As a writer in the personal finance sector, I spend a lot of time reading blogs about how to improve or establish credit. The information out there is great. I’ve come across tons of articles that offer a variety of ways to improve your credit score. Reading between the lines, it’s become pretty clear to see that there is one thing that is most important above all when working on your credit. It’s not a credit card, it’s not a budget, and it’s not a plan. No, it’s a general understanding of how your credit works, and why you have a score in the first place.
Let’s Start With The Why
Credit scores didn’t just happen. There was a genuine need for a way to gauge the creditworthiness of consumers, businesses, and even entire countries. The reality is, before credit reports, loans were made on a handshake and smile—a system that simply didn’t work.
So, credit reports were born. When consumers wanted to get a loan, the lender had a way of figuring out what the chances were of those consumers paying the money back. The credit report was and still is a track record of how each entity has handled their debts in the past. Therefore, if a lender sees that the borrower has a history of paying back their debts, they will be more than willing to give a loan at reasonable rates. However, if the lender sees that the borrower has a track record of poor financial habits, they will either decline the loan altogether, or provide a loan at much higher interest rates to offset the risk.
Then Came The FICO Score
Credit reports did great. More loans were becoming profitable and it was all because lenders could get a good idea of the financial history of those they were giving loans to. However, it takes quite a bit of time to go through and analyze a credit report. To combat that, the FICO® Score was born. The Fair Isaac Corporation, also known as FICO, came up with a computer algorithm that could automatically analyze credit reports and produce a 3-digit score for each borrower.
So, How Does It All Work?
Think about it this way, if you were a lender, what would be important to you? Here’s what I’ve come up with after tons of research, as well as years as a credit counselor.
- Payment History – If I was a lender, the single most important thing to me would be the borrower’s payment history. If the borrower had good payment history, it would be easy to expect that they would pay me on time every time.
- Length of Credit History – If you’re new to borrowing money, there’s a good chance you might fail to make your payments as agreed. Therefore, if I was a lender, I would want to know how long you’ve been using your credit, and how many loans you’ve had.
- Revolving Account History – Revolving accounts include accounts like credit cards and signature lines of credit. These accounts offer a spending limit and a way to access funds up to that spending limit at any time. These are important because if a borrower is capable of consistently borrowing money, and paying that money back as agreed, chances are, the borrower would have no problem getting my money back to me.
- Debt-To-Income Ratio – No matter what your credit history was in the past, if you’ve got more debt than you do income, at some point, you’ll have no choice but to start missing payments. This would be a crucial factor for me if I was a lender.
- Revolving Credit Utilization – When borrowers use up too much of their available credit on revolving debts, it shows poor spending habits, which almost always lead to financial hardships and missed payments. Therefore, if I was a lender, I’d make sure that any revolving credit lines had 40% to 50% available credit or more.
Using This Information To Create A Plan
Knowing what’s important to lenders, and learning that what lenders like to see is also what improves your FICO Score, we can now create a viable, step-by-step plan for credit improvement:
Step #1: Work On Bad Debts – We know that lenders don’t like to see debts that have gone unpaid. So, the best place to start is to get an idea of what bad debts you have and then create a plan to start paying them off.
Step #2: Establish Positive Credit Accounts – Lenders like to see positive credit accounts. More importantly, they like to see revolving credit accounts. One of the best things to do in the process of improving credit scores is to open a secured credit card. Doing so will give lenders a revolving account to track and watch your financial habits. Just make sure to use it properly. Keep your balance below 50% of your credit line and make more than minimum payments in advance.
Step #3: Keep An Eye On Your Revolving Debt-To-Income Ratio – The equation to come up with this ratio is as follows:
Your Revolving Debt / Your Income = Your Debt To Income Ratio
Lenders are most comfortable when this ratio is below 15%. So, if you have an annual income of $40,000.00 per year, you wouldn’t want to have more than $6,000.00 in revolving debts.
Step #4: Make Financially Sound Decisions – The truth is, lenders look at credit to get an idea of whether or not you’re living a financially stable lifestyle. Therefore, by continuing to make smart financial decisions, your FICO Score should only go up. Don’t take out loans you can’t pay back, try to establish a savings, make sure you treat your loans well and always stay ahead of your debts.
Check out this calculator to learn how your FICO Score affects your loan limits and interest rates.