In part one of this two-part series on credit scores, I provided some basics about credit scores, including a definition and some background on the credit bureaus and the methods they use to calculate your credit score (click here to read part 1).
Now let’s dig deeper and explore some of the ways your credit score can be impacted either positively or negatively, and the main reasons why building and maintaining a good credit score is important.
What affects your credit score?
There are many factors and combinations of factors that can alter your credit score for better or for worse; I’m going to mention a few key factors that typically have the greatest impact.
As a general rule, the single biggest factor that can have the greatest impact on a credit score is a mortgage. The ability of an individual to obtain a mortgage and then effectively manage that mortgage by making timely payments on a consistent, long-term basis carries a lot of weight in credit bureau calculations. On the flipside, a credit history sprinkled with late or missed mortgage payments will be reflected by a low credit score and an unfavorable credit rating. The credit bureaus consider individuals that fail to pay a mortgage on time as a major risk. The bureaus assume that a missed mortgage payment is a strong indicator that the homeowner is either unwilling or unable to make payments on time – and they consider either reason risky. For those who do not have a mortgage, keep in mind that late and missed rental payments may also be reported to the credit bureaus and negatively impact credit histories and scores.
Beyond housing, virtually any late or missed payment for any debt owed can be reported and drive your credit score down. Credit card balances, medical bills, cable, phone, Internet, utilities … if you owe money and fail to pay on time your credit score can be hammered. The credit bureau algorithms also incorporate the number of open trade lines you have, the total amount of open credit, and the overall amount of your collective debts. There is no hard and fast rule about the optimum number of trade lines to have open because everyone’s financial profile is unique, but too many or too few open trade lines can decrease your credit score. A balance, which suggests smart money management, is the ideal target.
Credit score tips
As I mentioned in Part 1 of this series, a perfect credit score is unattainable. However, here are a few tips that can help you protect your credit score from damage:
- If you have trouble remembering due dates and paying your bills on time, leverage technology. Most loans and credit cards, including mortgages, have due date reminders and even auto-draft payment features so your payments are never late.
- Make sure you pay at least the minimum payment on credit cards before the due date. Some people may put off a payment because they are expecting some income that will allow them to pay the balance in full. But, if you miss that payment due date, it’s going to hurt your credit score. Go ahead and make the minimum payment, and then pay the rest of the balance once you have the money to do so. Paying a little interest is better than having a late payment on your credit history.
- Keep your revolving debt at about 35 percent or less of your open credit limits. If bureaus see that your balances are growing to more than 35 percent, it’s a red flag that you’re having trouble keeping up, and that can decrease your credit score.
- I advocate having two credit cards. Use one regularly and pay it off each month and have an extra in case of emergencies. Be sure to use each card at least once every six months, even if it’s for a small purchase only. This will keep the date of last activity current so that it counts as an open trade line.
- Don’t overdraft your checking or other bank accounts. Even with overdraft protection, an over-drafted account can harm your credit score.
- Remember that co-signing on a loan will affect your score if a payment is late or missed. So be sure you can trust the person you’re co-signing with to make timely payments.
- Unpaid medical bills can end up in collections and hurt your credit. Don’t assume that just because you’re waiting for reconciliation with your health insurance company that the outstanding debt can’t count against you. If the debt is overdue, it’s better to go ahead and pay the bill up front and then reconcile the insurance claim on the back end.
- If you have a debt that goes to collections, do not ignore it. Address it by either paying it or working to have it removed from collections.
- Find out what your credit score is and choose a way to monitor your credit score on a regular basis. The bureaus make mistakes and your score may not always reflect your creditworthiness. Knowing your score and noticing a drop in your score allows you to be proactive in restoring it to a favorable status. When it comes time for you to borrow money or buy a home, you don’t want any surprises.
As previously mentioned, everyone has a different situation, but a good baseline from which to start is to have four open trade lines including two revolving lines (like a credit card or line of credit), an installment loan and a mortgage. If you don’t have any open trade lines, it’s difficult to build credit history and will be reflected as a low credit score. Opening one or two trade lines will probably play in your favor if you’re prepared to manage them properly. As a side note, most trade lines, like an installment loan, won’t be part of your credit score calculation for the first 12 months.
Why is a good credit score important?
Your credit score is the primary factor that lenders use to determine whether you qualify to borrow money, and the rate you’ll pay if you do qualify. A lousy credit score can literally determine whether or not you can own a home or even rent an apartment. If you do qualify, your score drives your interest rate and can mean the difference of thousands of dollars.
I once had a client applying for a mortgage. When I pulled his credit report his score was 664. We discovered that his report listed an unpaid phone bill for $331. Upon investigation, this client found that the bill had been paid and the phone company had erroneously reported it to the bureaus. We made a few calls and had the mistake corrected. Through a process called rapid rescore, my client’s credit score jumped to 746 in less than 72 hours. The correction allowed my client to qualify for the mortgage, provided him with a low rate, and saved him $5,000 in closing costs.
Plan ahead to get the best rates
If you know six months or a year ahead of time that you’re going to buy a house, I strongly recommend that you meet with a reputable mortgage professional and begin the planning process early. A good mortgage professional will immediately pull and analyze your credit score. With access to your current credit report, your mortgage professional can help you proactively address negative issues, advise you on revolving debt levels, which could mean opening and closing trade lines as necessary and taking other actions to optimize your credit score. When it comes time to apply for that mortgage, your credit score will determine your rates, so taking steps to improve your score is just smart money management.
Patrick Stoy has 15 years of mortgage lending experience. Patrick is CEO of Wilmington-based Market Consulting Mortgage, which he started in 2005 with a mission to build lifelong customer relationships by providing real value. To learn more about Marketing Consulting Mortgage, visit www.macmtg.com. Patrick can be reached at [email protected] or 910-509-7105.