Boost Your Credit Score

by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
April 22, 2009

Financially fit individuals pay as much attention to the liability side of their personal balance sheets as they do to the asset side. Theoretically, at least, you have a lot more control over the amount and terms of your debt than on how the markets might impact the value of your investments. But do you really have as much control as you would like? Or are the currently low interest rates you’ve been reading about out of reach for you because your credit score isn’t as high as it needs to be? It’s never too late to get your debt under control and take steps to boost your credit score. Here’s how:

Why does your credit score matter?
The most widely accepted measure of credit worthiness is the so-called “FICO® score.” Named for its originator, the Fair Isaac COrporation, your FICO score is used by lenders as a quick gauge of your ability to repay debt. Think of your FICO score as the grown-up version of a high school grade point average or Scholastic Assessment Test (SAT) score—the higher the better. A high credit score can not only help you secure a lower interest rate when you do need to borrow—it can also help you get hired or reduce your insurance premiums because, generally speaking, the companies that use the FICO score believe that people with higher scores tend to act more responsibly in other areas of their lives. Conversely, a lower score makes it all the harder to land a job, get a loan or qualify for the best terms on a wide variety of consumer contracts.

FICO scores can range from 300 to 850. Only a small percentage of consumers have scores above 800. The median score is around 725, but a score of 760 or higher typically gets the best deal on interest rates. Income and assets (which are not included in the credit score formula) can also affect the amount and terms of your loans. But a good job and net worth might not be enough to overcome a poor credit score, depending on the lender’s standards. A higher credit score will give you more leverage in negotiating the best terms, while a lower score will limit your options.

See the difference: MyFICO.com estimates that someone with a FICO score of at least 720, who takes out a 36-month $20,000 auto loan, will pay a 6.098% annual percentage rate (APR)—translating into $609 monthly car payments. In contrast, someone with a score between 500 and 589 will pay a 16.240% APR—$706 monthly car payments. That’s $3,492 more over 36 monthly payments than the person with the higher score.¹

Five primary factors impact your score
These are the five areas that determine your FICO score:

Payment history: Someone once said that 90% of success in life is just showing up on time. That’s certainly true when it comes to paying your debts in a timely fashion. If you make a habit out of paying late, your credit score will suffer.
Length of credit history: The longer your history, the better. Anyone can look good or bad over a short period. Borrowing and repayment patterns over a longer period of time carry more weight.
Credit utilization: Never confuse what you can borrow with what you should borrow. Your score will suffer if you utilize more than 50% of the available limit on your credit cards and lines of credit. The level of outstanding debt relative to available borrowing power has a big impact on your score.
Frequency of new credit requests: Just as a hiring manager might frown on a job applicant who has worked for a large number of employers over a short period of time, frequently applying for credit cards or loans in a given period can negatively affect your score.
Types of credit used: A combination of different types of installment (such as auto or mortgage loans) and revolving (e.g., credit cards) debt is better than having just one category of debt on your credit history.

How to boost your credit score
Here are some steps you can take to improve your FICO score:

Pay your bills on time. This is the most important thing you can do, as your payment history accounts for roughly 35% of your score. If you’re behind, get caught up as quickly as possible and then stay current. If you’re struggling, contact your creditors as early as possible to work out a payment schedule. The sooner you get current, the better. The negative impact of old late payments will diminish over time and is likely to be completely erased from your credit report after seven years.
Increase the length of your credit history. It accounts for 15% of your FICO score. Cancelling an old card or getting a lot of new credit within a short time span can hurt your score because it lowers the average age of your accounts.
Keep your credit card balances low. Credit utilization makes up 30% of your total credit score. Ideally, you should keep the amount you borrow below 25% of your available credit—for example, borrow no more than $2,000 from a card with an $8,000 limit. Surprisingly, even if you pay off your credit cards every month, the average balance will still impact the utilization component of your score.
Minimize the frequency of new credit requests. It accounts for 10% of your credit score. Your credit report records an inquiry every time a potential lender requests a copy of the report—and that can make lenders nervous. If you’re thinking about taking out a mortgage or applying for some other type of loan in the near future, don’t apply for any new credit cards beforehand, especially those individual store credit cards that are offered at the time you make a purchase. You can also ask the three main credit reporting agencies—Experian, Equifax and TransUnion—to stop unsolicited credit card offers.
Keep a combination of different types of installment and revolving debt. About 10% of your score depends on the types of credit used. The way you handle revolving credit (like credit cards) carries more weight than the way you deal with installment debt (such as car loans and mortgages).

Check your credit report for free
The three main credit reporting agencies—Experian, Equifax and TransUnion—are required to provide a free copy of their credit reports to consumers once every 12 months. It’s a good idea to request a free report from one of these three agencies every four months on a rotating annual basis. To do so, just go to www.annualcreditreport.com.

As you check out your credit reports be sure to look for errors (e.g., accounts you never heard of or closed long ago, late payments that were actually paid on time, debts you paid off that are still shown as outstanding, etc.) and follow instructions for correcting any mistakes.

Bottom Line
For most people, some level of debt is a practical necessity. Borrow smart. If you’re in a position where you need to borrow, then take appropriate steps to make sure you’re in charge of the terms and conditions—not the lender. For additional tools and information, check out www.schwabmoneywise.com.

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

Important Disclosures

1. Source: www.myfico.com. This data is as of April 6, 2009. The interest rates noted are national averages.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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