Dos and don'ts of improving credit scores

Few things have a larger impact on borrowing and purchasing power than a positive credit score. A person who wants to make a purchase that involves a line of credit, such as buying furniture or financing a new car, must be aware of how his or her credit rating can affect the proceedings.

And the significance of a personal credit store goes beyond purchasing power. Many employers now perform credit checks on job applicants to determine if the potential hires will be trustworthy, while renters often find that landlords run a credit check to determine the probability that a tenant will default on a rent payment.

Much importance is put on a high credit score, so much so that people go to great lengths to improve their score. When individuals try to improve the health of their credit scores, they may engage in behavior that seems on the surface to be beneficial but actually may be compromising the score even further. Understanding credit scores is one way to avoid such mistakes.

What is a credit score?

The credit score that is carefully scrutinized is a person's FICO score. FICO is an acronym for Fair, Isaac and Company, the organization that historically assigned credit ratings. This score is the rating used by creditors and others to determine a person's financial risk level, therefore identifying if an individual is worth the risk of a line of credit. FICO also influences interest rates, as a weaker score usually earns borrowers a higher interest rate. Lenders will study an applicant's FICO score when individuals apply for a credit card, apply for a mortgage loan or want to finance a car or another large purchase.

According to the FICO score scale, the highest credit score issued is 850, which is excellent. Few people actually achieve this score. More fall into the range of "good," which is between 660 and 749. Individuals who fall into the good or excellent range will have little trouble borrowing money and getting loans. These people also will receive the lowest interest rates possible, which could make a significant difference in the overall cost of a loan.

Who determines credit scores?

In the United States, credit scores are typically calculated by the three main credit bureaus: Equifax, Experian and TransUnion. Different creditors report to different bureaus, so the scores between the three may vary. An average of the three bureaus is used to determine an overall credit score.

Things that lower credit scores

Paying bills on time and being aware of any breaches of identity theft are positive steps that can raise a person's credit score. However, there are other myths that prevail that could cause a person to actually harm his or her score rather than improve it.

* Failure to check credit scores: Many people shy away from regularly requesting their own credit reports because they've learned that too many credit inquiries can reflect badly on a credit score. However, requesting your own report has no negative effect. In fact, doing so regularly could help you discover any irregularities or mistakes that could be negatively affecting your score.

* Closing unused accounts: People mistakenly assume if they have too many credit accounts that immediately closing them before applying for a new loan will reverse the damage. This is not the case. It actually is the process of opening multiple accounts in a short time that reflects badly. Closing out accounts -- particularly long-standing ones -- could make a credit history seem short. FICO includes the length of credit history in its calculations.

* Closing accounts with high credit limits: Closing out these accounts reduces the amount of potential untapped credit a person has. If he or she has debt, closing out these accounts can contribute to that debt seeming more sizeable thanks to debt-to-credit ratio formulations. Having high credit limits on cards is actually good for a credit score say many financial experts, provided that the person does not use all of that credit. Debt-to-credit ratio accounts for 30 percent of a credit score.

* Getting rid of credit cards entirely: Paying off credit cards and resolving to only use cash may help a person who has some trouble managing credit, but it won't change a credit score. Past history of late payments or any mishaps do not disappear when a particular card or account is closed out. In addition, not using credit may help one to avoid debt, but it doesn't help establish a credit history. Having no outstanding debt could negatively affect a credit rating. People who have no credit accounts over a certain period of time may have no credit score at all -- which could be worse than a poor credit score.

What will improve credit score?

According to the Federal Reserve Bank, the best way to improve one's credit score is to pay credit debt on time. Consolidating debt is one way to get credit under control and eliminate any late payments.

Having a mix of installment loans, which are any long-term loans that require monthly payments, and credit accounts can also improve a credit score. If you don't want too many credit cards, establish a credit history with one and keep small purchases on it that can easily be paid off.

Credit scores are important components for an individual's credibility and financial security. Learning the right ways to improve credit scores can make it easier to borrow money.