Apr 10, 2012 | Updated Jun 10, 2012
InvestingAnswers Helping individual investors build and protect their wealth
A higher credit score means more money in your pocket. It's as simple as that.
A typical credit card for someone with poor credit may have an interest rate of 20 percent. If you carry a balance of $5,000 on that card and make payments of $150 each month, you'll pay more than $900 in interest alone in the next 12 months. Bump that rate to 25 percent and the interest grows to almost $1,200!
Now, let's say you've got great credit. You're carrying the same balance and making the same monthly payment, but your interest rate may be just 12 percent. You'd pay only about $500 in interest in that first 12 months. That means you'd save about $400 -- or almost three full monthly payments -- simply because your credit was good enough to help you get that lower interest rate.
Even small increases in your credit score can have a real impact. Bumping your credit score from 690 to 720, for example, could land you a card with a low interest rate instead of an average one. That equates to less money out of your pocket in the long run.
So how do you get good credit? Any expert will tell you that the most important way to improve your credit score over the long run is to pay your bills on time, every time -- and they're right.
However, that's not the quickest way to a better credit score. There's an often-misunderstood formula within credit scoring models that, if you grasp it, can help you make a big impact on your score in a big hurry.
Do your homework before buying a score.
Before I continue, it's important to note that countless credit scores exist -- many of which are virtually worthless. Why? Because the only credit score that should matter to you is the one used by the institution from which you're trying to borrow. In the vast majority of cases, that score comes from FICO, the credit scoring behemoth once known as Fair Isaac Corporation.
Each of the major credit reporting bureaus -- Experian, Equifax and TransUnion -- offer their own FICO scores. and the scores can be quite different because each bureau can have different information about you. Ask your lender which credit score they'll use to make their decision, and they'll likely tell you. That way, if they say they use a FICO score from Experian, for example, you can check your Experian credit report for any mistakes or inaccuracies that may lower your credit score. (Correcting those errors can improve your credit in a big hurry. However, not all credit reports contain errors and not all errors have a significant impact on your score, so it's unwise to rely on them to jump start your credit.)
Your FICO score, which ranges from 300 to 850, is made up of five components of various weights.
- Your payment history -- 35 percent of your score
- How much you owe -- 30 percent
- How long you've had credit -- 15 percent
- The different types of credit you've used -- 10 percent
credit (or how much credit you've applied for lately) -- 10 percent
However, while your payment history ranks as the most important piece of your credit score, it can take months or even years to dramatically improve it. Looking for a quicker fix? Focus on what's known as your credit utilization rate.
What is credit utilization?
Put simply, your utilization rate is this: how much debt you have compared to how much credit you have available.
It's a major component of the second-most important part of the credit scoring formula -- how much you owe -- and the lower your rate, the better. Why? Because using a smaller percentage of your available credit makes you look like less of a risk to a bank, and less-risky borrowers get the best interest rates.
Here's how this works: Say you've got three credit cards. The cards' combined credit limit is $10,000 and the total balance is $4,000. Your credit utilization is 40 percent. ($4,000 is 40 percent of $10,000) That's not good. Most experts recommend keeping your utilization below 30 percent.
However, knock your balance down to $2,500 and your utilization rate falls to an acceptable 25 percent. That will increase your score. It won't happen immediately, since banks typically only report cardholders' balances about once a month, but it will happen. And the bigger the drop in your utilization, the more your score can climb. (Don't expect miracles, though. It won't change a 550 score to a 750. However, as I said earlier, small changes can make a real impact in how lenders view you.)
There are other ways to improve your utilization as well. For example, you could focus on increasing your credit limit rather than reducing your debt. This would lower your utilization, but it could also have a side effect. If you increased your overall credit limit by acquiring another card, you would take a small hit in the "new credit" category, which considers how much credit you've applied for recently. The impact would be small and short-lived, assuming you don't go crazy and apply for too many cards at once. However, it would blunt the impact of your improved utilization rate.
Remember, also, that it's not just your overall utilization that matters. FICO officials have said that utilization rates on individual cards are considered as well. Thus, in the above example, it's better to have that $4,000 debt spread among the three cards rather than having it all on one card that would likely have an unacceptably high utilization rate.
The Investing Answer: Do the math to figure your own utilization rate and how much debt you'd need to lose to get that rate down to an acceptable level. Then, get creative to raise the cash you need. Sell something of value that you own. Put in extra overtime at work. Do whatever you need to do to raise that money, as long as you don't put yourself in a short-term financial bind in the process.
Finally, resist the urge to cancel any cards you pay off in full. By cancelling the card, you would lower your available credit, hurting your utilization rate, and essentially undoing much of the good you did in getting rid of your debt.