Don't tell me where your priorities are.

Show me where you spend your money and I'll tell you what they are.

-James W. Frick

Plan YOUR work! Work YOUR Plan!

Monday, August 2, 2010

Understanding How Credit Scores Work

One of the biggest things I am always asked is “how can I increase my credit score?” Well the answer is pretty simple but actually doing it takes a lot of discipline and involves many aspects to actually raise your credit score. Increasing your credit score involves paying down your debt, building a credit history, paying bills on time, not having too many dings on your credit, the length of your credit history, debt to credit ratios, and more. It’s all related.

ING had a quiz this morning to see which activities people think will negatively affect their credit score. Let’s see how you do:

• A. Opening a new checking account
• B. Applying for a new credit card
• C. Bouncing a check/paying fee for insufficient funds
• D. Charging high amounts/paying bill in full each month
• E. Lowering your credit limit
• F. Closing old credit card accounts
• G. Paying an ATM fee
• H. Having a high credit limit
• I. Never having a credit card
• J. Keeping old, inactive accounts open
• K. Accessing your credit report
• L. Having a short history of credit
• M. Exceeding a credit limit
• N. Having a lot of debt
• O. Using checking account overdraft protection funds
• P. Paying a mortgage late
• Q. Paying bills late
• R. Checking your credit score

Many of these are activities we often do with no thought or understanding of how they will affect our credit. I often tell people, “It’s the little things that add up.” Let’s look at the answers and look at how and why they affect the credit score.

B. Applying for a new credit card – each time you apply for a new credit card your credit takes a hit. Basically, anytime someone checks your credit, it gets dinged and too many dings in a short period of time can negatively affect your credit. If you have to apply for credit of any type try to space it out (a couple of months) from the last time you had your credit run. This will help you have fewer dings.

E. Lowering your credit limit - lowering your credit limit might seem like a good idea because it leaves you with less credit to mess up, but it’s not. The amount of credit you have is important for building your credit score. Creditors look at something called your “debt to credit ratio” when determining if or how much money to lend you. So if you lower your credit limit, or your limit gets lowered for you, it messes up your debt to credit ratio and makes you look like a bad candidate for lending credit too. Think of it this way, if your limit is $5,000 and your balance is $2,500, your debt to credit ratio is 50%. Now if you lower you limit to $3,000 and your balance is still $2,500 this leaves you with $500 in available credit and totally messes up your debt to credit ratio. Rule of thumb: keep you credit balances below 70% of your balance, the lower the better.

F. Closing old credit card accounts - a part of your credit score is how long you have had credit. The longer you have a card the better for you. The rule of thumb for keeping old cards open is to pay off the balance and only use the card for small purchases every few months. This keeps the card active and keeps it on your credit report. But remember to always pay off the balance, in full.

I. Never having a credit card – this is bad because if you have never had credit, you don’t have a credit history. Lenders see you as high risk and won’t lend you money. It will be hard to get any type of loan if creditors see that you have never had a credit card. Sadly, the older you get the harder it becomes to obtain a credit card. There are options out there. I suggest working with your bank or credit union, since they know you and your money, to help you find the right type of card to help you build credit.

L. Having a short history of credit – this is often referred to as “not having enough credit”. These are usually people who haven’t had a credit card or haven’t had one long. This is also bad because lenders don’t know your credit and payment history and will be very reluctant to lend you their money. The only way around this is to continue to build your credit positively, while keeping the dings away.

M. Exceeding a credit limit – I’m sure this one is pretty obvious. Spending more than you have is bad and makes you look very risky to creditors. Remember the 70% or lower debt to credit ratio and you will be fine.

N. Having a lot of debt – we all know this. A lot of debt is bad. If you have a lot of debt, don’t even think about trying to get credit with the way banks are lending right now. I should say, the way they aren’t lending right now. The debt to credit ratio is not just for credit cards, it’s your overall credit and the more debt you have the worse your debt to credit ratio will be. Develop a plan to significantly lower your debt before trying to obtain a loan.

P. Paying a mortgage late – paying anything late is bad for your credit and makes you high risk to anyone who would potentially loan you money. Each late payment makes you look worse and worse. If you cannot pay your mortgage on time call your lender and try to work a new payment plan out with them.

Q. Paying bills late – same as with your mortgage, if you know you are going to be late, call. The worst that can happen is they say too bad, pay us. On the flip side they might be willing to work with you.

R. Checking your credit score – this wasn’t one of the answers ING gave, but I feel this needs a little explanation. Every year each one of us is able to check our 3 credit reports, for free, from the federal government. While it is good to check your credit reports, checking them too often can be bad. Just like when an outside person checks your credit, you can ding your own credit. There are services that allow you to check it more than once a year, for a fee of course but using the annual free credit report from the government is only allowed once a year.

Gaining control over there things will not only help increase your credit score and open a lot more doors to you, but will take a lot of stress out of your life when it comes to your finances.

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