If you’re like most Americans, the last several years have not been kind to your coffers. Wages have stagnated, unemployment has remained stubbornly high, and economic growth has been anemic. Many individuals and families have seen their once-immaculate credit profiles severely tarnished, while those who once had average to good credit now find credit far more expensive than before—if it’s even accessible at all. All too frequently, however, this damage is less the result of changing economic circumstances as it is the result of individuals refusing to adapt to these changes. That is, your credit profile is almost always within your control.
No matter what your current credit profile looks like, it can always be improved. Whether you’ve never had spectacular credit or it has just been damaged over the last few years, repairing your credit profile is not difficult. It merely seems difficult because most people don’t understand how the underlying models that build an individual’s profile work. So individuals will fixate on minute items that have only a marginal effect on their profile while ignoring more substantial items.
As an example, people will obsess over keeping the number of inquiries on their credit report low. This means they’ll visit only one or two car dealerships for fear that excess inquiries will impact their score. In fact, inquiries, and more importantly the type of inquiries, make up only 10% of one’s credit profile. And most scoring models will treat up to four inquiries made over a 72-hour period as a single inquiry.
As another example, people will close credit accounts, such as credit cards, once the balance is paid since they believe more open credit lines means a lower credit score. In fact, the scoring models prefer seeing more available credit than less. If a borrower has several credit lines open with small balances, it means they’re responsible enough not to abuse their access to credit. The quality of one’s credit lines accounts for 10% of their credit profile. Further, a full 15% of their credit profile is informed by the length of time the borrower’s accounts have been open. Closing a ten-year-old, zero-balance account can have a substantial effect on your credit score versus leaving it open.
People often ask what an ideal credit profile looks like. My advice is to have five open, active credit lines composed of 1 mortgage, 1 auto loan, and 3 other trade lines—personal loan, credit card, store card, etc. Most models prefer to see a 20-25% balance on the last three accounts, although lower balances are preferable to higher balances. And, of course, you must be sure to pay all your bills on time. Any delinquencies showing on a credit report will raise questions with creditors.
Over the last few years, there has been a small but growing movement arguing that individuals should disregard their credit profile. Their argument—one to which I’m mostly sympathetic, by the way—is that individuals should live without depending on credit. That is, everything from household staples to cars should be paid in cash. Although I largely agree, I believe savvy individuals can use credit as a tool to improve their financial situation, if used responsibly. Instead of saving for an automobile and paying in cash, they can direct these savings toward investment vehicles whose returns exceed the interest rate on the loan. And as nice as it would be to pay for a house in cash, this is far beyond the realm of possibility for most people.
While credit is not a necessity, it is a high-value tool that most people can and should use. Having a poor credit profile, however, makes the use of these tools very expensive. Many creditors will not even lend to borrowers below a certain FICO score, while virtually all creditors penalize borrowers will low scores. As an example, a low credit score can mean a manual underwrite on a mortgage. This not only costs about a half-point up front on the loan, but also costs over the long-run as a higher interest rate. The mere use of a manual underwrite can add around $10,000 over the life of a 30-year, $200,000 dollar loan!
Now that you know the consequences of a low credit score, you’re probably more motivated to improve your own score. You should begin, of course, by acquiring a copy of your credit report. This allows you to assess your starting point, and also lets you address any potential errors on your report. In fact, 79% of credit reports contain factual errors that can have a severe effect on the consumer’s profile. Next, you should follow the six pieces of advice we covered in detail on the radio show this week. They are:
Increase your credit limit. You can add 30-50 points just by calling your credit card company to increase your card’s credit limit. This makes the relative balance lower and improves your score.
Keep accounts open instead of closing accounts.
Keep your inquiries low.
Pay all your bills on time. One late payment on a high-balance account can lower your score by 70 points.
Don’t pay all your debt off at one time.
Set up auto-pay with your bank. This will ensure bills are paid on time and allows you flexibility in scheduling bills before they’re reported to the credit bureaus.
One more piece of advice, which I covered in great detail during the second hour of the show, is to find an accountability partner to hold you accountable as you improve your finances and credit profile. I covered the attributes and qualities of a great accountability partner, and suggested ways you can hold yourself accountable.
The entire lending industry can seem vague and esoteric to most people. This, I believe, leads people to thinking their financial situation is beyond help. Even a basic understanding of how lenders think, and how credit profiles work, proves it’s not only worthwhile but also incredibly easy to rebuild your credit profile. This will be a recurring theme on this show, so be sure to follow along either on the air or online in the archives.
2-8-14 6 Ways to Improve Your Credit