4 Steps to Spotless Credit

Everything you need to know to polish your image with lenders, score better rates and guard against identity theft.
By Jean Chatzky, MONEY Magazine editor-at-large
January 22, 2006: 8:43 AM EST

NEW YORK (MONEY Magazine) - Imagine being rejected for a credit card because you once forgot to return a library book. Or not landing a job because you were late paying bills while you were unemployed. Or finding you can't refinance your mortgage at a low rate because a thief (or your cousin) opened accounts in your name. All of these scenarios are outrageous, but none, unfortunately, are far-fetched.

Your good name, once something you could build and nurture face to face, is now analyzed by a computer and ruthlessly boiled down to a single three-digit number, your credit score. That score not only affects how much you can borrow and at what interest rate, it also drives whether you can get a decent rate on car insurance or a new job.

And as creditors routinely peek at your behavior with other lenders for an excuse to hike your interest rate to as much as 30 percent, or even cut you off at the knees, just one slip can be especially painful.

That's why being in control of your credit is arguably the most important financial move you can make. The good news is that there's plenty you can do to boost your credit score, keep identity thieves at bay and restore your good name--and, by extension, qualify for better credit deals and wow anyone who thinks a three-digit number sums you up. The story that follows will tell you how.

Step 1:   See how you look to a lender -- get your credit report and score.

Exercise your right to a free credit report
As of last year, everyone is entitled to a free report from each of the three major bureaus -- Equifax, Experian and TransUnion -- every year. The only source for truly free reports is AnnualCreditReport.com (877-322-8228).

Why patience pays off
Getting your credit report online can be an exercise in frustration. Why? Proving who you are means answering a series of detailed questions such as the model-year of a car you sold long ago or the name of the lender that financed your home-equity loan 10 years earlier.

A better bet is to print out and mail the short order form. Yes, it will take two weeks for your report to arrive. But unless you are applying for a mortgage tomorrow, that's no big deal.

Then find out your credit score
There's one important thing missing from your free credit report: your credit score, which is the calculation of your creditworthiness that lenders, insurers and even utility companies look at when you do business with them. Your score can range from 300 to 850, but practically no one has one lower than 500.

To learn what your score is, you have to buy it -- or ask a loan officer when you apply for a mortgage or other loan. By law, he must provide it upon request.

Not all scores are equal
You actually have at least three scores, each one generated for a different bureau. You're best off buying a FICO score (for Fair Isaac, the company that pioneered credit scoring) because more than 75 percent of mortgage decisions are based on it.

Of the three credit bureaus, only Equifax sells a FICO score, and you can buy it for $6.95 at AnnualCreditReport.com when you request your free report. When you're applying for a major loan, though, it's smart to get FICO scores from all three bureaus in advance because the information can vary; you can buy the trio for $45 at Myfico.com.

The higher your score, the less you pay
A credit score of 720 might typically qualify you for a credit-card rate of 9.6 percent vs. 18 percent for someone scoring 600. For every $1,000 of your balance, you'd save $86 in annual interest.

Step 2:   Know what lenders want to see on your credit report -- and then give it to them.

Scour your credit report for errors
A full 25 percent of reports have errors serious enough to deny you credit, according to the U.S. Public Interest Research Group, and it's up to you to fix them. Your credit report includes directions for filing a dispute.

For mistakes such as a misspelled name, contacting the bureau by phone or online is fine. For anything else, write a certified letter with return receipt requested. With a free report, the bureau has 45 days to investigate your claim. In the meantime, contact the creditor who erred as well.

A "consumer statement" is generally a waste of time
You have the option to add a 100-word statement to your credit report that explains your side of the story -- a dispute with a lender, say, or a bankruptcy.

But think about how online mortgage lenders work. You type in your personal data and within a few minutes get multiple offers. It's all computerized. There's no one taking the time to read your carefully crafted defense of why a bill was late.

Even when there is, a statement may not help and can occasionally hurt.

"People do more damage by admitting to their bad behavior," says Stephen Snyder, author of "Do You Make These 38 Mistakes with Your Credit?" "It validates the fact that it's actually true."

Always pay your bills on time
Nothing is more important to your credit profile (see the chart). Missing your credit card's 2 p.m. deadline by even a few hours can trigger a $39 late fee.

That's not all. Once you're late, that issuer will hike your interest rate into the stratosphere, and after 30 days report your slip to the credit bureaus. When other lenders take a look at your file, which they do from time to time, they may raise your rate too.

Deny your kids
Adding a child to your credit card can help his or her credit but sabotage yours. If your kids can charge on your account at will, and their wayward spending makes it tough for you to pay the bills, both of you may end up regretting your leniency.

Live well within your limits
How much you borrow vs. how much you can borrow, or your utilization ratio, is the second most important factor behind your score. Using 30 percent or less of your available credit is best. More than 70 percent is a serious drain on your score.

You can reduce your utilization ratio in two ways: Pay down what you have borrowed or expand what you can borrow. To do that, raise your credit limits or open a new card. Just be sure you resist the urge to borrow more simply because you can.

Watch out, big spender
Even paying your bill in full every month doesn't guarantee a low utilization ratio. How maxed out you look depends on your balance the day your issuer reports to the bureaus.

If that's right after you've made a big purchase but before you've paid your bill, your score suffers, notes Evan Hendricks, author of "Credit Scores and Credit Reports." For 60 days before you apply for a loan, put off any major shopping trips.

Open and close accounts with care
The most valuable accounts are your oldest ones. If you cancel credit cards that you've had for a long time, for instance, you may take a file that's 20 years long and reduce it to four or five years.

To make sure a card company doesn't try to get rid of you -- you could be costing them more in postage than you're producing in fees -- use the card every three to six months.

Be a snob about lenders
You can be docked for having a finance company listed among your creditors, says John Ulzheimer, a credit expert at lifeafterbankruptcy.com.

"Finance companies are the lenders of last resort," he notes. Think you've never used a finance company? You may have if you have ever borrowed for a purchase (furniture, say, or a computer) through the store.

Trolling for credit can ding your score
A flurry of credit applications hurts you. Don't worry about shopping around for a mortgage or a car loan -- multiple applications you make within 14 days for either loan count as only one. But those cards you apply for to earn 10 percent off at the mall? Big mistake.

Be wary of "pre-approved" card offers
When issuers compile prospects for junk-mail campaigns, they make a "soft" credit inquiry, which has no impact on your score. However, it doesn't give them enough information to close the deal. For that, you have to send back the application, giving them permission to do a "hard" inquiry.

That counts as a new credit application and can take your credit score down a handful of points.

Step 3:  Defend yourself from easy opportunity thieves.

Protect your paperwork
Think of your Social Security number as the key to the kingdom. Anyone who has it can easily open an account in your name. Give it out as seldom as possible, and don't carry your Social Security card in your wallet.

To thwart thieves who go into your mailbox or trash (what's called Dumpster diving), call 888-5OPTOUT to put a stop to credit-card offers in the mail, tell your bank not to share your information and elect to receive and pay bills online.

Shred what's left
Make a cross-cut shredder your last line of defense. In a MONEY field test of five machines that ranged in price from $40 to $380 ("Let It Rip,"), the $130 Fellowes eight-sheet cross-cut shredder (model PS-60C) won. A great all-around machine, it eats old credit cards as well as paper.

Trust your computer (but verify)
Banking online is safer than you may think -- and becoming even more secure. Federal regulators recently ordered banks to tighten their online security by the end of 2006, requiring more than just a password to log on. Some financial services companies, including E-Trade and Bank of America, already offer this two-factor authentication, but you may have to sign up for it.

If the extra security isn't yet an option, make sure your password is a random sequence of letters and numbers. Never respond to e-mails that ask for your personal information (what's called phishing). Instead, contact your bank directly.

Be wary of wireless
The new frontier in phishing is the wireless Internet connection. When you attempt to log on to your bank in a public place, explains Internet security expert Richard Rushing, an ID thief can capture your data by misdirecting you to a fraudulent network and recording your keystrokes.

Mount your own defense
Credit monitoring services scan your credit reports and alert you to any changes daily or weekly, from a new account to a new address. For that, you will pay $25 to $60 a year, or even $150 or more for services that include theft insurance, score analysis or counseling to rebuild your good name. But most people can handle monitoring on their own.

The exceptions: You've already had your identity stolen and worry that your personal information is still floating around, or you run a business that needs frequent cash infusions and can't afford any credit glitches. Or maybe a monitoring service is the only thing that will let you sleep at night. In any of those cases, a no-frills service that covers one bureau is enough and should cost no more than $50 a year.

How to monitor your credit for free
No one should let too much time pass between glances at a credit report because creditors value recent behavior more highly than ancient history. If you're smart about it, you can get a free report three times a year from AnnualCreditReport.com. Simply order a report from a different credit bureau every four months.

Say no to ID theft insurance
Most ID frauds are simple shopping sprees with your credit card (or the number). In those instances, federal law limits your liability to $50, and major credit-card issuers won't charge you at all. The pitch for ID theft insurance is that a policy will cover the costs you incur to restore your identity, such as legal fees and lost wages if you miss work.

The majority of victims, however, have no out-of-pocket losses, according to the Federal Trade Commission. For the few who do, the damage averages about $500, a small loss compared with the $25-to-$70-a-year premium. Plus, your homeowners policy may cover identity theft already. Bottom line: You don't need this insurance.

Step 4:  Recovering from identity theft is a necessary hassle

When you suspect ID theft, call a credit bureau first
If you lose your wallet or see signs of ID theft (an unfamiliar account on your credit report, say), first contact one of the three credit agencies and ask to have a 90-day fraud alert placed on your report (Equifax: 800-525-6285; Experian: 888-397-3742; and TransUnion 800-680-7289).

This lets creditors know that your identity may have been compromised and that they need to be cautious about new loan applications. One call will trigger an alert at all three bureaus.

Next, call your creditors. Close accounts that have been tampered with or opened in your name, and challenge fraudulent charges. Follow up with certified letters. Many lenders have forms, or use the Federal Trade Commission's ID theft affidavit. File a police report, which will let you extend a fraud alert to seven years.

To bounce back from mistakes, become a model citizen
The best way to undo the damage caused by your own bad behavior is to pay bills on time, whittle away at balances on cards that are maxed out and resist opening new accounts.

Don't turn down help
If you are in deeper trouble, consider credit counseling. Yes, repaying debts through an agency doesn't look good on your credit report, but it can be less damaging than bankruptcy.

The industry has been plagued by conflict-of-interest problems, so start with the government's list of approved counselors or the National Foundation for Credit Counseling.

The secret of 24 months
Bankruptcy stays on your credit report for seven to 10 years, late payments for seven. But you can vastly improve your credit within two years. Creditors consider your recent behavior a much better indicator of your creditworthiness than what you did in the past. Cleaning up your act today can mean lower interest rates by the time you ring in 2008.