Just about everybody knows a low credit score can cost you thousands of dollars in interest when you finance a car.
Now, more and more people with low credit scores are paying higher auto insurance premiums, too, because research has connected lower credit ratings with higher incidences of claims.
If your credit score is on the lower side and you’re paying more for auto insurance, you have a few options:
- You could argue it’s not fair and tell your agent you’d be an exception to this general rule.
- You could ask your state’s insurance commissioner to bar insurers from considering your credit rating, as California, Hawaii, and Massachusetts have done.
- Or you could take control of the situation and start working to improve your credit score which will pay off not only with lower insurance premiums but with more borrowing power and lower interest rates as well.
You may be tempted to hire a credit repair company to improve your credit score. Our best advice is: don’t. There’s nothing a credit repair company can do that you can’t. In fact, you can do it much better.
It’s a worthwhile goal, too. In today’s credit driven world, your credit score is a major source of information about you in an increasing number of capacities. Raise your credit score, and you’ll not only pay less for credit, but you may also open new opportunities in life.
Why Good Credit Matters
Whether you’re applying for a mortgage, a car loan, a credit card, or a business loan, your credit score is one of the major factors determining the likelihood of approval.
Loan approval isn’t all that’s is at stake either. Your credit score will often determine how much you’re able to borrow, the terms of the loan, and even the interest rate you’ll pay.
The screenshot below shows the effect credit scores have on the interest rate you’ll pay for a home mortgage:
(Source: myFICO Loan Savings Calculator)
Notice the highest credit score range (760 and above) gets an APR of 4.268%, with a monthly payment of $986 on a $200,000 mortgage. At the opposite end of the credit score spectrum, the 620 to 639 range has a rate of 5.857%, with a monthly payment of $1,181.
The highest credit score range pays total interest of just under $155,000, while the bottom pays just over $225,000 over the life of the loan. The difference of just a little over 120 points on the credit score results in $70,000 more in interest paid over the life of the loan!
Borrowing isn’t the only area where you can be affected by your credit score. Other ventures where your credit score will likely be considered are:
- Applying for employment, especially higher-level positions.
- Various types of insurance applications, which use a credit based insurance score.
- Renting a house or apartment.
- Setting up new service with a utility, phone, or cable/internet service.
- Entering into a business venture or partnership.
In each case, the level of your credit score can determine whether you’re able to enter the venture and even the rate you’ll pay.
This is why you owe it to yourself to improve your credit score.
How Your Credit Score is Calculated
There are five basic factors used to calculate your credit score:
Payment History. This tracks your payment history going back seven years. More recent payments, such as those in the past year or so, will count more heavily than those that are several years old. Other derogatory information is included are collections and charge-offs, as well as legal records, such as judgments and tax liens, which can go as far back as 10 years.
Amounts Owed. This refers to credit utilization ratio. That’s the amount you owe on your credit cards, divided by your total credit limits.
For example, if you owe $7,000 in credit card debt, and your total credit card limits are $20,000, your credit utilization ratio is 35% ($7,000 divided by $20,000).
According to the credit bureaus, a credit utilization ratio of less than 30% works in your favor. To the degree the ratio exceeds 30%, it hurts your credit score. If the ratio is 80% or higher, it’s considered a strong indicator of future default.
An excessive credit utilization ratio is the primary reason why even someone with a good payment history will have a relatively low credit score.
Length of Credit History. This is a factor because it gives the credit bureaus more time to measure your credit performance. If your average credit age is eight years, your score will be higher than if it were just two years.
Credit Mix. The credit bureaus prefer to see a mix of credit types. If you have five credit lines, and they’re all credit cards, that will work against your score.
New Credit. This will work against you only because the credit bureaus haven’t had time to adequately assess your payment performance.
Credit Score Ranges
FICO scores can range between a low of 300 and a high of 850. As you might expect, relatively few people are at the extremes.
Each lender has its own definition of what constitutes various credit levels. For example, one lender may determine that a credit score of 650 is fair, while another may consider 700 to be very good, and eligible for the best loan products available.
Perhaps the most subjective category is the “fair” group, but lenders usually have a very different view of this credit score range.
For example, in the mortgage industry, the minimum credit score is typically 620. Anything below would prohibit loan approval, therefore making it poor by definition.
Credit cards would assess that range in much the same way. While they might approve a credit card with restricted terms on a credit score of 660, they might decline an applicant with a credit score of 640.
Is 700 a Good Credit Score?
Generally speaking, a credit score of 700 or above will at least get you approved on any type of loan. In most cases, it will also entitle you to the best pricing and terms the lender has available. This is true of many different lenders, including mortgage companies, auto lenders, and credit card issuers.
However, there may be some lenders who provide preferential pricing and terms for what they consider to be elite borrowers. Higher credit scores may be necessary to get those very best rates and terms. A lender might set the minimum credit score to a number like 720 or 750. 800 or above is a fairly rare requirement, since relatively few people fall into that category.
What’s more, many people with scores that high reach that level precisely because they tend not to borrow. The 800 and over crowd is comprised primarily of people who have long and deep credit histories, but very little outstanding debt.
What is a Bad Credit Score?
As we’ve already discussed, it’s not possible to declare a certain credit score to be bad. It all depends on the lender and the industry.
For example, one credit card lender might determine a credit score of 630 or lower is poor, while another might set the threshold at 660.
There’s also another important factor: Credit isn’t always determined strictly by credit score. It all depends on the factors creating the score.
For example, if a lender refuses to make loans to anyone who has a bankruptcy in their history, they could conceivably decline an applicant who has a credit score of 700, with a bankruptcy that was discharged six years ago.
An auto lender who normally make loans to borrowers with credit scores of at least 650, might decline the application of someone with a score of 675 because they’ve had three 30-day late payments and one 60-day late payment on auto loans within the past two years.
Naturally, credit card lenders look very closely at your credit utilization ratio. Even if your credit score is over 700, if your credit utilization ratio is 85%, they may either decline your application, or offer you a card with a very low initial credit limit, like $1,500.
This is why while you may want to improve your credit score, you will also have to look very closely at the components that make it up. Your credit score is often just the starting point. The lender will then do a deeper dive into your credit report to look into any factors that might adversely affect their loan decision.
A low credit score sometimes highlights those issues. But other times, they may be hidden by a high credit score.
How to Improve Your Credit Score
Now that you see how important your credit score is, and how the level can affect both loan approval and what you’ll pay for a loan, the need to improve your credit score should be obvious. Raising your credit score substantially not only means you’ll pay less for credit, but it will also open doors to new opportunities, like employment, insurance policies, apartments, and even business deals.
Virtually anyone can increase their credit score significantly by making some basic changes. But ironically, it’s actually easier to increase your credit score dramatically – such as by 100 or more points – if you have a low score to begin with.
Improving your credit score by addressing the following issues could start paying off sooner than you think.
Pay Your Bills On Time
If your credit score is weighed down by a long history of consistent late payments, then you already understand why this matters. Though it sounds incredibly simple, the best fix for this problem is to simply begin paying your bills on time from now on.
One of the built-in advantages of bad credit is that it actually gets better with time. That is, as long as you put a stop to the bad credit. A three-month old late payment will have a significant negative impact on your credit score. But as it becomes one-year-old, two years old, and three years old, the negative impact will decline steadily.
The basic idea then is to put bad credit as far into your past as possible. This includes paying all bills on time, not just loan payments.
There’s an unfortunate arrangement when it comes to non-credit payments, like rent, utilities, cell phone services, and even gym memberships. They won’t report your good payment history to the credit bureaus, but they will report any past due balances. This is why it’s so important to get into the habit of paying all bills on time, all the time.
You’ll get a lot of bang for your buck by improving this piece of the puzzle. There are some strategies you can implement to help you with this process:
- Set up auto payments when possible: We get it. When money’s tight, you may need the flexibility to hold onto a bill payment until payday. So start with your lowest monthly payments — your student loan payment or a credit card bill, maybe? — and set them up to be paid automatically each month. That way you know those bills should never be late.
- Pay bills online: Paying bills online will help avoid extended delays that can be up to several days or even weeks in some cases for payments to make it through the mail.
- Make a calendar or reminder system: It doesn’t have to be elaborate. Just saving a list of monthly due dates on your computer desktop or your phone’s Notes app will do. Type an X or an asterisk when you’ve paid a bill for the month. Then, at the end of the month, reset the file for the next month. Or, just set recurring reminders on your computer or phone
- Pay a bill or two early: If your credit card bill is not due until the 20th but you have enough money to pay it on the 12th, go ahead and knock it out early. Otherwise, you may find other ways to spend that little windfall which could require you to pay the bill a few days late.
Reduce Your Debt
Earlier we discussed credit utilization, and the fact that it’s the second most important factor in determining your credit score (30%). Depending on where your credit score is, you might be able to improve your credit score by 100 points by paying down or paying off credit card bills.
This probably isn’t something you can do quickly. Instead, set up a plan to begin paying down the debts gradually. Even lowering your credit utilization ratio from 85% to 65% can significantly improve your credit score.
If you have a new, six-figure mortgage, a new car loan, and you just graduated from college with $35,000 in student loan debt, your hands may be tied with this one, so just do what you can:
- Keep your credit card balances as low as possible.
- Pay off a credit card or two if possible (but don’t close all the accounts).
- Avoid unnecessary borrowing.
Keep Some Accounts Open
People who are deep in debt often close out and “cut up credit cards” after they’re paid off. It’s kind of like sweet revenge.
Cut up the cards if you want, but don’t close the accounts. Ever.
If you pay off a credit card AND close out the credit line, your credit utilization ratio won’t improve. The debt may be gone, but so is the credit limit. An unused credit limit contributes to your overall combined credit card limit, which brings down your credit utilization ratio.
So definitely pay down and pay off your credit cards. But leave your credit lines exactly where they are.
Another tip about leaving accounts open is to leave small balances in some of them just so that they show relationship history. Leaving small balances shows that you maintain long-term relationships.
Keep New Credit Applications to a Minimum
In the credit universe, applying for credit too frequently is seen as a distress sign. It can indicate you’re having cash flow problems and looking for credit to make up the difference. This is the New Credit slice of the credit factors, accounting for 10% of your credit score.
But it can also have an effect on Length of Credit History, and that’s 15% of your credit score. If you have several newly opened credit lines, it can weigh down both New Credit and Length of Credit History, having a more severe negative impact on your credit score.
Also, be aware that with new credit applications come credit inquiries. And while a single credit inquiry won’t have a major effect on your credit score, having several can make a significant difference.
New credit should only be applied for sparingly, and only when absolutely necessary.
Maintain a Balanced Variety of Accounts
Another of the smaller slices of the credit factors is account variety. If you have a mortgage, a car loan, a couple credit cards, and maybe a medical credit card or a personal loan, you already have a good variety of loans.
How to Check and Monitor Your Credit Score
Improving your credit score is a lot like improving your health. You have to make good decisions consistently and then wait patiently before enjoying the benefits.
Checking your credit score, however, is as easy as stepping onto the bathroom scale — actually, it’s easier since you might not even have to stand up.
There are various ways you can monitor your credit free of charge:
- Sign up for free credit score providers, like Credit Karma and Credit Sesame, and even Upgrade, who helps with personal loans too. They provide educational credit scores that roughly approximate your actual FICO score. They also provide the credit report details that affect your score.
- Take advantage of any offers by existing lenders or banks to provide your free credit score.
- You can get an official copy of your credit report once each year, for each of the three major credit bureaus, Equifax, Transunion, and Experian, through a site known as AnnualCreditReport.com. They are the only service officially authorized to provide your report from each of the three major credit bureaus.
Credit Sesame takes checking your credit score to a new level by showing a breakdown of your score’s elements and offering suggestions — accounts you could open or close — to improve your credit score.
With Credit Sesame’s app, your credit score is just a phone tap away, and this kind of access can help prevent costly errors.
If you notice a sudden decrease in your score, for example, one of your creditors may have made a reporting mistake.
By tracking your credit score continuously, you’ll always have at least a general idea what’s going on. And just as important, you’ll know before applying for a loan. You should always know your credit score – as well as the major information contained in your credit report – ahead of a potential lender.
That will not only avoid surprises when you make application for credit, but it will also give you an opportunity to improve your credit score before the fact. That’s important, because it can often take anywhere from several days to several months to correct an error on your credit report.
There’s an important fact to be aware of with free credit scores. Free credit scores are generally educational scores – which is why they’re free. They’re not your official FICO score, and are almost never the score used by lenders. The basic function is to give you a general idea where your credit score is at – which is valuable by itself.
Dispute Any Credit Errors
If you see any entry on your credit report that’s an error, contact the creditor and dispute it. You’ll need to provide written documentation proving your point.
If the creditor agrees that an entry is an error, have them confirm it to you in writing. Also request that they correct the information with all three major credit bureaus.
Be sure to get your understanding in writing from the creditor. If they fail to correct the information with all three credit bureaus, you can use the letter or email from the creditor to have the credit bureaus make the corrections.
Other Factors That Affect Your Insurance Premiums
Of course, your credit score isn’t the only factor your insurance company considers when it sets your premiums.
Any reliable information underwriters can gather will help them calculate your likelihood of filing a claim, and the more likely you are to file a claim, the higher your premiums will be.
Underwriters will consider factors such as:
- Your age.
- The age of your car.
- Your car’s safety features.
- Your driving record.
- How often you drive.
You can’t control some of these factors, such as your age or how often you need to drive. But you can drive more carefully and encourage others on your policy to do likewise.
Any time you avoid a wreck, you also avoid potential increases in premiums for years to come.
Remember, too, that auto insurance underwriters aren’t unique when it comes to credit-based insurance decisions.
- Your homeowners or renters insurance underwriters may consider your credit, along with other risk factors such as age of your home, your home’s location, and whether you have safety features such as a security system.
- Even life insurance companies may consider your credit score, along with your age, occupation, and health.
Each state regulates insurance differently, so if you’re interested in learning more about your credit rating’s impact on your premiums, check your local laws.
Some states, for example, require insurers to notify you when they look into your credit history. Others states allow you to prevent insurance companies from using your credit score, though insurers can respond by plugging in the lowest possible score which may cost you even more.
In a World Where Credit Matters…
The use of credit scores in underwriting decisions has been growing steadily for 20 years, and your score will likely influence your premiums for the foreseeable future.
Sure, it’s not always fair because some applicants inevitably will fall outside the limits of general correlations. Somewhere on the highway, for example, there’s a maniac behind the wheel who always pays his bills on time.
From an underwriter’s point of view, though, credit ratings provide a useful tool — a way to gain a quick and typically reliable insight into an applicant’s likelihood of filing large claims.
If you’re paying too much for insurance because of your credit score, it’s time to attack the issue head-on. It’s time to start the slow and steady journey toward controlling your financial life.
When you get there, your bank account will thank you every chance it gets.