Rules of the Road for Improving Your Credit Mix
Looking to edge up your credit score to get the most attractive rate on a mortgage in the next year or so?
While handling credit cards responsibly is the best way to boost a credit score, if you need to break through a barrier, you can look to your credit mix. Having greater diversity in the types of credit you use can nudge your score up -- as long as you make your payments on time.
The biggest factors in calculating your credit score are payment history (35 percent) and the amount you owe (30 percent), according to FICO, the San Jose, Calif.-based agency that calculates and issues FICO credit scores. Length of credit history (15 percent), new credit (10 percent) and credit mix (10 percent) make up the rest of the pie.
While credit mix is a small category, it can make a difference if you are struggling to shift a FICO score up a notch -- from, say, 720 to 740. "We're talking about 10 to 20 points, not 100," says Ethan Dornhelm, principal scientist at FICO.
Having a variety of successfully managed credit accounts, ranging from revolving credit cards to installment loans (such as personal loans, auto loans and mortgages), shows responsibility in handling a wide variety of credit types, Dornhelm says. "If we look at risk patterns, we find that people who show a healthy balance of usage of all types are a lower risk," he says.
No pain, no gain Before you go hunting for new credit, be warned: Taking on different types of credit won't automatically boost your score. In fact, your score may dip temporarily, Dornhelm says, when the lender performs a hard pull on your credit to determine your ability to repay. Hard pulls are just temporary dings, however, as long as you proceed slowly and carefully when applying for new credit. Too many new accounts may be interpreted by a lender as a sign you are in financial trouble.
But making payments on time will help your score recover. For example, Dornhelm says taking out a $5,000 car loan has the immediate effect of lowering a score because it's new credit. After making five steady payments, though, your score should rebound to its former level and then some.
Just make sure you can afford those payments. If you take on debt you can't afford, you'll end up doing more harm than good. Paying on time is key. "As long as you demonstrate responsible use, you'll benefit," says FICO's Dornhelm.
With that in mind, here are some good -- and not so good -- ways of adding variety to your credit mix with installment loans. A green light means go ahead, as long as you've weighed the pros and cons. Yellow means take care -- there could be trouble ahead. Steer clear of the red lights.
Car loan: green light Even if you can afford to pay for a car with cash, you may want to consider paying it out over time. If your credit is good, you may qualify for a very low-interest loan that could help your credit mix and eventually boost your credit score even higher.
You can get car loans from several different sources. Most dealers are affiliated with finance companies that offer loans. You can also get a loan through your bank or credit union. The better your credit score, the lower the interest rate you'll be offered.
If your score is less than stellar, consider using a credit union. Interest rates at federal credit unions are limited by law to 18 percent, and may be more reasonable than rates at buy-and-drive car lots or finance companies, says Rex Johnson, owner and founder of Lending Solutions Consulting Inc., a credit-union consulting firm in Elgin, Ill.
In addition, nonprofit credit unions want to help people build credit scores and are more forgiving of less-than-perfect credit, he says.
How long should the loan be for? Let your budget be your guide.
Johnson says that, because credit history counts for 35 percent of your FICO score, a longer loan paid off faithfully will do more to boost your credit score than a shorter loan. But you'll end up paying more interest with a longer loan, and it's not worth stretching out your loan terms just to improve your score, Johnson warns.
Personal loan: green lightPersonal loans are generally made to individuals without any collateral needed. People use personal loans for consolidating credit card balances, paying tax bills, financing weddings or any number of other expenses.
One of most attractive things about personal loans is that they may have a lower APR than a credit card. San Francisco-based Wells Fargo, for instance, offers personal loans from $3,000 to $100,000, starting at around 7 percent APR. That compares to the average credit card APR of 14.96 percent.
Peer-to-peer loans arranged by companies such as Lending Club and Prosper are an increasingly popular route to personal loans. Those firms report your account activity to the credit bureaus, meaning they should help build your credit if you pay on time. You generally need a very good credit score to qualify, but the application process can be easier than going through a bank.
Student loans: green light FICO also considers student loans when looking at your credit mix. As installment loans, student loans carry the same weight as, say, a car loan, Johnson says.
The key to having student loans build your credit score is to stay on top of the payments. Ideally, that means making the required payment every month. It can also mean keeping in touch with lenders if you can't pay on time. Heidi Berardi, director of education and community outreach at the nonprofit credit counseling organization Family Credit Management in Chicago, advises contacting the National Consumer Law Center's Student Loan Borrower Assistance Project if you're having trouble with payments. They can help you find out about consolidating your student loans. "If you are communicating, you're current," she says. "That's very big."
Store loans: yellow lightInstallment loans from furniture or hardware retailers also can add variety to your credit -- but proceed with caution. Home Depot, the Atlanta-based chain of building supply stores, offers a Project Loan for up to $40,000. You get six months to repay the loan interest-free. After that, you'll be charged interest at a rate "as low as" 7.99 percent annually, according to the store's website.
Such loans come with a caveat, says Berardi. She recommends you pay off the loan in the allotted time before interest charges begin.
Other experts are even more cautious. "For the most part, these loans aren't worth it even if you pay everything on time," says Tom Joyce, vice president of marketing at the Better Business Bureau serving Chicago and Northern Illinois.
Better to pay with a credit or debit card, he says. He notes that credit cards usually have lower interest rates than store loans and a credit card company is more likely than the retailer or finance company to have your back if the furniture falls apart a month after you buy it.
More importantly, credit bureaus look askance at store loans, "because they make people look like they're in financial trouble and can't pay for something themselves," Joyce says. They're considered a last resort.
The BBB's final advice? Use your credit or debit card to pay for big purchases. If you do succumb to temptation, read the fine print for interest rates, prepayment penalties and other potential traps.
Gearing up your credit score before a house purchase