The Best Ways to Improve Your Credit Rating

By Brandon Cornett
© 2011 All rights reserved

Reader question: "My FICO score is around 590, and my husband's is a little lower than that. We want to buy a house, but were told these numbers were too low for mortgage qualification. What's the best way to improve a credit rating as quickly as possible? Any information you can provide would be appreciated!"

In a nutshell: You need to pay all your bills on time, especially your credit cards and other debts you owe. You should make sure there aren't any mistakes or errors on your credit reports (since they can drag your score down). You'll also benefit from reducing the amount of debts you owe. If you do these things, you should see your credit rating rise over the coming weeks or months.

That's the short answer. Here's the long one:

I'll expand on the things you can do to improve your credit in just a moment. But first, I want to go over some of the terminology we are using here. This response will be shared with a larger audience. So I need to make sure we are all on the same page.

Credit Ratings Defined

Most consumers in the U.S. have a credit score assigned to them. In fact, we usually have more than one score, because there are several different scoring models in use today (FICO, Vantage, etc.). The last time I checked, most mortgage lenders were still relying on the FICO credit score to evaluate borrowers. So that's the one a home buyer should care about the most.

The FICO score is a three-digit number between 300 and 850. A higher number is better. These numbers are based on the information contained in your credit report. Here's an illustration of how the reporting industry works:

Some people refer to it as a credit "score," while others call it a "rating." I'll mostly be using the term credit rating in this article, just to be consistent with the reader's question. The meaning is the same. I am talking about your three-digit FICO credit score. In theory, this number gives creditors an idea of how you have borrowed and repaid money in the past. That's why they place so much importance on it. It helps them measure the level of risk associated with giving you a loan.

Qualifying for a Mortgage Loan

You'll certainly benefit if you can improve your credit rating before applying for a loan. But what kind of score do you need? What number should you be aiming for? There is no exact answer to this question. It will depend on the type of mortgage loan you're using, and also how strong you are in other areas.

Here are some general guidelines:

A conventional mortgage will generally require a higher score than an FHA loan (with all other things being equal). Your other qualifications play a part here, as well. For example, if you have a down payment of 20 percent and very low debt levels, the lender might be more flexible regarding your credit score.

The "magic number" I see most often these days is 640. Many lenders will require you to have a score of 640 or higher to qualify for a home loan. But other lenders are willing to work with borrowers who have scores below this number. Credit unions, for example, are generally more lenient in this area. And again, it depends on how well you measure up in other areas. Your credit rating is only one piece of the qualification puzzle -- and it is a puzzle.

The FHA program allows scores as low as 500. But you have to apply for this program through a regular lender (not through the government). So you're at the mercy of that lender's guidelines. Many mortgage lenders impose their own guidelines on top of those set by the FHA. These are known as "overlays." So again, it comes down to the lender you use. With that being said, you'll have an easier time qualifying for an FHA loan than a conventional mortgage, if you have a low credit rating.

See also: FHA vs. Conventional Mortgage Loans

If you can improve your credit rating, you will benefit in two ways. First, you'll have an easier time getting approved for a home loan. We talked about the reasons for this earlier. Secondly, you'll qualify for a lower interest rate on the loan. This is something a lot of first-time buyers overlook. A lower mortgage rate could save you thousands of dollars over the life of the loan. For example, 

As you can see from the two scenarios above, a higher FICO score can save you a lot of money over time. Lenders generally reserve their best rates for borrowers with excellent credit. And that's the dual benefit we discussed earlier -- easier qualification, and better rate.

This brings us to the question at hand: How do I improve my credit rating before applying for a mortgage?

The Best Ways to Improve Your Rating

If you look at the chart below, you'll see where you need to focus your efforts. These are the five categories of information that determine your FICO score. I'm going to focus on the two biggest items on this list -- payment history and amounts owed. This is where you can make the biggest gains in the shortest period of time.

Your Payment History

Take a look at your credit report, and you'll see a history of every loan or credit card you've ever had. Or most of them, anyway. You'll also see information regarding your payments on those accounts. This is an area where you can do a lot of damage to your credit rating.

Did you know a single late payment can lower your score by more than 100 points? It's true. Imagine if you had a 680 credit score, and you were more than 90 days late on a payment of some kind. When the creditor reports that to the reporting agencies (TransUnion, Equifax and Experian), it could drop your score down to 670 or lower. Is that what happened to you? If so, you should be able to find it on your report.

Now for the good news. Your payment history can cause a lot of damage, but it can also help you undo that damage. The key is changing your habits. The things you do today will become your payment "history" tomorrow. If you want to improve your credit rating, you need to keep up with your bill payments. This is where it all starts. 

The passage of time helps a lot, too. The longer you maintain the habit of paying bills on time, the more your credit score should increase. A credit slipup from two years ago won't affect your score as much as one from last month. The older they are, the "weaker" they are. When you combine this with a new-and-improved habit of paying bills on time, you have all the ingredients for a higher credit rating. 

Tip: Use payment reminders and automatic bill pay to your advantage. Your bank probably allows you to sign up for email reminders whenever a payment is due. Most credit card companies do the same. You could also sign up for an automatic payment plan through your bank or other creditors. This will reduce the chance of having any more late payments. Remember, this is the number-one thing you can do to improve your credit rating. So do whatever it takes to stay on top of your bills.

The Amounts You Owe

As you can see from the pie chart above, this is the second-most important factor that affects your FICO credit score. The amounts you owe on your various debts contribute another 30 percent to the overall FICO calculation. This is why people with "maxed out" credit cards usually have low credit scores. They are using too much of their available limit. The "amount owed" is too high, relative to the limit. And thus, the score suffers.

If you reduce the balances on your credit cards and other revolving credit lines, you should see an improvement in your score. This also lowers your debt-to-income ratio, which will make it easier to qualify for a mortgage loan down the road. So you'll benefit in two ways -- you will likely improve your credit rating, and you'll be better qualified for a mortgage.

Caution: Be careful with your oldest credit accounts. It's one thing to reduce the balances. But if you close the account entirely, you could hurt your FICO score. How is this possible? Refer back to the pie chart from earlier. You can see that the length of your credit history is the third-largest piece of the pie. If you close out your oldest accounts, you'll end up with a shorter history. This could lower your credit rating.

Where to Learn More

This article gives you a good overview of credit reporting and scores. But it's certainly not an exhaustive study of the subject. There is plenty more to learn. If you would like to research this topic further, you can use the search tool at the top of this page. We have quite a few credit-related lessons on this website. You can also visit our comprehensive library for this topic. Good luck!