(Article Updated March 31, 2019)
In the world of personal finance, credit is king, and if you don’t have a good credit score history, your options when it comes to loans, credit cards and other financial products will be substantially limited. Not only do you have access to fewer loan products but your interest rates will not be as competitive.
So what can future homebuyers do in order to improve their credit before approaching a house purchase? There are plenty of things one can do to boost credit score for the long term. First and most important, it’s key to familiarize yourself with your existing credit score and then build awareness around those behaviors with the greatest impact on the credit score.
How are credit scores determined
If credit score calculations seem mysterious to you, you are not alone. The three existing credit reporting agencies (Trans Union, Equifax and Experian) responsible for determining credit scores use secret algorithm-driven equations to generate objective and unbiased measures of whether or not people pay their bills on time. Thes credit scoring models are proprietary and are kept confidential to keep lenders separated and unable to determine the factors behind the algorithm.
What factors make up the credit score
Despite not being able to distinguish the exact components of your credit score calculation, there are five general areas that drive your rating. Knowing what they are and how to fix them is an essential part of improving your credit. Here are the top factors responsible for your credit score and what you can do to improve them:
Payment history (35%) – This is one of the most important factors in determining your score. Lenders want to see you take your obligations seriously, so be sure to pay on time, every time. If you are just beginning to build your credit, start small but and keep it under control. Pay off what you charge as quickly as possible.
Credit utilization (30%) – Your utilization refers to the amount of available credit you're using. Generally, the higher your utilization rate – that is, the more of your available credit you're using – the lower your score, so get those high balances paid down. Also, if you do pay your cards off, don’t automatically close the accounts because your utilization percentage will go down if you have no available credit showing.
Length of credit history (15%) – When making lending decisions, a longer history simply shows the lender that you have more experience using credit. In theory, the longer your credit history, the more accurate a lender can be when determining the level of risk you present.
Credit inquiries (10%) – Whether it be applying for a car loan or a retail credit card, each of your credit inquiries is recorded and included on your credit report. Too many inquiries at once could indicate to lenders some kind of financial trouble.
Types of accounts (10%) – Having a mix of different types of accounts – a mortgage or home equity loan, personal loan and credit card for instance – is looked upon more favorably because it shows you can qualify for and handle different types of financial obligations.
How to boost your credit fast
One of the most impactful detriments to your credit score is simply paying your bills on time. Although missed payments stay on your credit report for seven years, you can start counteracting the effect right away by focusing your efforts on paying every bill on time from here on out. Also keep in mind that items such as monthly mortgage, credit card, auto loan, and student loan payment are reported to all three credit reporting agencies. However, rental payments, utility bills, cable bills, and insurance bills are not.
Another way to improve your credit score is to leave your old credit card accounts open even if you never use them. Having old credit lines is a positive for your credit score as they demonstrate a history of your ability to maintain credit lines. What many often don’t realize is that credit scores plummet when they close out all of their old inactive credit cards in hopes to “clean up” their credit report. Having only new and recent credit accounts communicates limited experience managing debt, which causes the scoring model to reduce points.
Lastly, as previously mentioned, one of the biggest factors that affect your credit score is the percentage of available credit. If you max out your credit card balances, your credit scores will suffer. It’s not uncommon for people to have low scores despite a relatively clean credit profile with no late pays or real negatives. For example, if you have a retail store credit account with an approved credit line of only $300, but used up $280 of that available credit, the scoring model reads the account as 93 percent utilized (blind to the dollar amount). The credit score suffers as a result. However, if you pay down $150 to bring the balance down to $130, you can reduce the utilization to below 50 percent. Therefore, by staying cognizant of your credit utilization you can dramatically increase the score used for mortgage approval and obtaining a competitive interest rate.
Paying attention to and monitoring your credit profile will pay big dividends when managing your credit life. One way to check your credit score for free is through an annual credit report. You can also ask for help from reputable loan consultants early in the mortgage process as it will allow you the benefit of most competitive interest rates down the road.
A loanDepot licensed loan officer can help with these and any other lending questions. Call now for more information.
Originally Published June 16, 2015