Even a small improvement can mean big savings
By AnnaMaria Andriotis, MarketWatch
Last Update: 8:00 AM ET Jan 15, 2014
Most New Years resolutions require consumers to spend money, but heres one that actually doesnt cost anything and ultimately helps people save: Boost your credit score.
Low credit scores result in higher interest charges for all types of debt, including credit cards and home loans. Borrowers with a FICO credit score (the score used for most consumer lending decisions) of 700 save an average of $648 in interest on their credit card, $1,392 on their car loan and $2,340 on their mortgage each year, compared with borrowers who have scores below 620, according to a study by CardHub.com, a credit-card comparison website. Those savings get even larger for borrowers whose credit score is above 700. Separately, lower scores can lead to larger home and car insurance bills and make it harder to rent or buy a home.
Fortunately, there are ways to improve a low credit score and most involve scaling back on credit-card usage. Thats because in the world of credit scores, all debt is not treated equally. FICO scores tend to drop as consumers rack up more credit-card debt but dont decline as much if someone signs up for a student loan, car loan or mortgage. Here are five steps to improving your credit score.
Pay down credit-card debt
To improve their credit scores, borrowers need to lessen their credit-card debt.
Once a borrower surpasses a 10% credit utilization ratio that is, the amount of their credit card debt in relation to their total spending limit their FICO score will likely drop, says John Ulzheimer, consumer credit expert with CreditSesame.com, a credit-management site, and a former manager at FICO. For instance, borrowers whose credit-card spending limits total $10,000 should not surpass $1,000 in debt whether or not they pay off their balance in full each month.
That can be an onerous task for many borrowers. Theyll need to adhere to stricter limits if they want the highest score possible. According to FICO, borrowers with the best credit scores of 785 or greater use an average of 7% of their total credit-card limit. In contrast, student loans, car loans and mortgages are not considered by the credit-utilization ratio.
Consumers can consider asking their card issuers to increase their credit-card limits, which could in turn increase their credit score. Of course, that will require not swiping for more purchases on those cards.
Convert credit-card debt to personal loans
Borrowers with a lot of credit-card debt arent out of luck. They can actually improve their score before they even pay down their debt with a bit of strategizing: They can consider rolling their credit-card debt into a personal loan.
Heres why: Credit-card debt tends to be more damaging to credit scores than a personal loan, which is considered installment debt. The credit-utilization ratio (see previous section) does not take installment debt into account. This strategy would result in zero dollars of credit-card debt on the borrowers credit report, which could boost their score by 100 points or more, says Ulzheimer. Theyll also pay lower rates to boot: The rates on personal loans currently average 11.36%, according to Bankrate.com. In contrast, rates on credit cards average just over 13% to 15.4%.
This strategy will only help borrowers if they stop using their credit cards or if they pay off the charges they make on their card quickly. Otherwise, their score wont stay up for very long. Of course, consumers should pay off all their credit-card debt with their savings rather than signing up for a loan. But that assumes they have enough cash set aside after paying this debt for their emergency fund. (Financial advisers typically recommend people have savings equal to six to eight months of living expenses in a savings account.)
Be selective when accelerating debt payments
Theres no doubt that its a great feeling: paying off a car loan or student loan especially when you manage to do so ahead of schedule. But rather than sending extra cash payments to these types of loans, consumers looking to raise their credit score should consider putting those payments toward credit-card debt instead.
Thats because credit-card debt hurts consumers scores more than other types of loans. Credit experts say they often hear from consumers who are surprised to find their scores dont improve after they pay off one of these loans; instead, they say, credit scores would improve significantly if borrowers paid off their credit cards while leaving their other loans intact and remaining up-to-date on minimum payments.
In addition, there are often perks to holding on to installment debt. With home loans, for instance, borrowers can usually deduct interest payments on a total of up to $1 million of mortgage debt on their taxes.
Check credit reports often
One in five consumers has an error in at least one of their three credit reports, according to a 2012 study (the latest) released by the Federal Trade Commission. The information on consumers credit reports from the three major credit bureaus, Equifax, Experian and TransUnion largely determine borrowers credit scores. Mistakes can send credit scores into a tailspin: Roughly 13% of consumers had credit-report errors that impacted their credit scores, while 5% had errors that could lead to paying more or being denied credit, according to the FTC study.
Ideally, consumers should keep tabs on such issues before they need to apply for a loan. (Many find out there are errors when a lender pulls their credit report.) At AnnualCreditReport.com, consumers can get a copy of their credit report for free every 12 months from each of the three bureaus.
Consumers who spot errors should contact the credit bureaus, which are legally required to respond with their findings within 30 to 45 days. They should also ask the lender or collection agency that has the account to present proof that they (rather than an impostor) actually opened that loan; if they are unable and the credit bureau also cannot provide evidence, the bureau is required by law to remove it from their credit report.
Pay on time
The quickest way to tarnish a credit score is to miss a debt payment. Lenders can start reporting a late payment to the credit bureaus once 30 days from the bills due date have passed, says Ulzheimer. That late payment will stay on a consumers credit report for seven years.
No matter what other steps a consumer takes, they will need to be on time with all their debt obligations even if its just the minimum required payment thats due that month if they want a high credit score.
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