That 3 digit number known as your credit score has a tremendous influence over your daily life. This is especially true when it comes to real estate investment. If you can improve your credit score, you will not only have greater opportunity but you will save significantly on financing costs.
What is Your Credit Score?
Your credit score is essentially a measurement of how you manage debt. If you take on too much debt and /or you do not make your payments on time, your credit score will be negatively affected.
History of Credit Scores
Credit scoring began in the 1950s. In 1956, Bill Fair and Earl Issac teamed up and formed the Fair Issac Corporation, now known as FICO. Their aim was to create an objective and impartial credit scoring system. Within 2 years, they began selling this system.
The current system was introduced in 1989 and has become the industry standard. The scores range from a low of 300 to a high of 850.
Your score is determined by the following factors (by descending level of importance): payment history
a) amounts owed
b) length of credit history
c) types of credit used
d) recent credit inquiries
Types of Debt
There are essentially two types of debt:
1) Revolving Credit
Credit cards, department store cards, and even HELOCS fall under this category.
2) Installment Debt
Any type of debt that requires a fixed monthly payment is defined as installment debt. Mortgages, car loans, student loans, or personal loans are all forms of installment debt.
Who Measures Your Credit Score?
There are 3 major credit reporting agencies:
All of these agencies are private businesses and are not heavily regulated by the government. They essentially sell your data to other businesses.
Corporations that you do business with will report the amount of credit you have with them, late payments and non-payments to one or more of these agencies, but not necessarily all of them. As such your score can vary from one agency to the next.
Under the law, you have a right to view your credit score from all three agencies for free, once per year. You can dispute any items that you believe are not a fair representation of the facts.
The Most Important Elements of Your Credit Score
Of all the elements included in your credit score, there are 2 that account for 65% of the total score.
1) Payment History
This could be more accurately stated as late payment history. Every time you made a late payment, and the business who you made that payment to, reports it to any of the credit bureaus, your credit score will go down.
It is important to note that a late payment will stay on your credit report for 7 YEARS! Also, if you are more than 30 days late, your score will be reduced by 50-100 points.
Therefore, ALWAYS make your payments on time. You can take steps to remove a late payment. More on that later.
2) Credit Usage or Utilization
To explain this simply, let’s use an example. Let’s say you have a credit card with a $5,000 limit. Over a period of time you have built up a balance of $3,000 and you make the monthly minimum payment on time every month.
Your credit utilization is 60% ($3,000/$5,000). In order to maintain a maximum score, your credit utilization should be 30% or less.
Other Elements That Affect Your Score
There are 2 other elements that affect your credit score but are not as important as the two above;
a) Credit Mix
This is essentially the ratio of revolving credit to installment credit. For example, if you have credit card debt, but no mortgage or car loan, your score will be negatively affected. The FICO formula likes to see a balance between both types of credit.
b) Length of Credit History
Let’s take a look at two different people. Both people have the same amount of debt and both have always made their payments on time. However, one has a 10-year history of credit usage and payments while the other has only a 2-year history. The individual with the 10-year history will have a higher score.
You will note that one of the criteria above is recent inquiries. Many consumers do not even consider this but it can have a significant effect on your credit score.
For example, you are in the market for a new car. You are not really sure what make or model you want to buy so you choose a day to make the rounds of the various dealerships.
As you may be aware, when you ask the salesman if you can take a test drive, he will ask you for your driver’s license. His excuse is that they need that on file for insurance purposes.
Unbeknownst to you, while you are taking the test drive, the finance department is checking your credit score, so if you choose to buy or lease the car, they will know exactly what deal to offer you.
Over the course of the day, you visit 6 car dealerships. Every time the dealer checks your credit, you LOSE 5-10 points on your credit score. The worst part is those inquiries remain on your credit report for up to 3 months.
In this example, your score would be reduced by 30 to 60 points!
Never agree to a credit inquiry until you are ready to purchase! In the above example, you can prevent the car dealer from checking your credit. All you have to do is make a photocopy of your driver license, and underneath add the following text:
NOT AUTHORIZED TO CHECK CREDIT
Should the dealer disregard that and checks your credit anyway, it will show up on your credit report. You can file a complaint with the credit bureau and the dealer will be fined $500 for the unauthorized check.
How To Improve Your Credit Score
Now that you understand how the credit reporting system works, what can you do to improve your score?
1. Pay Down Credit Card Balance
If your credit utilization is above 30%, begin immediately to pay down the balance until it is below 30%
2. Late Payments
It goes without saying, NEVER MAKE A LATE PAYMENT AGAIN! As mentioned previously, late payments remain on your credit report for 7 years.
In the event that you had an occasional late payment, you can send a letter to the creditor explaining the circumstances of your late payment, and they may agree to remove the late payment notice from your credit report.
If you have a history of late payments, this will likely be ineffective.
3. Deletion Letters
Another method of improving your credit score is to contact your creditors and negotiate a payment in lieu of a deletion letter. This means that the creditor will agree to delete the notice from your credit report in exchange for the agreed-upon payment. You can negotiate over the phone but make sure that you get the deletion letter in writing before you make the payment.
4. Dispute! Dispute! Dispute!
70% of all reports made to the three credit bureaus contain errors. Therefore, always try to dispute any kind of negative report on your credit profile. If the creditor cannot validate it, then it must be removed.
Always make the disputes in writing. Never make disputes online. There are a number of websites that offer sample letters. However, do not use them verbatim. Change up the language to make it unique.
5. Secured Credit Card
If your credit has been severely damaged, you might consider getting a secured credit card. A secured credit card is essentially a debit card. You actually pay the card issuer the amount of the credit limit you need with a minimum of $200.
Be careful when shopping for a secured credit card. Some issuers charge hefty upfront fees with high annual fees. The best-secured credit cards at the time of this writing are:
Use the secured card sparingly. Pay the balance in full every month. You should see an improvement in your credit score in a few months.
6. Authorized User
This is probably the fastest way to improve your credit score. If you have a family member or friend who has an excellent credit score, you might ask them to register you as an authorized user on one or more credit cards. This is obviously based on mutual trust.
Once the authorized user is registered, the credit history of the credit card will be added to your credit profile. You have to be careful that the friend or family member does not have a credit utilization of over 10%. If their credit utilization is higher than yours, the authorized user registration could negatively affect your credit score.
If your debt or payment is more than 4 months past due, the creditor will sell the debt to a collection agency. Many people assume that the collection agency is working on behalf of the creditor. That is not true. The collection agency purchases the debt for pennies on the dollar.
For example, you have a debt for $500 that you defaulted on. The collection agency purchases that debt for $50. They then attempt to collect the $500 from you. If they succeed, that is a big profit for them.
As a rule, you should NEVER pay a collection agency, set up payment arrangements, or settle the debt. This is especially true if the debt is more than 5 years old.
As discussed previously, the only way you want to pay a collection agency is in exchange for a deletion letter. First of all, when you contact the collection agency, never admit that you owe the debt. That can be used against you in court. Most collection agencies will demand payment in full but it does not hurt to try to negotiate. Again, do not make the payment until you receive the deletion letter.
When making the payment, pay either in cash, with a money order, or cashier’s check. You do not want to give them access to another credit card or bank account number.
The Bottom Line
We live in a society where our credit score impacts almost every aspect of our daily life. The higher your score is, the more opportunities you have and the more money you save.
Credit Monitoring Services
Once you have completed all the steps above and optimized your credit score, you will want to protect it. This is especially important if you are going to make a career out of real estate investing. You should consider a credit report monitoring service such as Privacy Guard or CreditCheckTotal. The cost is around $30 per month.
The service will notify you when there is any change in your credit score. This can be critical if your credit card information is stolen. You will be notified of any unusual activity so that you can take action immediately to limit the damage.
If you have taken all the above steps and you were unable to improve your score significantly, you might consider partnering with someone who has a great credit score.
As I stated in a previous post, Managing the Coronavirus Crisis, the most prudent course of action is to wait and see where the dust settles. Instead of just waiting, this is a great time to take action to improve your credit score. When the time is right to invest, you will be in a good position to take advantage of the market opportunities.
Given the current environment of uncertainty, lenders are already tightening their lending criteria. For example, JP Morgan has raised the minimum credit score to 700 and increased the minimum down payment to 20%. Other banks will likely follow suit. It is also possible that the criteria may be tightened further.
Your goal should be to get yourself into the best position to get access to financing even in difficult times and to keep your financing costs as low as possible.