Building and maintaining an excellent credit history and credit score are more important now than they have ever been.  Even if you want to pay for everything in cash, solid credit can determine if you will be accepted by a landlord for a rental unit or even make the difference in a job application.   There are even dating websites out there that match people based on their credit scores.  The FICO (Fair Isaac and Co.) credit scoring system was just implemented a little over 20 years ago as part of mortgage approvals by Fannie Mae and Freddie Mac, but now it is everywhere and an important part of your financial life. 

You do not have to worry about incurring significant amounts of debt in order to build up a solid credit history.  Ultimately, your FICO score is just a measure of your recent payment history and how well you manage your available credit.  Using credit for small purchases such as groceries and gasoline and paying off your credit cards every month is one great strategy to building a good credit history and FICO score.  Let’s first talk about the basics of credit to lay a good foundation for what a FICO is and where it comes from.

The Basics of Credit Scoring

The FICO scoring model is the most commonly used method in lending decisions, especially for mortgage lenders.  The scoring generally ranges from 300 to 850 points and is determined by several scoring factors, such as payment history, available credit, current balance versus high credit balance ratios, public records (such as bankruptcies and tax liens), types of credit (such as revolving or installment accounts), number of recent applications for new credit, etc.  Each of these factors has a weighted percentage of importance in your overall FICO score.  For example, installment loans, such as auto loans, personal loans, or student loans, carry more positive and negative weight on your score than revolving debt, like credit cards and more recent payment history (most recent 2 years) outweighs older credit history (2+ years). Your FICO score is basically a snapshot in time based on your payment history, current balances, and available credit at that particular moment and changes from month to month as you utilize credit and pay down balances.

There are currently 9 versions of the FICO scoring system with most consumer credit reports using the latest versions 8 and 9.  This is generally what you see when you run your own credit through places like CreditKarma or other free and paid websites.  When you apply for credit cards or auto loans, they’ll typically work off of versions 5-8 and only pull credit from one reporting agency or another.  Mortgage lenders typically use the more conservative versions 2 and 3 of the FICO scoring system and run credit from all 3 credit reporting agencies, Experian, Equifax, and Trans Union.  Mortgage lenders will then use the middle FICO score of the three to determine your score for your mortgage loan.  If applying jointly with your spouse or another borrower, mortgage lenders will use the lowest middle FICO of the two borrowers for the loan score.  You could have an 800 FICO score, which is considered excellent, but if your co-borrower is 650, then your interest rate is based on the 650 score.  Make sure if you plan to apply for a mortgage loan with another person, that you are both in a good position with your credit.

The higher your credit score, the better interest rates and terms you can secure for any financing or credit card you are looking to obtain.  That is one of the  major reasons it is so important to build up a solid credit history.  Typically in mortgage lending, the best interest rates are available for FICO scores over 740, which is considered excellent. Generally, 680 is considered good credit and that is right around where the national average is for credit scores.  Credit scores from 620-679 are considered poor to marginal and this is generally where mortgage lenders will set their minimum FICO scores for you to be approved for financing. Since mortgage loans are so much larger than other types of financing, achieving a high FICO score prior to purchasing a home can save you thousands of dollars over the life of the loan.

What is Typically on Your Credit Report

A full credit report containing all of your personal credit history can be accessed annually at no cost to you at www.annualcreditreport.com.  You can obtain a full report from each of the three credit report agencies, Experian, Equifax, and Trans Union.  This report will not come with a FICO score, but it is important to review each of these reports annually to ensure the information being reported about your credit history is accurate and no fraud or identity theft has occurred. 

Review the report entirely to verify that your personally identifiable information is accurate, such as name(s), address, social security number, date of birth, credit accounts, loans, and employment history. Income information and banking information should not be contained in your credit report.

If your find errors, you should contact the creditor or company that reported the information to the credit reporting agency and file a written dispute. The credit report will contain instructions on submitting a dispute to rectify inaccurate information. If you believe the errors are the result of Identity Theft, complete a report immediately at IdentityTheft.gov.

Build a Solid Credit History

Establishing good credit and achieving an excellent credit score will take time, so it is best to get started right away if you have not yet done so or take steps now to re-establish credit if you have had credit issues in the past.  The key to building a solid score over time is to have 3 open and active lines of credit.  This can be anything from a credit cards, charge cards, even auto or student loans, it just has to be credit or loans for which you are personally responsible for repayment.  You can be the authorized user on a parent’s credit card or spouses credit card but this has very little positive impact on your personal FICO.  If you are a joint applicant on a line of credit or credit card, then you are personally liable and helping to build your credit. 

If you have no credit history, start small by opening a credit card such as through a retail store or gas station.  Use the card monthly and pay it off every month for a few months and then apply for a Visa, Mastercard, or American Express (AMEX).  It is okay if the credit limit you are offered is only $300 or $500.  Once you have established a solid history of on time payments, you will have the opportunity to expand your credit limits.  The important thing to do is start small and build your credit history with a solid foundation, by never missing a payment, and avoid running balances from month to month.  As long as you payoff your charges monthly, you’ll avoid paying interest and will not be accruing debt.  Building credit this way will take approximately 18-24 months to establish an excellent credit score.  In order to build credit faster, apply for an auto loan in addition to credit cards as part of your strategy to establish credit.  Auto loans and other installment debt carry more positive weight for your credit score and can help you build up an excellent credit score in 12-18 months, as long as there are no missed payments.

If you have a poor existing credit history, the first thing you will need to do is bring all past due accounts to current, if any exist.  Then, go to www.annualcreditreport.com and access a full credit report from each of the three credit report agencies, Experian, Equifax, and Trans Union.  Go through each report and follow the steps necessary to clear any collection accounts, past due accounts, or erroneous accounts.  Finally, you will need to re-establish credit in the same way you would if you had no prior credit history.  Basically, you want to replace all of the bad credit history with good credit history and over time your FICO will improve and become excellent as long as everything is paid as agreed and on time.  Even if you have had a bankruptcy, foreclosure, or short sale, you can re-establish credit and be approved to buy a home in as little as 2-4 years depending on the circumstances and the mortgage loan type you are seeking. Do what it takes now to establish and maintain a solid credit history and an excellent FICO score so that whenever the opportunity presents itself to buy your first home, second home, or investment property, you will be ready to go and be able to obtain the best possible rates and terms available.