Improving Credit Scores
Financial institutions, as well as companies, will usually check an individual's credit score before extending new credit, or lending money. Better scores can mean lower interest rates on a loan, or eliminate the need to provide a deposit before receiving service from a utility.
In this article, we're going to start by examining the five components of a credit score. Then we'll use that information to outline ways to improve them, including correcting errors found in credit reports.
Credit Scoring Process
Credit bureaus are responsible for reporting and calculating credit scores. Each agency will use a slightly different approach, and have different partners that provide data on payment patterns. The most commonly used score is FICO®, developed by Fair Isaac Corporation.
Five Components of a Credit Score
One of the ways these agencies make money is by selling scores to lenders and creditors. The scores are calculated by the agency based on information gathered from a variety of sources. These sources of information, or partners, can include credit card companies, utilities, and other lending institutions.
These partners share an individual's payment history, loan, and line of credit information with the agency. This information is then used to calculate a credit score, which has five components or parts:
- Payment History (35%): Does the person pay on time? Late payment patterns and bankruptcies can hurt this section, while on-time payments help.
- Outstanding Debt (30%): How much money is owed all creditors and lenders? Is the individual making use of all the borrowing limits available? Are there a large number of outstanding loans?
- Overall Credit History (15%): How long have they been borrowing money from lenders?
- New Credit (10%): Have they applied for new credit recently? Are they currently seeking many new loans or just a single loan?
- Other Factors (10%): Do they have a mix of credit such as credit cards, installment loans, mortgages, and car loans?
Maintaining a good score can be as simple as borrowing money, and paying back the lender on time. One of the biggest mistakes people make is thinking they should not borrow money until they really need it. That's simply not true. One of the components of the score's calculation is payment history. If someone never borrows money, then lenders will never know if they are responsible enough to pay it back. This is called a "thin" file. It's important to demonstrate the ability to pay back smaller loans if a mortgage is ever needed to buy a home.
Some of the best ways to go about improving, maintaining, and creating a good credit score include:
- Payment History: borrow money, and pay it back on time. This includes school loans, automobile and personal loans, and payments due on credit cards. Pay utility bills on time, and try not to carry a balance on credit cards. Whenever there is an outstanding balance on an account, make sure minimum payments are made before the due date.
- Outstanding Debt: although borrowing money and paying it back on time helps a credit score, be careful not to borrow too much money. If credit card balances are starting to build over time, this might be interpreted as an inability to meet future debt obligations, and be seen as a negative.
- Overall Credit History: the longer someone has been paying back loans, the better. Whether it's a gasoline card, retail store or a credit card; don't be afraid to open an account. It's important to demonstrate to creditors that money will be paid back.
- New Credit: agencies like a slow and steady approach when it comes to applying for credit. Applying for ten different cards at the same time will hurt a credit rating.
- Other Factors: agencies like individuals that demonstrate they can be trusted to make timely payments on a variety of loans. This provides more information to analyze and will add to the confidence of their calculations.
Potentially Illegal Practices
Any promise to improve a score that does not address the components above may be illegal. Be wary of offers to improve a score "overnight." It's not possible; and if an offer sounds too good to be true, then it is probably unethical or illegal.
Anyone that's been paying bills on time, and believes their score is lower than it should be (a good score is 700 or higher), may have an error on their report. These types of errors need to be addressed immediately.
Errors in Credit Reports
Anytime someone is denied credit they can request a free copy of their credit report. Consumers should always obtain a copy if they think they've been wrongfully denied the opportunity for a loan. Nobody's perfect, and that includes credit reporting agencies. They are moving a lot of information around every day, and street addresses, names, and account numbers can get mixed up from time to time.
Even worse, sometimes life events like getting married, changing a name, or getting divorced can result in credit card disputes, errors, and incorrect information being applied to an account. For example, after a divorce one person might own a credit card that continues to show up on their ex-husband's or ex-wife's credit report.
Other than re-establishing a credit score by paying future bills on time, correcting errors on reports is the one action that can have an almost immediate, and significant, impact on a score. Anyone that finds an error can follow the six step process outlined in our article: Fair Credit Reporting Act. That process includes sending documentation to the reporting bureau and creditor to have the error corrected.
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