“How can I increase my credit score?” I get this question often, and while there’s no instant way to have a great credit score, somethings grow your score faster. But most people have no idea how their credit score works and even assume that it works one way when it indeed works another. In some ways it’s counter-intuitive and in other ways, it’s simple.
The part that throws everyone off is that a credit score is based on proven debt and credit handling. It is not based on how responsible you are financially.
My sister-in-law paid for her house with cash. Both of their cars were bought with cash. She did her college without student loans. She is extremely responsible with her finances. Perfect candidate for a loan for a second house right? Wrong.
She was denied because she had no credit history. Some how people assume that your credit score is based on how responsible or well off you are. But it’s not. It’s solely this: is there proof that you can handle credit and debt well? That’s it.
If you think about that, the logical implications are reversed from what the average person assumes about what is bad for your credit. Think about having multiple credit cards. Whatever you think it says about you is irrelevant. Handling multiple credit cards proves you can handle credit.
In fact, more credit cards proves your credit worthiness more and faster.
I always tell the story of my friend Ben. He just needed to ask about if my having multiple rewards cards would hurt my credit. Eventually he decided to test the water with one rewards card. His score went up, and after a little bit he got a couple more.
Ben already has great credit as he’s had a credit card or two since college. But imagine his surprise when he logged on to CreditKarma one day to check his ratings for his score. One way they rated his score was by the number of accounts.
He checked and for most everything else he had an “A”, but for number of accounts he saw a big fat “C”. His eyes widened a little bit and he looked at me. I felt the look was saying, “I knew you were screwing me somehow!”, but then he looked further.
It said “C” but then went on to say why: “Open accounts = 8, rating = C… for too few accounts.” His eyes got even wider, and now he seemed upset that the system seemed so backwards. Well, fast-forward, Ben got in on a few promotions and now his score has moved up to a “B”.
Listen, in the end your score is about having good open accounts. Good history multiplied by multiple good acounts makes you look good. But don’t get me wrong, much of your score is exactly what you would expect.
What does good history mean?
On time payments is huge. This is about how responsible you are with the credit you have. Did you pay it back or were you tardy. These marks are huge. For this reason I recommend not losing track of which account has what and only really use your one favorite card.
Having a high credit limit is good. Add up all the credit card credit limits you have and put them together; that is your ability to go into debt. In other words, you can screw yourself that bad.
And credit card debt is bad for your score. There are a lot of myths about this and I’d like to do a piece on that alone, but carrying a balance is not good for your credit score. Paying off your card balance is the biggest instant improvement you can have on your credit score.
Total credit usage should be below 10%. This is dividing how much debt you currently have by the credit limit. If you have a 50% credit usage (debt/credit limit), you should not apply for a credit card. At least I am pretty certain you will get declined for a good rewards credit card.
I read an interview with the head of FICO and he stated that the ideal credit usage is between 1% and 10%. (I’d love to find that article by the way). The way I took this is that it is both good to have low credit usage and to use your card.
Using your card is good for a number of reasons. First and foremost it shows the bank that you are trustworthy. Over time a bank will increase the credit limit of an active credit card. This alone will improve your score a little. Plus, I like to have a good relationship with my bank (Chase), and the way to do that is make them money. When I use my credit card they make money, and I get rewards. I think I’ll keep that relationship going.
Length of Credit
It is not the biggest factor, but it is a good indicator of how good you are at borrowing money. Equally backwards to what people think. People who pay off their cars in 9 months, guess what! It’s financially responsible but doesn’t prove creditworthiness. Crazy right?
They would rather see you paying back the car for a long period of time. Plain and simple. Of course it is likely not worth it in any way to pay the interest when there are other ways to grow your credit score, but length comes into play.
It’s simple though at the same time. In 9 months they have less chances to see your patterns than 5 years. But whether or not you agree, it’s how it works.
Similarly, having long-open credit cards is very important.
I tell people to make sure your first credit card has no annual fee, and your second one is downgradable (Chase Freedom and Chase Sapphire). But really you want to still have these cards in 10 years. Because your oldest account is a factor in your credit score.
And your average length of credit comes in to play as well. Longer is better. Canceling after the first year to avoid the annual fee is only acceptable if you have other accounts to increase the average.
It’s a numbers game. Longest account and average account.
Type of Credit and the Order of Credit
Apparently, diversifying credit is good. Seeing as the other better types of credit involve interest and debt, obviously the positive impact on the credit score is not worth it alone. But if you have other types of credit it doesn’t hurt.
And apparently this is the order of what type of credit has the biggest impact on your credit score:
- Installment loans (student, car, etc…)
- Credit Cards
- Retail Cards (Belk, JC Penny, BP, etc…)
I say apparently because in the results I’ve seen, it’s not always apparent.
My wife has loans from university and now has credit cards. I have only had credit cards. Our accounts are similar in length of history and number of accounts and all that. Yet, I have a higher score but just a little bit. Her having installment loans in addition to just credit cards has produced not so different results.
Of course, that could change in 10 years. Maybe I’ll notice those differences but at the moment I do not.
Similarly, when I study the credit score of friends who have had a car loan for a year vs. friends who have had a credit card for a year, the odd thing is that the credit card produces the higher score every time.
Again, it could be that the diversity of different accounts will play out in the long run. It also could be that the credit cards provide other aspects to a credit score, like credit limit and credit usage. This is my theory at least, that on time credit card payments might have less credit power, but the contribution to credit limit is better. And if you don’t already have those things, it helps the score more.
The other thing I’ve noticed is that retail cards have very little effect. And again, whether or not you make on time payments just means less because of the nature of the product. But also, it doesn’t contribute much to credit limit and what not.
These are the things I’ve noticed. My friends have probably found my interest in their credit scores quite creepy. I’ve even had some of them send me before and after screen shots and screen shots showing growth of their scores mapped out with the number of cards.
Note that I know nothing about mortgages. One of my friends should be my guinea pig.
One last part of your credit score are hard inquiries. The purpose is to track how often you are applying for credit. If you applied for a ton of credit 2 weeks ago, it’s quite a red flag of desperation, and you’ll get denied.
But I have noticed barely any affect of hard inquiries. It seems that there is a dip of 1 or 2 points after the application and then the score jumps up way higher than before due to the good history, the increased credit limit, etc…
Why do these things have so little effect on your score?
First of all, know that these hard inquiry “marks” go away in two years. After two years there would be no way to know you applied for credit and got denied, based on your credit report and score. It is just erased from your history.
Further more, there are three credit bureaus (Expedian, Eqifax, and TransUnion) that turn your credit report into a credit score. When you apply for a card with a bank, the bank will ask a credit bureau for your score, they put a little red mark on your score. In turn, this means that hypothetically, if you applied for three cards across three bureaus on the same day, each one would show 1 hard pull.
Lastly, the purpose isn’t to penalize asking for credit but to reflect desperation. However, many banks use other signs to determine desperation, like credit usage and debt in general. If you have hard pulls and debt, it may be worse than just having debt.
But otherwise, the effects seem to be non existent both on your score and during application time. Although if you applied for a ton of cards a month earlier, they may decline you. But the fact that three months later, they may approve you, shows that it isn’t about the hard pulls as much as desperation.
Credit Score vs. Bank Decision
Understand that the banks use the credit score to help determine approval. There is no set number they are looking for; they use all your info though. How long you’ve had accounts, if you have good credit limits, good payments, etc… But you can have a high score and still get denied because of too little credit.
And as of late 2011, the banks are allowed to use your income. This is not included in your credit report though, so the only way they know this info is by asking. But do not think it is part of your credit score, it’s not. It’s an added qualifier by the bank.
As I mentioned, there are three credit bureaus. You can check your score with any of them, but it’s not free. Although it’s easy to do the free 14 day trial… but don’t forget to cancel! This is very important. It is good to know your credit score and check every couple of years with the bureaus themselves.
However there are “proxy” credit score agencies. Most popularly Credit Karma and Credit Sesame. These replicate one of the bureaus and are decently accurate. It’s close enough, as the specific number doesn’t mean too much, it’s the general idea.
Here’s what I’m really trying to get across, you don’t need to go out and get a loan. (I get that question a lot). You don’t need to get a loan for your cash if you have the ability to pay cash. You just don’t.
I wasn’t going to share this here, but I thought I’d share one screenshot from a friends credit score. Had a car loan but couldn’t get a single credit card. Got one and built up a little bit of credit, and then got a few more. Here are the results of the few credit cards at the end of summer:
This to me, is incredible. 42+ points and counting. Also note, that this person was at a similar time added to their spouse’s card who may have had a higher credit limit.
Excellent credit is excellent credit. Meaning, as your credit score grows, you would qualify for better and better loans. But after “Excellent”, there’s not added benefit. You are just at the top, and the number from there is arbitrary.
I have friends with 800+ credit scores worried about hurting their credit score with a credit card application. *face palm* I mean, 1) That’s backwards on how your credit score works and 2) Having a credit score that high doesn’t do anything more than the scores of those of us with 760. But different strokes for different folks.
Lastly, be careful. Credit cards are not a joke. Dave Ramsey says people spend 10% more when they have credit cards. And some people begin to justify maxing out. Doing this once could ruin your score. And even if you don’t go bankrupt, interest is very high on credit cards. Once you’re in the debt hole, it can be hard to get out.
Okay, now I’m done sounding like a mom. My honest opinion, is that credit cards are smart if you are smart at using them. They increase your score and rack up a ton of frequent flyer miles. Simply put. And I don’t just say that because I get paid per credit card signup through the ads… Honestly, I say it because we do it.
We’ve tested this, both on the credit score end and the miles end. Tested it over and over both with ourselves and our friends. (We have good friends).
And at this point it is absolutely painful for me to see people not using a rewards card. I cringe. With strangers I don’t care. My closest friends all have rewards cards. But everyone in the middle doesn’t realize how much they pain me when they settle their bill with a debit card or something. Like nails on a chalk board.
But that’s it. This is what us in the miles and points hobby have realized very quickly: Having multiple credit cards increases your credit score faster.
Anywho… If you have any questions or comments I’d love to hear them. And if you have any scientific monitoring of your own with credit score, I would love to see them. Odd, right?