Whether you want a car loan … a mortgage … or even a job in many cases, there’s a single number that could make or break your plans. Or at the very least, it could easily cost you thousands of dollars in extra interest payments.
I’m talking about your credit score, of course.
So let me start with a simple question: Do you even know what your credit score is right now?
More and more financial institutions are finally making this information available to consumers. But the companies that create these scores still don’t provide them free-of-charge to regular Americans as a matter of practice.
Worse, they never reveal their proprietary methods for calculating these scores — only general guidelines.
And now, at least one credit score company is about to overhaul its system … which could automatically cause your number to adjust sharply.
In today’s article, I want to explain what’s happening. We’ll also look at how you might aim to boost your credit score under the new methodology.
First, let’s talk about FICO scores …
FICO scores, which are produced by Fair Isaac Corporation, are far and away the most popular measure of a consumer’s risk to lenders.
The scoring system has gone through several overhauls. But the basic methodology is underpinned by the following three major tenets:
1. Pay bills on time
2. Keep low credit card balances
3. Open new accounts only when needed
No. 1 is a no-brainer, even if you simply want to avoid unnecessary interest or penalties.
But what about No. 2?
Fair Isaac says all versions of FICO penalize people who carry high credit card balances. Meanwhile its newest system, called FICO 8, assigns an even HIGHER penalty to anyone in this category.
What constitutes high revolving credit?
I have previously heard it might be 25% of your available lines.
In other words, if your total credit card limits are $10,000 and you’re carrying $2,500 in balances, your score could be suffering.
However, just because someone carries a high balance doesn’t mean they’re a big risk. I’m a great example of why that is …
I pay for almost everything with one of my few credit cards.
Not because I can’t afford to use cash, but simply because I earn substantial rewards that I can then apply toward hotels, airfare and other luxuries.
In fact, I treat my credit cards AS cash … paying off my balances on time and in full every month.
Yet all a credit scorer sees are monthly balances that represent a high proportion of the overall credit that has been extended to me. This is partially because credit card companies generally report balances a few days before billing cycles end.
So in a perverse twist, it has often made sense for consumers to open an additional credit card … or request credit-line increases … to BOOST their credit scores.
I consider that strange — especially since a future lender has absolutely no guarantee you won’t end up tapping all that available credit even if you haven’t historically used it.
Meanwhile, another rule has always been to maintain a long credit history.
Thus, many experts — myself included — have traditionally told consumers not to close out very old credit card accounts even if they aren’t really used.
After all, an old credit line increases the average age of your accounts. It also provides extra borrowing power to reduce your total debt-to-credit ratio.
However, another credit score company called VantageScore — which was created by the three credit bureaus Experian, TransUnion and Equifax — is about to challenge these two ideas.
VantageScore isn’t used by mortgage companies, but it did affect 8 billion credit card applications last year. Thus, it has a wide reach and a broad impact on regular Americans.
Starting at the end of the year, VantageScore is changing its methodology so that:
A. The trajectory of your debt will become more important — meaning overall debt that is trending higher will hurt your score while steadily declining debt levels will improve your score
B. Excessively large credit limits will also hurt your score — under the idea that you have the potential to quickly tap those lines even though you aren’t currently using them
One practical implication of these changes is that you may no longer want to keep old credit cards open unnecessarily.
Another is that you may no longer want to have a large overall credit line.
Especially since I would expect Fair Isaac to consider implementing some of these same ideas in future versions of its FICO system.
Therefore, I’m changing my recommendations to the following steps:
#1. Keep only a few credit cards open that you are regularly using. This is different from my previous recommendation to maintain old, dormant accounts.
#2. Among the cards you use, stick to ones with better-than-average rewards programs and no (or at least low) annual fees.
#3. Pay your balances in full every month, and be sure to keep the overall debt-to-credit trend flat or going down.
#4. Limit activity that results in credit inquiries — i.e., opening unnecessary accounts, asking about loans you don’t really want, etc.
#5. Consistently pay your bills on time.
#6. Regularly review your credit reports (which are now available to you free of charge once a year) and correct any errors you see.
#7. And most importantly, aim to get your life to a point where you no longer even need to rely on the financial system in the first place!