Here is “Week 3” Installment of the Money Monday series. If you need to contact the writer, Jay Turner, you can email him at firstname.lastname@example.org
We are halfway through our credit shape up clinic, and I hope that you now have a better understanding of some of the factors that influence your FICO score and are considering a couple of tried-and-true strategies for reducing your debt load. Today we’ll discuss debt types, key changes in the FICO scoring model, and two things you can do right now to improve your score.
When it comes to debt, there are two kinds: installment debt and revolving debt, both of which comprise 10% of your FICO score. Installment debt is a set loan amount paid over a period time with a fixed payment. A mortgage and a car loan are examples of installment debt. Revolving debt is a debt instrument that can be charged up to a limit, paid down, and charged back up again. A credit card is a type of revolving debt. Those are the basics. Easy enough, right? Here is why debt type matters.
In 2008 the FICO scoring model underwent an overhaul that changed how scores are calculated. First, the new model, known as FICO 8, favors borrowers who have a good mix of installment and revolving debt. Second, FICO 8 is more sensitive to highly utilized credit cards. Understanding these changes can provide you with an opportunity to tack on a few points to your FICO score. My experience illustrates this.
When I purchased my home in 2007, my middle FICO score was 660, a decent but unspectacular score at the time. At that juncture in my life, my credit profile was all revolving debt (credit cards) with the exception of my two student loans. Within a year of purchasing my home in 2007, my credit score jumped from the mid-600s to the low-700s, because a lender deemed me worthy enough to grant me a large installment loan: a mortgage. After I financed my car in 2008, my score went from hovering in the 720s to hanging out in the 750s, because I added another installment loan. Obtaining these loans gave me a better blend of debt types, thus enhancing my score. This is an overly-simplified explanation of a complex system, but the point is that improving the mixture of debt in your profile may improve your FICO score, sometimes by leaps and bounds depending on your current mix of debt types. Now is a good time to review your credit report and see if it makes sense to take on a loan for a major purchase or apply for another credit card to enhance your blend of debt.
Admittedly not everyone wants or needs to take on additional debt to improve their credit. If you are not in a position to get a loan or another credit card, consider gardening the credit cards you have. As I mentioned, the FICO 8 scoring model does not like your credit cards to show high utilization – the amount you owe measured against the amount of credit you have available. You should think of utilization in two ways: the utilization of each credit card you own and the utilization of your total credit limits.
For instance, if you have a credit card with a $1000 limit and you currently owe a balance of $500, you are at a horrendous 50% utilization for that credit card ($500/$1000). Let’s go a step further and pretend that you have three credit cards and all of their limits add up to $3000. Between all three cards, you owe $500; therefore, your total utilization across all of your credit lines is a not-so-good 17% ($500/$3000). Utilizing 10% or more of your total available credit will adversely affect your FICO score. Likewise, utilizing more than 10% of each card’s credit limit can adversely affect your score. If either of these is true, start whittling down your balances immediately without making any new purchases.
There is no magic bullet for increasing your credit score, but by ensuring that you have a good mix of debt types and staying beneath 10% utilization will definitely help you reach your target score.