3. Burnish Your Credit Score

Credit scores have been around for decades, but they’ve become increasingly important in recent years. Lenders, insurance companies, and landlords often rely heavily on scores derived from credit information to evaluate applicants and to determine how much to charge. Bad or nonexistent credit scores can cost you tens of thousands, if not hundreds of thousands, of dollars over your lifetime, as I wrote in my book Your Credit Score: How to Improve the 3-Digit Number That Shapes Your Financial Future (FT Press, 2011).

However, you can rehabilitate bad scores and protect good ones by engaging in the right behaviors. Here’s what you need to know.

A: First, you need to understand that you don’t have one FICO credit score—you have three, one from each of the three major credit bureaus. You can buy two of your three FICOs from MyFico.com, the only source for the FICO scores that most lenders use. (You can’t buy your third FICO because credit bureau Experian has stopped selling those scores to consumers, although it continues to sell them to lenders.)

Your mortgage lender uses the middle of your three scores to help determine your interest rate, so it’s important to review all three of your credit reports for errors and other problems. You can get free access to your reports at www.annualcreditreport.com. Ignore the pitches for credit scores you see when you visit that site; the scores typically offered aren’t FICOs.

If you continue to use your credit cards responsibly—charging no more than 30% of your limits, and preferably 10% or less—your scores should improve over time. You don’t need to carry a balance to improve your numbers.

An installment loan could help you rehabilitate your scores somewhat faster. The problem is that it may be difficult for you to get a loan, and the interest rate is likely to be sky high. If you’re considering an auto loan, make sure you can make a substantial down payment (25% or more) so that you can refinance to a more reasonable rate when your scores improve. Another option is getting a small personal loan from a credit union or bank that reports to all three credit bureaus.

There’s no easy, quick fix for battered credit scores, so be patient. In the meantime, you can work on saving up a substantial down payment so that you can better afford to be a homeowner when the time comes.

Many people think we have a right to a free credit score, but we don’t. What we have is a federally mandated right to see our credit reports, which are different from our credit scores. Reports list your credit accounts, whether you’ve paid on time, and whether you have negative public records, such as a bankruptcy or foreclosure. Credit scores are three-digit numbers compiled from those reports, but your scores aren’t a part of your reports. The only place to get your free credit reports is www.annualcreditreport.com.

If you’re being offered a free score, it’s almost certainly got strings attached like the ones you described, or the score isn’t the FICO score that lenders commonly use.

The first time I did this, my Experian FICO score shot up 30 points. But the next month, I did the same thing, and it dropped back down. I was told my score was lowered because it “shows no recent balances.” Is this valid? Does it mean I should be paying the balance minus, say, $20, before the first of the month, and then pay the rest after the first? This seems like making a system overly complicated.

A: First of all, the credit score you’re monitoring is not a FICO score. Although Experian sells FICO scores to lenders, it sells other scores to consumers. What you’re probably looking at is a PLUS score, which lenders don’t currently use. So any gyrations you’re seeing don’t necessarily reflect what’s happening with your FICO scores—and your FICO scores are the ones most lenders use. Although you can’t buy a FICO score for Experian, you can get FICO scores for the other two bureaus at MyFico.com for $19.95 each. Along with the three-digit numbers, you’ll get reasons behind your score and suggestions for improvement.

Paying down a balance before it’s reported to the credit bureaus is one way to improve your FICO scores; the reported balance is used to calculate your credit utilization, which is an important part of the FICO scoring formula. But you also can improve your credit utilization simply by limiting how much you charge to any card in a given month. A limit of 30% is good, and 10% is even better.

A: You might want to take a look at the contradictory attitudes you just expressed.

You have a car loan, which means you’re in debt and pay interest to a lender. But you refuse to get a credit card, which can help you build your credit scores without having to incur debt or pay a dime in interest.

Having a credit card does not make you a slave to lenders, unless you’re stupid enough to carry a balance. On the contrary: It can help you build your credit scores to the point that you’re in the cat bird seat, being pursued by mortgage lenders eager to give you a great deal.

If you absolutely can’t trust yourself to have a card without carrying a balance, then, of course, you should forgo plastic. Otherwise, you could use a card like the helpful tool it can be, charging small amounts each month and paying off the balance in full, to boost your credit scores over time.

A: There are a few legitimate reasons to temporarily carry a credit card balance. If you suddenly lose your job, for example, you may want to conserve your cash and pay only the minimums on your cards.

But for most people, carrying a balance is a sign that they’re living beyond their means. And that’s pretty stupid.

Carrying a balance can cost you a fortune in interest, plus it doesn’t help your credit scores (in fact, high balances can hurt your scores). So the smart thing to do is to get in the habit of paying balances in full every month.

A: Lenders aren’t required to give you their best rates because you think you deserve them. They are allowed to use reasonable criteria to judge your creditworthiness, which can include credit scoring formulas—and those typically reward people for having and using different types of credit (credit cards as well as installment loans). You can have good scores using only one type of credit, but the best scores are typically reserved for credit reports that have both.

The good news is that you don’t have to carry credit card debt to have great credit scores. Using two or three cards lightly and paying them off in full each month is the best way, for both your scores and your pocketbook.

In any case, the interest rate you got was phenomenally low, even if it wasn’t the lowest you might have gotten. Yes, you’re paying a penalty for not using plastic, but it isn’t a stiff penalty.

A: Congratulations on your progress in paying off your debt. Erasing your debt on those two cards is doubtless already helping your scores. You can continue to improve your numbers by using the cards lightly but regularly, paying the balances in full each month.

Credit scoring formulas want to see you actively, and responsibly, using credit. Shutting the cards in a drawer won’t demonstrate that you can do that. You’re also running the risk that a card issuer will shut down your account because of inactivity. So the best approach is to use the cards lightly, then pay them off in full.

If you discover that you can’t use the cards responsibly, however, then locking them in that drawer (or freezing them in ice) is better than running up credit card debt again.

A: The primary concern with paying off a loan is that the lender may stop reporting the account to the credit bureaus. Although there are limits to how long most negative information can stay on a credit report, there are no limits to how long good information can or must be reported.

Still, most lenders continue to report accounts that have been paid off for several years. If you can pay off a high-rate loan, you probably should, and trust that you’ll get “credit” for your on-time payments for years to come.

A: Closing accounts won’t help your credit scores, and may hurt them.

Shuttering an account can change your credit utilization ratio, which is important to your credit scores. The FICO credit scoring formula likes to see a wide gap between the amount of credit you have available and the amount you use. When your available credit shrinks because of an account closure or credit line reduction, your scores may suffer.

So you shouldn’t close accounts if you’re trying to improve your scores or plan to get a major loan in the next several months. If your scores are fine and you don’t expect to apply for a mortgage or car loan soon, then you certainly can close a few retail cards. But try to keep open your major credit cards, such as Visa, MasterCard, Discover, and American Express, especially if they have high credit limits.

A: One of the many persistent myths about credit is that having too many cards is bad for your credit scores. In reality, the leading credit scoring formula, the FICO, doesn’t punish you for having “too much” available credit. You can, however, hurt your credit scores by closing accounts.

That doesn’t mean you have to leave credit accounts open forever. If you no longer use some of the retail cards, or you’re tired of keeping track of so many accounts, go ahead and close a few cards. You would be smart to keep open your general-purpose cards, since those enhance your scores, unless you’re being charged an annual fee for a card you no longer use. In that case, you may want to suffer the temporary damage of closing the account, as long as you don’t expect to apply for other credit in the next year or so.

A: How about plugging the leaks that are causing your financial ship to sink instead of musing over how much water you can take on before you’re swamped?

Steadily growing credit card debt is a clear sign that it’s time to make changes to get your spending in balance with your current income. That’s because carrying credit card debt is simply too dangerous to your financial health and can lead you straight to bankruptcy court. It’s too easy to see something as a “need” and charge it rather than make the tough decisions to cut back on what you can no longer afford.

For credit scoring purposes, it’s better to spread out the balances. For life purposes, it’s better to stop charging.

A: If you can’t pay off your credit card debt, you can’t afford your current lifestyle.

You never could, really, but that fact was obscured by loose lending practices that didn’t punish you for carrying big credit card debts. Times have changed, and you need to change with them.

Carrying credit card debt has always been foolish. It’s expensive and a signal that you’re living well beyond your means. Furthermore, as you’ve learned, you’re vulnerable to the changing whims of credit card companies, and those whims can have serious effects on your perceived creditworthiness.

Paying down your balances may not boost your credit scores right away if your lenders continue to slash your available credit, an industry practice known as “chasing down the balance.” But you need to do so anyway to free yourself of this toxic debt.

Your problems refinancing aren’t just due to your scores, in any case. Your current scores won’t necessarily prevent you from refinancing (although you would get a higher interest rate than if they were 740 or above). Your bigger problem is the fact that you owe more on your loan than the house is worth. You could explore the federal government’s Home Affordable Refinance Program, at www.makinghomeaffordable.gov, to see whether you qualify for an underwater refinance. If not, you might want to approach your lender to see if you qualify for a mortgage modification. Start by talking to a HUD-approved housing counselor, who can review your situation and recommend options. You’ll find referrals at www.hud.gov.

A: No. Your credit reports and credit scores aren’t combined when you marry.

If you apply for a loan together, both of your credit histories and scores are taken into account. His bad scores could prevent you from getting approved. If you did get approved, you would probably have to pay a much higher interest rate.

If you do plan to get a mortgage or other loan together down the road, he should start to rehabilitate his scores as soon as his home situation is resolved. He should expect his scores to remain in the poor-to-fair category for at least three years, and it may take as many as seven years to get them into the “excellent” range.

A: Typically, your delinquent account will be turned over to a collection agency. Not only will your credit scores take a hit, but you may be subject to nasty collection calls as well.

If your time share is paid for, you might consider giving it away. Some people have successfully gotten rid of time shares by listing them for $1 or so on Craigslist or eBay.

If you still owe money on the loan you used to buy the time share, though, giving it away is probably not an option unless you’re able to pay off the loan first.

At 16, my then-stepmother added me as an authorized user on her credit card “for emergencies.” I never used the card without permission, and I learned that credit cards are not free money. When I was in college, she and my father divorced, and we lost touch. I haven’t used that account in more than four years. Last fall I applied for a new credit card to use for business expenses and was rejected. I checked my credit report, and lo and behold, the account I am an authorized user on is now in serious straits.

Apparently, after the divorce, my former stepmom had some financial trouble and eventually ran up that card to its limit, then filed for bankruptcy in 2010, leaving a glaring (and, according to the bank, immutable because the account is closed) spot on my credit. I have very little else as credit history, which makes this an even larger problem. My fiancé and I are planning on buying a home in the next few years, and we’ll probably have to leave my name off to avoid serious increases in interest or even face being turned down for a mortgage.

In uncertain financial times even for the responsible, parents who add their children to their accounts need to know that they are signing up to pass on all of their credit history, good and bad, to their children. Sometimes that’s more of a burden than a blessing.

A: Your experience shows the real potential downside for anyone who is added as the authorized user of a credit card. But you shouldn’t accept the bank’s initial response as final.

You can be removed from this account if the bank is willing to do so. Take your case to the bank’s chief executive. You can find his name and the bank’s corporate address on the bank’s Web site (check its regulatory filings under Investor Relations if the bank doesn’t make the information obvious).

Your experience also shows the importance of checking your credit reports at least once a year, since you could have spotted the problem and asked your former stepmother to remove your name from the card long ago. Also, it’s important to build credit in your own name rather than continue to rely on the record of someone else.

A: If you have good credit scores now, a single skipped or insufficient payment can knock more than 100 points off your numbers—and it could take up to three years for your scores to recover. The negative marks themselves will remain on your credit reports for seven years, but their effect on your scores diminishes over time if you make no other credit mistakes.

Clearly, the best solution is to pay at least the minimums on your cards until your windfall comes through and you can pay off the debt entirely. Look at every way possible to trim your expenses so you can free up the necessary cash. Stop eating out and switch to less costly food, such as beans and rice instead of meat. Suspend pay television and other pricey subscriptions. See whether you qualify, at least temporarily, for basic or “lifetime” service from your utilities. Consider renting a room in your home, or a parking spot in your driveway, to generate extra income.

Going forward, you should avoid carrying credit card debt. The only smart way to use plastic is as a convenience, not as a way to live beyond your means.

If you’re not able to pay the minimums, you can talk to your issuers to see if they have a temporary hardship plan that will allow you to reduce the amount you pay. Ask about the hardship plans’ effect on your credit, though, since these arrangements also may hurt your scores, depending on how they’re reported to credit bureaus.

A: Lenders have different policies on short sales, which is when they agree to let a borrower sell a home for less than what is owed on the mortgage. You’ll need to talk to yours about what’s required. But expect your credit scores to take a major hit, whether or not you stop payments first.

A short sale typically has the same impact on your credit scores as a foreclosure, according to Fair Isaac, the company that created the leading credit scoring formula, the FICO. Fair Isaac has released a chart showing the effects of various credit score blows, from a missed mortgage payment to a foreclo-sure or a short sale with a deficiency balance (which is the difference between the home sale proceeds and what you owe). Someone with FICO scores in the 780 range would lose 90 to 110 points with a single skipped payment. A short sale or foreclosure would trim 140 to 160 points from that 780 score. (You can see the charts at Fair Isaac’s Banking Analytics Blog, http://tinyurl.com/3eze2a5.) Your score will plummet that far whether or not you stop making payments before the foreclosure or short sale.

You might be able to reduce the damage from a short sale if you can convince the lender not to report the deficiency balance to the credit bureaus. Short sales without a reported deficiency balance would trim 105 to 125 points from a 780 score, according to Fair Isaac. But lenders who’ve been cajoled into a short sale often aren’t in the mood to grant you additional favors.

There are some advantages to a short sale over a foreclosure. One is that you can start the long road to credit recovery sooner, since foreclosures usually take much longer than short sales. The other bit of good news: You can qualify for another mortgage faster. Lenders typically will consider you for a home loan two years after a short sale, versus a wait of up to seven years if you let the current lender foreclose.

A: Although foreclosures may not carry the same stigma they did before the real estate bubble burst, they still wreak havoc on your credit scores. Your scores will need three to seven years to completely recover, and that’s if you inflict no further damage. Paying your bills on time and using credit responsibly will help you rehabilitate those numbers.

In the meantime, you can increase your odds of finding a good place by looking for mom-and-pop landlords rather than applying at apartments managed by huge corporations. The big companies usually rely on credit scores to screen out applicants, but a smaller landlord may be more flexible. Offering to make a bigger deposit or to pay several months’ rent in advance might help persuade them, said Stephen Elias, author of The Foreclosure Survival Guide (Nolo Press, 2009).

A: It can take five years after a bankruptcy for your FICO credit scores to return to the 680 range, which is about where auto loan interest rates start to get more reasonable. People with FICOs in the range of 660 to 690 recently received interest rates averaging about 7.5%, according to the MyFico.com site, compared with 11% and up for those with lower scores. It can take seven or more years to boost your scores above 740, which is where the truly low rates (4% and below) can be had.

To rehabilitate your scores as quickly as possible, first review your credit reports at www.annualcreditreport.com to make sure all the debts that were included in bankruptcy are listed that way. If you have any open credit card accounts, use them lightly but regularly and pay them off in full every month. “Lightly” means using less than 30% of your credit limits. If you don’t have a card, consider applying for a secured card, which gives you a credit limit equal to an amount you deposit with the issuing bank, typically $200 to $1,000. You can find secured card offers at several Web sites, including MyFico.com, CreditCards.com, CardRatings.com, and NerdWallet.com.

After a year or so, consider adding an installment loan such as a personal loan or an auto loan to your credit mix. A credit union may give you a more reasonable rate than a traditional bank. Paying off that loan should help boost your scores.

Don’t close accounts or apply for a bunch of new accounts. Pay all your bills on time, and don’t let disputes or medical bills wind up in collections.

There aren’t any quick fixes, so don’t waste your money on credit repair firms or other pitches that promise instant results. What will repair your score is using credit responsibly over time.

A: Adding an installment loan such as an auto loan, mortgage, or student loan to your credit mix can indeed help rehabilitate troubled scores. But it’s advisable only if you’re well on your way to having the rest of your debt paid off. Otherwise, you risk stalling on your debt repayment or, worse, adding another bad debt to the pile.

If your scores are still troubled, the car loan probably has sky-high interest rates. If you go this route, put down at least 25% of the purchase price so that you can refinance to more favorable terms in a year or two when your scores improve.

A better option may be to skip the car loan and try to get a three-year personal loan from your credit union. This fixed-rate loan would allow you to pay off some of your other debt while improving your scores.

When your debt is paid off, you can save up to either buy your next car with cash or at least make a substantial down payment so you have to finance only a portion of the purchase.

Finally, you should know that although using and paying off your credit card is definitely helping your scores, paying off old debts may not be so helpful to your numbers. If the bills are already in collections, you may not see dramatic improvements in your scores as you retire those debts. That’s why you would be smart to look for other means to improve your scores.

A: Plenty of lenders don’t report to credit bureaus. Even some credit unions, which are normally consumer friendly, opt to report to only one credit bureau.

If you’re trying to rehabilitate battered credit scores, you want accounts to be reported to all three bureaus so that all three of your FICO credit scores (one from each bureau) can benefit. It doesn’t do your scores any good if a loan you’re paying on time isn’t reported to any bureau, and it does you only limited good if it’s reported to just one bureau—your other two scores won’t benefit.

You typically can find out simply by asking before you apply for a loan whether the creditor reports to all three bureaus.

The fastest way to improve your scores is to have both installment and revolving accounts. Revolving accounts include credit cards, but you don’t have to borrow money to improve your scores. Using a credit card and paying it in full each month is enough. If you don’t have a card, consider applying for a secured version, which gives you a credit limit equal to an amount you deposit with the issuing bank. But again, make sure the issuer reports the account to all three bureaus before you apply.

A: Your income and assets have no effect on your credit scores. Plus, you should understand that there’s no benefit to having scores over 800. Lenders typically reserve their best rates and terms for anyone with scores that exceed lower benchmarks, such as 740 or 760. Furthermore, nothing in credit scoring is permanent—even if you vault over the 800 mark, you may not stay there.

If you want to play the game of trying to max out your FICOs, however, there are a few steps you can take. Make sure your mortgages and your credit cards are being reported to all three credit bureaus, since having both installment and revolving credit will help your scores. Continue to make all your payments on time. Don’t use more than 10% of your credit limit on any card, don’t apply for new credit, and don’t close any accounts. Finally, grow older. A longer credit history is a better credit history, in FICO’s eyes.

A: One of the things you can do is stop worrying about why your credit scores aren’t higher. When you get above 760 or so on the 300-to-850 FICO scale, you’ll get the best rates and terms from virtually any lender. The software that provides the scores is set up to spit out “reason codes” for why your numbers are the way they are, but the higher your scores are, the less relevant those reasons may be. The software has to tell you something, even if “fixing” the “problem” wouldn’t really affect your numbers.

You also need to stop turning to the credit bureaus for information about your scores. Although they sell FICO scores to lenders, the bureaus use a proprietary formula purchased from another company (also called FICO). The bureaus can’t really tell you much more about how the formula works than you could find out for yourself at MyFico.com, which is a site FICO cofounded. Plus, the credit scores the bureaus want to sell to you typically aren’t the FICO scores most lenders use.

As for your right to decide where your credit information is kept, in effect, you have none. The credit reporting system was set up to benefit lenders, not consumers. If you want to change that, continue contacting your lawmakers.

A: You’re not quite done yet. If you’re contacted by a debt collection agency, you need to send a copy of the proof that you paid the bill to the agency, along with a letter saying that you don’t owe the debt and that reporting the debt to the credit bureaus would be a violation of fair credit reporting and debt collecting laws.

If the debt collector insists on reporting the debt to the credit bureaus, it could affect your scores. Continue monitoring your credit reports, and be ready to dispute the bogus collection account if it appears. You may be able to sue the debt collector if it persists in reporting a false debt. You can find more information at DebtCollectionAnwers.com.

A: Insurance companies don’t use FICO scores to set rates, but they do use somewhat similar formulas that incorporate credit report information in a process called “insurance scoring” to set premiums. Insurers, and some independent researchers, have found a strong correlation between negative credit and a person’s likelihood of filing claims.

The formulas insurers use sometimes punish behavior that has only a minor effect on your FICO scores. Since insurers use different insurance scoring formulas, however, you may well find a better deal by shopping around.

A: Only three states—California, Hawaii, and Massachusetts—prohibit insurers from using credit information when calculating premiums. In other states, the practice is common, since insurers have discovered a strong correlation between people’s credit histories and their likelihood of costing an insurer money.

Exactly what behavior can hurt your insurance scores differs from company to company, however. Unlike the credit world, where FICO scores dominate, insurers don’t use one single formula. Many use the LexisNexis Attract score, others use a formula that Fair Isaac provides, and still others develop their own, proprietary scores. So behavior that might not affect premiums at one company could jack them up at another. If an insurer disses you for having too many cards, closing accounts might not help, because that could inflict its own damage by changing the credit-utilization portion of your insurance score with that company.

This is yet another reason it’s important to shop around occasionally for insurance: You may be able to save hundreds or even thousands of dollars by switching to an insurer that uses a less punishing formula.