In our last post, we explored how having a high credit card utilization rate negatively affects your credit score. The utilization rate is the ratio of the balance owing to the credit limit. We also talked about just how much you can save on your mortgage by improving your credit score. Today, we’ll take a closer look at how that can be achieved.
How Is Your Credit Score Calculated?
As mentioned last time, the exact calculation that FICO uses to determine a credit score is a secret, however, we know that they look at the positive and negative information associated with your credit history to arrive at your score. The factors that make up your credit score are:
- Payment history (35%)
- Amounts owed (30%)
- Length of credit history (15%)
- New credit (10%)
- Credit mix (10%)
In most of those categories, improvement can only be attained through effort over time. If you have made late payments in the past, it’s only by continually making payments on time that your rating in this category will improve. Likewise, your score may be penalized if you have opened too many new credit accounts in a short period, and it will only be remedied with the passage of time.
The one area where you can see an improvement on your credit score almost immediately after taking action is in the amounts owed category.
How Much Can Paying Down Your Debt Improve Your Score?
On MyFico.com, you’ll find several useful tools including this credit score estimator. By answering the questions, it will give you an estimate of your current credit score. (To get a true look at your score, you can order your credit report for a small fee from Equifax or TransUnion.)
The nice thing about this free credit score estimator is that you can quickly see how much your score would improve by paying down the amount you owe on your credit cards.
For our exercise, we’ll look at “Steve”; someone with a credit scenario that isn’t uncommon:
- Currently, he holds three credit cards with a total balance owing of $6000 and a total credit limit of $7000
- He obtained his first credit card nine years ago
- He got his first loan seven years ago for a car
- Steve applied for one new credit card in the last year and opened a new credit card account over six months ago
- The last time Steve was late with a payment was 18 months ago (he was 60 days late), but none of them are past due now
- Steve has never experienced a foreclosure, tax lien, bankruptcy, repossession or had an account in collections
Based on that information, the credit score estimator returns a result in the 610 to 660 range. If Steve reduces his credit card debt by $5000, his estimated score jumps up to the 700 to 750 range.
What Difference Will This Make On A Mortgage?
Another handy tool on MyFico.com is the loan savings calculator. There, you can see the difference that a higher credit score will have on the total amount of interest you’ll pay over the life of your mortgage and your monthly payment.
For our friend Steve, if he’s looking for a $350,000 mortgage on a 30-year fixed rate term, he’ll realize a savings of more than $100,000 in interest charges just by having reduced his credit card debt by $5000.
Try out these tools for yourself to see how much you could save on your mortgage by reducing your credit card debt.