By: Dan Ridenour—
As someone considers buying a home, the saying – “Location, Location, Location” might come to mind. Many Realtors I have talked with indicate that location is extremely important and should be at the top of the list when deciding which property to purchase. However, before a great location and/or property should even be sought, a buyer should consider their credit score. Increasing your credit score is important because the score determines which loans you can get, the terms available and your interest rate.
FICO scores vary slightly inside the three credit bureaus but in general range from 350 to 850, with 850 being the best. The FICO score is designed to indicate to the lender how likely it is that this borrower will have late payments. As a result, the lower the credit score is, the higher the risk to the lender making the loan. When someone applies for a mortgage, the credit score for that person will determine what interest rate that person will receive. Small changes in the credit score can impact rates both positively and negatively. For example on a 30 year fixed rate mortgage, someone with a 719 score could have a rate that is .375% higher than someone with a 740 or higher credit score. This rate increase is to compensate for the increased risk that the lower score indicates.
The credit scoring system is divided into 5 sections. Pay history provides 35% of the score (297.5 points max). This means is that if someone has perfect pay history they only received 297.5 points. 65% of the credit score is influenced by factors that have absolutely nothing to do with how well someone pays their bills. The non-pay history sections of the score are: Balance Ratio provides 30% of the score (255.0 points max). Length of History is worth 15% of the score (127.5 points max). Types of Accounts provides 10% and Activity also provides 10% of the score (85.0 points each). These five sections work together to provide the final FICO score.
There are two recommendations I urge buyers to take before applying for a pre-approval. The world will not fall apart if these steps are neglected, but it could cost a buyer thousands of dollars over the lifetime of a mortgage. Both recommendations are easy to do and can be accomplished in less than 10 minutes. So what are these credit steps?
First let me set some groundwork. I have more than 30 years of lending experience and have authored three books on credit scores. One of these books, Financial Folly, is available on Amazon. This article and my books are my opinions alone and are not necessarily advice from my employer. These steps are just two of the recommendations I routinely provide people on how to improve and/or protect a credit score. Some people will take the advice and follow through resulting in increased scores like these: Mary (+90 points) in 46 days. Joe (+59 points) in 43 days. Sam (+27 points in 19 days). Some people will not use the advice and that’s okay as well.
The first credit scoring step is very basic and it is easy to see why some might question the value. But believe me it is important. By unwittingly doing the opposite of my recommendation you have committed the most common credit score mistake made by those with excellent credit. So what is this credit scoring step #1? KEEP YOUR OLD CREDIT CARDS OPEN. That’s it. I told you it was easy. Closing old credit cards is unfortunately a common thing and it is a critical credit scoring error.
I can understand the reasons a consumer might feel compelled to close out old cards. For example- They have not used the card in a long time or maybe they moved away and therefore have no use for the card. But most often, the reason to close old cards given by consumers with excellent credit are that the rate is too high. These may all seem like good common sense reasons to close out an old card but doing so will lower your credit score and will lower it immediately. This error impacts four of the five credit scoring categories in a negative way: Pay History, Balance Ratio, Length of History, and Activity. For our purposes today, I will only address the two most impactful categories- Balance Ratio and Length of History.
How Balance Ratio is impacted- 255.0 FICO points. This part of the scoring model will reduce your score if you close out the account. This section of the score awards points when your balance is low and your available credit is high. Let’s say you have a $100 balance on a $1,000 credit limit. The scoring system will divide your 100 balance by the credit limit $1000. This gives you a 10% balance ratio. For all balance ratios under 30% you are rewarded for being a careful borrower and receive many credit scoring points. With 31% to 50% balance ratios you will receive a small number of credit scoring points. For credit cards with a 51% to 80% balance ratio, the scoring model begins to take away points.
Finally with an 81% and higher balance ratio the scoring model will remove many points from your credit score because (in the opinion of the scoring system) you do not know how to manage revolving debt properly. Remember you may have a perfect pay history but you will lose points if you carry a high balance ratio. Most of the time when it comes to consumers closing credit card accounts, the balance on the account is small or zero. This means you ARE currently receiving many of the credit scoring points because your balance ratio was under the 30% range. Once you close the account, you no longer get any of those points because the balance ratio portion only applies to open accounts. Closed accounts get zero of the 255 credit scoring points. Keep your credit card accounts open to protect your credit score.
Length of History is impacted- 127.5 FICO points. This section of the scoring model determines your average months of history. If you opened an account in March 2017 and today is March 2018 that number would be 12 months of history. For this part of the score, if another credit card was opened in March 2013 then you would show 60 months of history on that account. If those were your only accounts, then the points are awarded by taking the total number of months 12 + 60 = 72 and divided by number of accounts (which is 2) = 36.0 to come up with your number of months average length. If you close that oldest account you would lose the 60 in this calculation. Your average would then be 12 divided by 1 = 12.0. Closing out an old credit card will have a negative impact on a credit score, guaranteed. It may seem like it couldn’t make that much of a difference but I assure you it will. If you are planning to buy a home in the near future, please heed my advice. Keeping your old credit cards open takes no extra effort or time and the end results could save you dollars in future interest costs. Keep your old credit card accounts open to protect your credit score.
The second credit scoring recommendation I would like to share is for each of you to take all the credit cards out of your wallet. Put them on a table. Now turn them all over. Get out your phone and call the number on the back of each card. When they answer say this, “I am thinking about making a purchase, I have been a customer of yours for a long time, would you be willing to increase my credit limit?” They will look into your history with them and if they increase your credit limit (which costs you nothing), your balance ratio will improve. This ratio improvement will increase your credit score. This strategy works well and it is very easy. Keep in mind they do not have to increase your credit limit, but if they do it will drive up your score. If they don’t no harm is done.
I had one customer with perfect pay history but who only had a credit score of 671. He had three credit cards and all three were over the 80% balance ratio level. His high balance ratio explained why his score was low even though he had perfect pay history. We did the whole turn the card over procedure and he called the three cards from my office. Two of the three increased his credit limit and both of the ratios went from over 80% to under 50% ratio.
The end result was that in 19 days his credit score went up 27 points to 698. Nothing else in the credit file changed, just the balance ratios. The objective of this credit scoring tip is to improve your credit card balance ratios. Your goal should be to bring all balance ratios to 30% or less so that you maximize your points. This example shows that any improvement in the ratio will improve the credit score even if it doesn’t take the ratio below 30%. Following this recommendation will jump start your credit score and costs nothing outside of a few minutes on the phone. A better credit score will result in a better interest rate and may help you qualify for a bigger or better home.
I have provided two credit score recommendations in this article that are both simple to do and cost nothing to accomplish. Please consider putting one or both of them into play within your own credit file. Once completed, you will be ready to get pre-approved. Next you can contact your realtor who will help you with “Location, Location, Location.”
Dan Ridenour is a Regional Retail Lending Manager for MutualBank directing the lending activities for thirteen branch locations covering a five county territory.
Dan’s book titled: Financial Folly: Why Seven Smart Financial Decisions Will Lower Your Credit Score.
Available on Amazon at this link.