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Liz Weston, Published October 09 2011

Money Talk: Installment loan could boost credit scores

Q: I’m 27 and have been working hard for the past few years to bring up my FICO credit score. I’ve paid off all my credit card debt and disputed errors on my credit report. I’d like to purchase a home in the next few years and am trying to get my score over 700 (I am currently at 615). I have three credit cards that I regularly use and pay off.

Do you have any suggestions on how I can continue to bring up my credit score? Should I take out a personal loan? Should I apply for another credit card? An auto loan, perhaps? This has been a frustrating experience, so anything that you can offer would be appreciated.

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 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 will use 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, since the scores typically offered aren’t FICOs.

If you continue to use your credit cards responsibly – charging no more than 30 percent of your limits, and preferably 10 percent 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 percent 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.

Q: Is there a reason not to panic? I see my investments tumbling, and I’m already very conservative. I don’t want to put it all under the mattress, but what else can a person do to hang on to what I have saved? I’m fast approaching retirement age.

A: If you’re prone to panic, you should turn off the television pundits who like to scare people, which seems to be most of them.

What you need are perspective and balance. If you’re within 10 years of retirement, you should invest in a session with a fee-only financial planner to make sure your portfolio is appropriately diversified. Taking too little risk can be as dangerous as taking too much when you have a 20-year (or longer) retirement horizon.

Over time, the stock market does march upward, although it’s never a smooth path.

Q: You recently advised a couple who were in sound financial shape about possibly refinancing their home loan to a lower interest rate. You suggested a 15-year loan to make sure they entered retirement without a mortgage. Why not recommend getting a 30-year loan to get the lowest required monthly payment and then making extra payments to get the loan paid off faster?

This approach offers the flexibility of being able to drop back to the lower payment in the event of a job loss or other financial setback. They sounded like well-disciplined people and probably could turn that 30-year loan into a 15-year loan by paying 13 payments a year instead of 12.

A: Refinancing to a 30-year loan can certainly make sense for people who want to lock in the lowest payment and maintain their financial flexibility in the face of possible financial setbacks. You’re also right that this couple seems disciplined enough to make the extra payments to get the loan retired before they do.

However, you missed a key factor: This well-disciplined couple had a mortgage with an interest rate of 5.875 percent. That indicates they’ve had this mortgage for a while. If they’ve paid down enough of the principal balance, they may be able to refinance to a 15-year loan with a significantly lower interest rate (as in slightly over 3 percent) without dramatically raising their payments. Many people, when faced with that option, would want to lock in the lower rate.

Liz Weston is the author of “The 10 Commandments of Money: Survive and Thrive in the New Economy.” Questions for possible inclusion in her column may be sent to 3940 Laurel Canyon, No. 238, Studio City, CA 91604 or via www.asklizweston.com.