There are few things in life that follow you the way that your credit does. Your credit score is essentially a score that represents your standing in the business world, and this has a direct impact on many major purchases and loans. Whenever you apply for a loan or a credit line, lenders check your credit rating.
Your credit score determines your risk — that is, your probability of paying back the loan. Lenders use your credit score to determine the interest rates you’re beholden to, the risk premium, and the flexibility of payment terms, assuming that they’d lend you money to begin with. In essence, a good credit score allows you to secure loans on lower premiums and lower interest rates. The better your credit score, the better terms you’re going to have. So, how do you improve your credit score?
Pay Your Bills Promptly
Credit scores are primarily a representation of your reliability when it comes to paying bills — but it also shows your ability to manage your finances. Any late payments and overdue bills reflect on your credit report poorly and the negative information will remain on your credit report for seven years. On the other hand, paying all of your bills on time will improve your credit score.
It’s also important to note that not all missed payments adversely affect your credit score. If you’ve missed a payment for less than 30 days, it’s usually treated as a result of forgetting your due date or getting billed late as long as you pay it off as soon as you can.
Pay Off Debts, Keep Revolving Credit Low
As previously mentioned, any overdue payment will reflect poorly in your credit report; the same holds true for debts. Always pay off your credit card debt, but moreover, it’s also important to keep a low credit utilization ratio. A credit utilization ratio refers to the percentage of your total available credit that you actually use. For example, if you have a credit limit of $10,000 but only use $2000 of that limit, you’re using only 20% of your credit limit.
Lenders typically like to work with borrowers with a credit utilization ratio of 30% or lower. You can also utilize authorized user trade lines to improve your credit utilization ratio as long as the account holder uses credit responsibly.
Open Credit Accounts Only As Needed
Opening a new credit account might increase your overall credit limit — and may also improve your credit utilization ratio — but the act of applying for a credit line prompts a “hard inquiry” on your report; this occurs when a lender, with your permission, reviews your credit report. Too many hard inquiries will adversely affect your credit score. The good news is, they only stay on your record for one year.
Keep Unused Credit Accounts Open
Closing any unused credit accounts hurts your credit utilization ratio. In fact, hurting your credit utilization ratio has a more lasting impact on your credit score than hard inquiries.
Your credit score has a significant impact on your standing in the world of finance. So it should be treated with care in the same manner that you maintain your reputation. It’s really just a matter of keeping your word and paying on time.
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This is another reason for using Dave Ramsey’s “snowball” technique for paying off debts. Dave says, “Pay off the smallest balance first, even if other larger loans have higher interest rates.” As soon as you pay off any loan, even a loan with a tiny balance, your credit score gets higher AS LONG AS YOU ARE PAYING ALL OTHER BILLS ON TIME. Then take the money you would have paid monthly on this paid off loan and make a bigger payment on the next smallest loan. Repeat until you are out of debt. I know, I know, a few of you will say that this is not the best money management, and THEORETICALLY you are correct. But human nature NEEDS reinforcement. Paying off the smallest balance 1. proves to yourself that you can climb out of debt 2. bumps up your credit score 3. frees up that monthly payment amount on the retired loan to add to paying off the balance of the next smallest loan balance.
Great post Len!
You’re going to crack a smile – I mentored a few young professionals who said that paying off credit card debt would actually hurt your FICO score… thankfully I was able to help them change that mindset. However, if they truly believed maintaining credit card debt would help their FICO scores, I wonder how many other people believe in this fallacy…
Thanks for sharing!
Fiona
Maybe the same people who think getting a 5 or 6 year car loan is good because you have lower monthly payments.
I’ll bet quite a few, Fiona.