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Roughly 90% of lenders use FICO scores — a calculation developed by the Fair Isaac Corp. more than 25 years ago — to determine how risky it would be to lend you money. Scores range from 300 to 850, and having a FICO score toward the top of that scale can save you big bucks over the life of your loans and improve your retirement prospects.
As a financial planner, I regularly work with clients who are saving up for their first home purchase. In addition to continuing a savings strategy, we spend several months with laser focus on improving their credit scores to the “very good” or “exceptional” range. The goal is to redirect the money saved over the term of the mortgage to fund other lifestyle goals, such as retirement, paying for children’s college, vacation homes or funding a business.
>> MORE: How much house can I afford?
Here’s an example: Let’s say Jane has been saving diligently over the past few years and is finally ready to purchase her first home, but she has a below-average FICO score (the U.S. average is around 695).
She is approved for a 30-year home loan amount of $350,000 at a 5% interest rate. At the end of those 30 years, she would have paid $676,395 in principal and interest.
Now consider a different scenario — Jane has a FICO score in the high 700s, which is in the excellent range, and is given a 3% interest rate, with everything else remaining the same. After 30 years with her lower interest rate, she would have paid $531,221, giving her a total savings of $145,174, or about $403.27 a month.
The benefits don’t stop there. If that $403.27 per month were placed into an investment account averaging a 6% return for the lifetime of the mortgage, Jane could have an extra $405,090 for her retirement goals.
As you can see from this example, a seemingly small change in your interest rate can significantly affect the amount that you pay — and the amount you have available for other important goals.
So what makes up a FICO score? Here are some of the key elements of the Fair Isaac algorithm that determines what your score will be.
Your payment history contributes a whopping 35% to your FICO score calculation, according to Fair Isaac. That means that making consistent on-time payments, or not making them, is the single biggest factor that can cause an increase or decrease to your score. This effect tends to dissipate over time, so the more recent the late payment, the bigger the effect on your score.
Your credit utilization percentage, or your total amount of credit card debt divided by your total credit limit, makes up 30% of the FICO score. You can increase your FICO score by improving your credit utilization percentage, preferably to less than 30%. Once the percentage gets as low as 10%, you will not get much more improvement from a FICO score standpoint, but you’ll gain peace of mind knowing that you have little to no credit card debt hanging over your head.
Length of credit history
The FICO score calculation likes to see credit histories that extend many years, and it assigns 15% percent weight in its calculations to your length of credit history. If you have a card that you rarely use, consider holding on to it if you have had it a long time, because closing the account entirely could dramatically reduce your average account age.
(A consumer’s particular credit mix and the amount of new credit he or she has taken on make up the remaining 20% of a FICO score.)
So how can you improve your score and start reaping the benefits? Here are six steps you can take right away:
1) Check your credit score. To improve in any area, the first step is to take stock of your situation. Knowing your score will let you know whether you have to improve and, if so, by how much.
2) Check your credit limits. Your monthly credit card statements tell you how much your credit limit is, and how close you are to it. This is important so you don’t accidentally make a purchase that puts you over the limit for a particular card. Going over your credit limit raises a red flag to credit agencies and can negatively affect your score.
3) Consistently pay bills on time. Set reminders. Create a spreadsheet. Enroll in auto-payment. Do what works best for you, but be timely in your payments.
4) Ask for a credit limit increase. Call each of your credit card companies and ask whether it will raise your credit limit. This will immediately improve the credit utilization portion of your FICO score calculation.
5) Optimize your credit utilization percentage. Use extra money each month to pay down your credit card balances, and resist the urge to put any new charges on your credit cards until you get comfortably in the 10% to 30% credit utilization range.
6) Be patient. Depending on your financial situation, increasing your FICO score could take several months to several years. The benefits of doing so can last a lifetime, however, so stick with it.
Use these tips as general guidance in improving your FICO score in a consistent, sustainable way. It could not only save you massive amounts of money throughout your life, but could open doors that might not have been available to you otherwise.
Image via iStock.