply for credit, the inquiry can ding your score by a few points. Each inquiry stays on your credit report for two years, but only affects your score for the first year (and the damage diminishes over that time). For a top score, consider steering clear of credit applications until you really need to apply.
The credit scoring agencies will reward you if you show an ability to handle different types of credit, like auto loans, student loans, mortgages, credit cards and so on. But most people don’t need to go out and get a loan just to improve their credit mix. It’s likely to happen naturally over time as you acquire student loans, credit cards, auto loans, mortgages, and other credit products through normal life events.
If a creditor is reporting negative data on your credit report, you could simply call and ask them to remove it. This is particularly effective if you have a history of good habits but slipped up one time. Also, some collection agencies are known to be willing to remove negative data in exchange for your payment of the amount you owe or the amount you negotiate.
How long it takes to get a better credit score
Your credit score is a snapshot of a moment in time. It represents the data available to the scoring agency at the moment the score is calculated. It’s fluid; a score can and does change with every new piece of information that becomes available, including the passage of time.
The truth is that you can change your credit score before lunch. For example, you could pay off a collection account or a credit card balance and request that the creditor report your new zero balance immediately. Some people do this when they’re trying to qualify for or get a better rate on a mortgage. It’s called a rapid rescore.
If your problem is poor payment habits, though, your score will take longer to improve. Recent credit behavior (the last two years) is much more important than old behaviors. If you pay on time every month for 6-12 months, you will probably see your score improve.
The only way to know what to do and how long it will take is to analyze your own credit history to identify the factors that are bringing down your score. For one person the problem could be high balances, while someone else may have a lower score because they pay cash for everything and never use credit cards or loans. Both of these scenarios have multiple possible plans of attack, but the strategies are very different, so you’ll need to know your starting point first.
Do it for your financial future
If you’re confused or overwhelmed, or you’re trying to overcome serious past problems, you might want to work with an accredited credit counselor. Many services are free, and others have a nominal monthly fee.
Great credit is worth the trouble. It’s your money. You should get to keep more of it. In the financial universe, we’re all somewhere on a spectrum between people who earn interest and people who pay it. Wouldn’t you really rather be on the earn side? Getting a great credit score under your belt can help you cut way back on the amount of money you pay to others so that you can have more in your pocket to spend or invest as you see fit.
Kimberly Rotter is an editor at Haven Life and a consumer credit and personal finance expert. She provides consumers with understandable, actionable information that can help them improve their financial and credit health.