As many of you are aware, I have been harping on how low mortgage rates have been over the past few months and how much of an opportunity we all have to lock in a long-term low interest rate right now. So let us assume you have decided to heed my advice, gotten all of your ducks in a row, and have gone to the bank or mortgage lender to negotiate a refinance. BAM! They offer you a refinance somewhere between 5.5% and 6.5%. But, but, but…. Brian, I thought you said mortgage rates were around 4.5% to 5%?
What has more than likely happened is that potential lender has pulled your credit report. Credit report? Well, Brian, I’m not a bad person. I’ve never stolen anything from anyone. I pay all my bills on time for the most part. Why are you mentioning credit report to me? The reason is because that small little number, aka your FICO credit score, affects every single one of us, good or bad.
Because of this, I feel that it is appropriate (especially since you, my listeners, are the cream of the crop) to share some tips with you to ‘outsmart’ the system. Basically you credit score is a mathematical equation composed of five parts. Those five parts are:
- Payment History
- Debt Level
- Length of Credit History
- Type of Credit
- Credit Inquiries
As you listen to the show, I will go through each one these as well as explain how much of an impact it has on your credit score. Listen for some of these high points:
Payment history 35%– Obviously lenders (credit card companies, mortgage companies, banks, etc.) are concerned with whether or not you will ever pay them back. There is not a truer indicator of your probability of repayment than how you have paid back debt in the past. For a moment, though, let’s assume you don’t have a blemish free credit history. Then what do you do?
Debt level 30% – The next largest component of your credit score is determined by your debt level. Another term for this is your debt-to-income ratio. Assume for a second that you have two individuals. Individual A has $2,000 in credit card debt and if he gets to $2500, his credit card will be “maxed out”. Let’s also assume Individual B has $2,000 in credit card debt, but his credit card doesn’t max out until it reaches $10,000. Which one of these two people would you feel more comfortable lending to: the one utilizing 80% of his available credit or the one utilizing only 20% of his available credit? Even though they have the same exact amount of debt, you can see how different this looks to the lender. So what should a young individual do? Always try to make sure that the amount of debt you are carrying is less than 50% of the total debt available to you.
Length of Credit History 15% – This may be the most difficult part for young people trying to establish credit. 15% of your overall credit score is comprised of how long you have actually been using debt. The easiest and most affective way to always keep this 15% working on your side is to keep open the first credit card you apply for. Even though it may have been that Macy’s retail card back in college and you don’t even use it anymore, cut it up, throw it away, and forget about it, but DON’T close it. The longer that account stays open (assuming there are no annual fees or inactivity fees) the higher your credit score will be.
Type of Credit 10% – The type of credit you have accounts for 10% of your credit score. This shows lenders that you have the ability to manage different kinds of credit. The two basic forms are open-ended and close-ended. Open ended credit is credit that can fluctuate or “revolve” such as a credit card or a home equity line of credit. Closed end credit is credit such as an auto or home loan and does not vary overtime.
Credit Inquiries 10% – The final piece of the credit score puzzle is credit inquiries. These are basically your applications for credit. Too many can harm your credit score. Having a retail credit card to every store at the local shopping mall isn’t going to look good to lenders. But what about the ‘pre-approved’ credit card offers? Don’t they say that they’ve already looked at my credit account and I’ve been approved? Yes, they do, but these are known as ‘soft’ inquiries and do not count against your credit score.
One other key point to note when considering your credit score is that good information never revolves off of your credit report, but unfortunately, it can take bad information, such as one late payment, up to 7 or 10 years to finally go away. Be sure to keep this in mind when deciding how you are going to utilized debt in your own personalized financial plan
If you do not know what your credit report looks like, you should know that you are entitled by law to one FREE credit report from each of the three credit reporting agencies (Experian, TransUnion, and Equifax) each year. Although there isn’t a catchy jingle or any well-made commercials, the website to access these free reports is actually www.annualcreditreport.com.