Understand And Improve Your Credit Score
So you’ve got bad credit. Maybe you missed a few payments on your phone bills. Maybe you were a bit irresponsible with a credit card and couldn’t keep up with the payments. Maybe you even had a debt sold to a collections agency. You’re not alone – according to a 2015 report from the corporation for economic development (CFED), 56% of consumers have subprime credit scores. These subprime scores mean consumers are unable to take advantage of the best interest rates, and in many cases even average interest rates are out of reach. Over a lifetime, someone with a subprime credit score pays 2-3 times the amount of interest of someone with a prime score. This is a huge incentive to aggressively tackle a bad credit score and save a fortune in lifetime interest payments.
So first of all, what is a credit score? Essentially, it’s a way that companies can quantify the risk associated with lending you money. The traditional credit score is calculated using an algorithm from Fair, Isaac and Company (FICO). The algorithm is based on the information tracked every time you are extended a line of credit – e.g. a personal loan, phone contract, or credit card.
Your credit score is affected by five factors. These are, by percentage of FICO score:
On-time payment history (35%) – tracked over the last 7 years of your credit file. Anyone lending you money wants to ensure that your debts are paid when you agreed to pay them, hence this is the most important factor in your credit score.
Debt utilisation (30%) – effectively the ratio of your total debt versus total credit limit. Interestingly, debt utilisation does not have a history – i.e. your debt utilisation is only measured at the time of a credit check. This is an important point to be conscious of when attempting to repair your credit score.
Length of credit history (15%) – the age of your oldest tradeline and average age of accounts. It stands to reason that someone with a longer history of managing their credit has a lower risk associated with lending.
Types of credit in use (10%) – Your credit score improves by having a diverse range of credit accounts, e.g. installments (like phone bills) and revolving accounts (like credit cards). Largely irrelevant when looking to improve your credit score, as it seldom makes sense to take out an installment account (like a loan) purely to improve credit. Credit cards are almost always a better method.
Credit-seeking activity (10%) – How often you have sought credit in the past 2 years. A consumer who regularly seeks credit tends to be higher risk. Be careful not to seek credit (i.e. apply for credit cards) from multiple lenders in a short period of time. Note that some lender enquiries, such as being pre-approved for a credit card, are considered a “soft enquiry”. Because these enquiries are not directly related to the extension of a line of credit (i.e. they are not a final credit check), they do not affect your credit score.
So, with this in mind, what’s the most effective way to improve your credit score? That depends on what financial products you have access to, which is determined by your current credit score.
Things To Consider When Improving Your Credit Score
Firstly, beware of predatory lenders who target people with low credit scores. These lenders offer products such as prepaid debit cards and payday loans, which have extortionate fees and interest rates. There is never a good reason to use these types of financial products. For example, one popular “no credit check” credit card has a $75 annual fee, which is deducted from the initial $300 credit limit. Annual fees also jump sharply after the first year and charge high fees for simple tasks such as raising credit limit.
The best financial products to improve one’s score are credit cards. There are two types of credit cards. Standard unsecured credit cards are usually the best, as they require no collateral. Unsecured credit cards are hard to qualify for with bad credit though, so you may need to look at a secured credit card instead, which usually requires no credit check.
Secured cards are specifically designed for people to rebuild their credit, and require a deposit which is usually equal to the limit on the card. Though you are just spending money that would have been in your bank account anyway, the lender will report your payment activity to the credit bureaus, which in turn improves your credit score as long as you make your payments on time. After several months of on-time payments, many lenders will increase your credit limit without requiring an increase in your deposit. You may even be able to graduate to an unsecured card.
The most important factor in rebuilding your credit score is to make payments on time. Make small, essential purchases such as groceries or utilities on a credit card, then pay the entire balance off before it is due. Though your credit score will still include any history of late payments over the previous 7 years, it will take into account any change in behaviour. Paying off your account regularly will keep your balance down, which in turn lowers your debt utilisation ratio. Given that on-time payment history and debt utilisation govern 65% of one’s FICO score, this is where the most progress can be made.
The other 35% is contributed from areas in which it’s hard to adjust behaviour specifically to improve credit score. You can’t change the length of your credit history, and you probably can’t sensibly take out any extra installment accounts (e.g. it doesn’t make sense to take out a two-year phone contract just to improve your credit score). The one thing you can do is avoid seeking credit from multiple lenders in a short period of time, such as applying for multiple credit cards. Wait until your applications have been either approved or rejected before you decide whether to apply for further credit.
If you have any unused credit accounts, don’t close them. Having a card you’re not using lowers debt utilisation ratio and increases the number of accounts you haven’t missed payments on. This can actually make a pretty significant contribution to your overall credit score.
So there you have it – some simple, actionable tips to get on top of your bad credit score. It may be challenging at times, but in the long run the reduction in interest rates will be well worth your while. Good luck!