Understanding and Improving Your Credit Score
By Ken DeLeon | Founder
While everyone in Silicon Valley knows the importance of a credit score, few know the algorithm that is used to determine their exact scores. Even fewer know the steps they can take to increase their scores. This article will help you understand and improve your credit score and illustrate the steps I took this month to increase my credit score by 92 points to 826.
A good credit score can make a difference of up to half a percentage point on your mortgage rate. With the average sale at DeLeon Realty being approximately $3.2 million, many of our buyers obtain mortgages for over $2 million. This half-point differential can cost several hundreds of thousands of dollars over a 30-year loan’s timeframe. Thus, it is wise to understand what factors impact your score and what steps you can take to improve it. Since it takes several weeks for actions to boost your credit score, you may want to implement the recommended tips before contacting your lender for a pre-approval letter.
First, I want to provide some basic background on FICO credit scores. FICO stands for Fair Isaac Corporation, which is the company that created the mathematical algorithm used to generate your credit scores. Credit scores range between 350 and 850. The average credit score in America is 695. Most lenders will give you their best rate with a credit score of 720 or higher, although a few such as Wells Fargo will provide an even lower rate for applicants with scores over 780.
There are three credit bureaus utilized by lenders: TransUnion, Experian, and Equifax. Lenders will generally use your median score of the three reports. These three bureaus offer a free report every 12 months that you can access at www.annualcreditreport.com. Your score is not lowered when you check your own credit report (a “soft” inquiry), whereas lender inquiries (a “hard” inquiry) will drop your credit score by five to ten points. As a tip, do not apply for credit very often—particularly before applying for a mortgage—as seeking new credit lines is a risk factor that results in your credit score dropping. Hard inquiries can stay on your record and result in a reduced credit score for two years, although their negativity declines over time.
There are five components to determining your credit score, with two of them accounting for 65 percent of your credit score. The most important part, or 35 percent of your score, is your payment history, so it is ideal to never miss a payment. Setting up autopay for all monthly recurring bills is an excellent option for both convenience and ensuring you are never delinquent on a payment.
The second largest component, which accounts for 30 percent of your score, is the amount of credit you are using. For example, if all of your credit cards have a limit of $50,000 when combined and you are using $20,000, then you are using 40 percent of your credit line. Using too much credit causes concern that you cannot properly manage credit or may have challenges paying off your balances. Reducing the percentage of credit you owe to below 10 percent is the quickest and easiest way to boost your credit score.
The length of your credit history accounts for 15 percent of your credit score. Credit agencies like to see a long history of having the same lines of credit and consistency in paying these accounts down and on time. As a general tip, do not close credit cards but rather stop using them. By closing an older account, the average age of your accounts will decline and, consequently, so will your credit score.
New credit requests are 10 percent of your credit score. Applying for new credit is a red flag for credit agencies as it can indicate that you are in financial trouble and require new credit. As a tip, do not apply for new credit unless you really need it and are confident you will obtain it. If you apply to several creditors for the same purpose, such as having two mortgage lenders run your credit within a short period, FICO will treat these inquiries as just one hard inquiry.
The final component, which is also 10 percent of your credit score, is the various types of credit used. This is a more nebulous category, but is based on the empirical data that shows repaying a range of debt (car loans, home equity lines, mortgages) has less risk of default versus those who only have one type of credit, such as credit card debt.
Here are several do’s and don’ts to keep your credit score high.
DO:
- Have two or more lenders check your credit score around the same time if you are considering multiple lenders. FICO views multiple credit reports pulled within fourteen days as one credit inquiry, causing less impact on your score than if each lender pulls your credit fifteen or more days apart.
- Keep balances low on credit cards and other “revolving credit;” below 30 percent of available credit is good and below 10 percent is ideal.
- Pay off debt as soon as you can rather than transfer it.
DO NOT:
- Close unused credit cards, as this can lower your score if you close longstanding accounts.
- Obtain new credit unnecessarily, as every inquiry lowers your score.
- Make large purchases during escrow that increase debt and lower credit, including a car, furniture, or appliances. Some lenders pull your credit again right before funding your loan, so increasing debt with these purchases may jeopardize closing.
Steps to Increase Your Credit Score
While it is always good to have a general awareness of your credit score, it is most important that it peaks when you are applying for a mortgage or other credit. As a mortgage on one of my investment properties needs to be refinanced, I took several strategic steps (see the following) which increased my score by 92 points—from a good score of 734 to an excellent score of 826.
- Pay down your credit cards every 10 days before you anticipate a lender will pull your credit. While you likely have autopay and pay your cards down monthly, this is not enough. Since a credit check is a snapshot on a specific day, you want balances to be below 10 percent of your credit limit. If you went shopping during a good sale and utilized your credit card, this will lower your credit score even though you will automatically pay down the balance.
- Use cash as much as possible in the month leading up to the anticipated credit inquiry. A high debt-to-credit ratio concerns lenders that you are maximizing your debt and may not be able to pay it back.
- Pay off credit cards with small balances, as one of the factors of your score is the quantity of accounts that have balances.
- Pay your car loan, not lease, down to 10 months of remaining payments, as it will allow you to be preapproved for more. If your car loan has 10 months or less remaining, the banks view the loan as effectively paid off, thus improving your credit score.
Hopefully, this article will help you boost both your credit score and your understanding of how it is evaluated to ensure that you can secure the lowest mortgage rate possible. This can result in significant savings over the lifetime of your home loan.
