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If you are in the lending and credit game, your best friend and potentially your biggest enemy is the FICO score, a number usually scaled between 300 and 850, computed as a weighted average of factors assessing your financial management and spending behaviors, claiming it can assess the risk you represent for a lender.
This indicator has been around since 1989 and it is now at the 5th variant. Numbered much like Windows, previous releases are from 1998 (FICO 98), 2004 (FICO 04), 2008 (FICO 8), and 2014 (FICO 9). Pay attention to different versions, used by different scoring agencies, for different lending needs, as explained by Investopedia: FICO 5 is the Equifax’s score used in the mortgage industry, FICO 2 is computed by Experian and FICO 4 comes from TransUnion. FICO 8 aggregates data from all 3 bureaus, that is why your score will be different, depending on the agency you used and can be different from the one used by your lender.
As you can deduct, there is a general FICO score and industry-specific scoring, but diligent financial behavior will help increase all of them simultaneously. We will discuss strategies focusing on FICO 8 and highlight some changes for FICO 9, to prepare for the future. For other versions please refer to this list.
Track your FICO and look for errors
As in every improvement process, you have to start with your current baseline and request your score reports from the 3 credit assessing bureaus. Note that you can do this once a year for free and for a fee, if you need it more often.
The first time it is advisable to request all the scores at once, but afterwards, as you start working on increasing your score, in order to track changes, you can request a report from a different bureau every 4 months, keeping a year in between each bureau.
After getting your scores, patiently and diligently asses each page of the report, looking for errors, like credits you did not take, payments that appear as delinquent, but were paid and so on. Most errors come from identity thefts and looking at your FICO report can help you see if you were subject to such a scam. A 2012 study found out that roughly 1 in 5 reports has some type of error, and 1 in 250 can get up to 100 points after clearing that out, so a careful audit can make a difference between getting the house or not.
After assessing the score and making sure all information is accurate, start working on each of the 5 categories that contribute to the final number.
Payment history 35%
This is the most important item on your credit core, accounting for 35% of it and includes details about credit cards, retail accounts, installment loans, mortgages, as well as public record items like foreclosures, lawsuits and bankruptcy, which remains as a mark for 7-10 years (of bad luck).
- Make all payments on time, setting reminders if necessary or scheduling automatic payments from your salary to make sure you don’t miss a deadline, not even with a few days.
- Speak up, negotiate debt and ask for “grace”. If you are a good payer going through difficult times (job loss, health problems) and you anticipate you won’t be able to make some payments, let your creditors know ahead of time and re-negotiate before your debt becomes delinquent. This is called a good will adjustment and can help you keep your scores up even in difficult financial times, because it shows finance management and responsibility.
- Size matters. Your FICO score takes into consideration the amounts owned, how many debts you have and how late you are, so start with the biggest and oldest debts.
- Small balance, medical bills and paid collections. FICO 8 and 9 are no longer taking into consideration balances under $100, collections paid in full and have a special regimen of medical bills, so they are more forgiving.
Figure 2- Estimated time to FICO recovery
Credit utilization 30%
The reasoning behind this measure is that is evaluates your spending habits. This score assesses the amount you spend in the relation to the amount you have access to, by computing the ratio between credit card balances and credit cards limits. It is computed for each credit card individually and as a total score and it is important to understand, as it is the fastest way to make a change on your score.
- Keep it bellow 30%. The lower the better, some consultants say 10% will give you the best ratings, others vote for single digits. Don’t get your plastic out for everything.
- Clean with discipline. Start a schedule to repay your debts and restrain from getting new ones. Don’t just juggle around with the same amount of debt, lower it gradually. Pay installments regularly to show diligent behavior.
- Open up new cards. This is a good move if you are looking to lower your credit usage score without really using the money you have access to. The reasoning behind this is that the score is computed as a ratio. For example, if Sue has 2 cards, Card A with $1500 balance and $2000 limit, the ratio is 75%, which is high risk and Card B with 30$ balance and $1000 limit, that is 3% utilization. In total she has $1530 balance and $3000 limit, which yields 51% utilization, still too high. Suppose Sue pays the 30$ and takes on a new card, Card C with $2500 limit. She takes $300 from card B and $600 from card C to pay some of the debt from card A. The new ratios are A=600/2000=30%, B=300/100=30% C=600/2500=24% and total A+B+C= (600+300+600)/(2000+1000+2500)= 1500/5500=27%. If Sue restrains from making new debts and maxing out her cards she might have excellent scores in a few month’s time.
- Pay before account statement closing date and don’t rely on others. FICO 8 is putting more emphasis on payments made on time and has changed the importance of becoming an authorized user on somebody else’s card. You are responsible for your finances.
- Check credit limits to make sure they were not reduced. If you have been subject to credit limit reduction, try to reduce balance accordingly.
Credit age 15%
Having a longer credit history recommends you as a trustworthy lender, much like a resume. Studies have shown that the score goes up with the age of the lender and the average age of the credit.
- Don’t open new cards, unless you need them. This is a way to penalize strategies as the one described before. The credit age takes into account the oldest credit, the average credit age and the newest credit; therefore a new card could damage this indicator.
- Don’t close existing credit cards. Credit cards remain on your report for 10 years; closing one now has no impact. Don’t close your oldest card, which could really change your score by shortening the period. Let good debt (paid on time) on your report, showing you are a great client.
- No sudden moves. Generally the best idea is to let things as normal, paying your debt at a constant rate and restraining from any actions that could indicate despair or trying to trick the score.
Recent applications 10%
Recent inquiries for loans or mortgages show up on your score as a sign for more financing, potentially signaling default risk.
- Pay attention when shopping around for the best rates. Ask lenders if they use soft or hard pull methods for your credit scores, as inquiries can lower your score a few points and results remain for a year.
- Scout quickly and efficiently. Keep your inquiry period under 30 days if possible, newer versions allow you to shop around for up to 45 days and count consecutive inquiries and one.
Mix of credit 10%
While it is not necessary to have all types of credit, including mortgages, installments and credit cards, having a portfolio of different debts that you already manage well recommends you as someone interesting to do business with.
- Mix it up. If you plan to boost your score a bit over a larger time period (over 12 months) you could take a new loan, for example a car loan to get some extra points.
- Only get what you need.
Before getting busy evaluating and raising your score, remember that the changes in FICO score should be dictated by responsible behavior and are designed to make your life easier when it comes to debt. A high FICO score comes with low worries and is attained much like a great body, through good choices made every day, not miracle cures.
As regards new versions like 8 and 9, they are not consistently adopted by lenders, but signal a change towards trusting people more and rewarding consistent behavior, instead of penalizing small mistakes and allowing algorithm tricks.