The recession has hurt many people's credit scores. How to fix it?
Post date: Mar 21, 2010 4:54:37 PM
The recession may have done a number on your credit score, even if it spurred you to reform spendthrift ways and cut up your credit cards. For many, the drops have come at the same time that lenders have tightened their standards and demanded higher scores to get the best interest rates.
Even if you haven't had major credit troubles, like a foreclosure, your score may have dropped if you missed a few deadlines or boosted your balances when cash was tight. A study by credit bureau Experian found that average credit card balances in the top tier of borrowers are 22 percent higher than they were a year ago.
And some people's scores have suffered even though they thought they were doing everything right. Credit card companies have been lowering credit limits and closing accounts in an attempt to minimize their risk -- 13 percent of people surveyed in January by Credit.com said their card company had lowered their credit limit over the past few months, and 11 percent said a card company closed their account.
Your credit score is the numerical summary of the information in your credit reports, which lenders use to predict the likelihood that you will repay your loans. The most common score that lenders use is the FICO score, which ranges from 300 to 850. The higher the score, the better. The median score tends to run between 710 and 720.
Your credit score can have a surprisingly large impact on your life -- affecting not only interest rates and terms made available to you, but your ability to get an apartment, cellphone service and affordable car insurance. And this magic number can make or break your ability to qualify for a good mortgage deal.
"It has become a very score-driven industry," said John Ulzheimer, president of consumer education for Credit.com. You generally need a credit score of at least 620 to qualify for a loan that can be bought by Fannie Mae or Freddie Mac, which gives you a wide range of mortgage options. Borrowers with low credit scores have always found the Federal Housing Administration mortgage program more welcoming, but even the FHA is growing more demanding about scores. The agency has proposed that, starting this summer, the program allow only borrowers with scores above 580 to qualify for a loan with 3.5 percent down payment. Those with scores below 580 would be required to make down payments of at least 10 percent.
Brad Sherman, vice president of residential lending for Nationwide Mortgage Services in Rockville, said most people need a 740 or higher to get the best rates these days. For people with scores below that level, Fannie and Freddie generally base rates on 20-point brackets of credit scores -- the lower your score, the higher your interest rate and the higher amount of equity, or cash down payment, the lender will require. "Having more equity in a house could counteract a poor score, but you still need to have at least a 620," Sherman says.
Just under one-third of your score is based on the amounts you owe. A key element is the portion of your available credit that you've used, called your "credit utilization ratio." Your available credit shrinks when your card company decreases your credit limit or closes an account. If the balances on your other cards remain the same, then your utilization ratio goes up and your score can go down.
There's good news, however, for homeowners whose home-equity credit lines' limits have been lowered because of declining property values. Such limit reductions do not affect credit scores.
Even a relatively minor score change can make a big difference in your interest rate. According to the FICO Web site, borrowers with scores of 760 to 850 paid average rates of 4.613 percent on 30-year $300,000 mortgages this week, while those with scores of 660 to 679 paid average rates of 5.226 percent -- translating to a payment difference of about $40,300 over the life of the loan. (You can run your own numbers at http://www.myfico.com.)
No matter what happened to your score during the recession, taking the following steps a few months before you apply for a mortgage can improve your score and translate into big savings.
-- Check your credit reports from all three credit bureaus, Equifax, Experian and TransUnion. Your credit score is based on information from your credit reports, and errors can unfairly hurt your score. You can get free credit reports from all three bureaus every 12 months at http://www.annualcreditreport.com, or you can order them directly from the bureaus for about $10 each. It's important to check all three because each can be slightly different, and an error can appear on just one version.
- Beware of offers of "free" reports and scores that require you to sign up for an expensive credit-monitoring program. Maxine Sweet, vice president of public education for Experian, recommends reporting any errors to the bureau online, which can speed up the process because you input the information directly into the bureau's system. Disputes must be processed within 30 days, but they usually are settled faster, she said.
-- Start paying down credit card balances. "It's the fastest way to improve your score," said FICO spokesman Craig Watts. The lower your balances, the better for your score. Keep in mind that it's the balance that the credit card company reports to the credit bureau that counts -- usually the total charges reported on your monthly statement -- not whether you pay your bill in full. Ulzheimer recommends keeping your balances below 10 percent of available credit, starting three to six months before you apply for a mortgage.
-- Pay your bills on time. This is the most important factor in your credit score. Late payments remain on your credit report for up to seven years but have a smaller impact on your score as time passes. If you're having cash-flow issues, make at least the minimum payment by the due date, which is more important to your credit score than whether you pay the bill in full. And be vigilant about payment changes -- several card companies increased their minimum payments from 2 percent to 4 percent or 5 percent over the past several months, which caught many cardholders off guard.
-- Don't close accounts before applying for a loan. Closing credit card accounts can never help your score, Watts said. In fact, your score is likely to drop if you close the account and maintain the same balance on your other cards, which increases your utilization ratio. Even though you may want to stick it to the card company after it raises your interest rate or imposes a new annual fee or inactivity fee, wait until after you get the mortgage to make your move. Then pay down the balances on your remaining cards so you can keep your overall utilization ratio low.
-- Avoid opening new cards in the months before taking out a mortgage. "Each time you apply for a new card, there's a very slight impact on your credit score," said Steven Katz, a spokesman for TransUnion. "Three or four applications over a period of months multiplies that impact and can have the effect of making you look credit-hungry in the eyes of lenders."
-- Pay off old fines. A library fine, parking ticket or missed utility bill can ding your score by as much as 100 points if the account ends up going to collection. Check your credit report for signs of trouble, and pay off any old fines before they come back to haunt you.
Kimberly Lankford is the author of "Rescue Your Financial Life" (McGraw-Hill) and "The Insurance Maze" (Kaplan).