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WELCOME TO CREDIT 101
What
Is A Credit Score?
You
probably know the score of last night’s football game. You
probably even know your last bowling score. Chances are that
you know the score of your son’s last baseball game. But what is
a credit score? Who uses them? What makes a credit
score? And why should you care?
A
Short Answer
Credit
scores provide lenders the best statistical guide to future risk based
solely upon statistical data reported to the credit bureaus.
Credit scores help lenders determine the credit worthiness of
prospective customers. The higher the score, the lower the risk.
Each lender has its own strategy for making lending decisions.
These strategies include the level of risk the lender finds acceptable
for any given product. There is no single “acceptable score”
used by all lenders and there are many additional factors that lenders
use to determine the actual interest rate on a product. The credit
score is only one of these factors.
A
Longer Answer
Credit
scores help lenders assess risk more fairly because they are consistent
and objective. Consumers also benefit from this method. No matter who
you are as a person, your credit score only reflects your likelihood to
repay debt responsibly, based on your past credit history and current
credit status. This eliminates any personal bias a lender may have
towards a customer.
Before credit scores, lenders had to physically look over
each applicant's credit report to determine whether to grant a loan. A
lender might deny credit based on a subjective judgment that a consumer
already held too much debt, or had too many recent late payments. Not
only was this time consuming, but also human judgment was prone to
mistakes and bias. It was just too inconsistent. Lenders
used personal opinion to make a decision about an applicant that may
have had little bearing on the applicant's ability to repay debt.
Because of this, fewer loans were made and it was much harder to qualify
for financing than it is today.
Scores
are not just used to evaluate the credit merit of consumers. Lenders
also use scores to predict consumer response to offers sent in the mail,
the likelihood that account holders will file for bankruptcy or that a
consumer will move their account to another lender. That’s the
beauty of statistics! Lenders can predict behavior for a group of
people as a whole.
How Is My Score
Calculated? That’s a
very good question. The software and the underlying formulas for
calculating credit scores are proprietary information. We do know,
however, that there are five categories that comprise each credit
score. Each category is weighted according to its importance to
creditors. It’s important to remember that your score only
evaluates information provided by credit reporting agencies.
Lenders will look at many other factors when making their credit
decisions. It’s also important to remember that credit reporting
agencies get their information from your current creditors and can only
compile that information for a history and calculate a score. The
chart below illustrates the five factors used in determining your credit
score and their respective levels of importance.
Below are the
factor explanations from Fair, Isaac, and Co (FICO), the company that
developed the software that determines most credit scores.
1.
Payment History (35% of score). The first thing any
lender wants to know is whether you have paid your past credit accounts
on time. The payment history factor of credit scoring takes into
account:
-
Payment
information on many types of accounts. These include credit
cards (such as Visa, MasterCard, American Express and Discover),
retail accounts (credit from stores where you do business, such as
department store or gas station credit cards), installment loans
(loans where you make regular payments, such as car loans), finance
company accounts and mortgage loans
-
Public
record and collection items. These include reports of
events such as bankruptcies, judgments, suits, liens, wage
attachments and collection items. These are considered quite
serious, although older items count less than more recent ones.
-
Details
on late or missed payments and public record and collection items.
A 30-day late payment is not as risky as a 90-day late payment, in
and of itself. But recency and frequency count too. A 30-day late
payment made just a month ago will count more than a 90-day late
payment from five years ago. Note that closing an account on which
you had previously missed a payment does not make the late payment
disappear from your credit report.
-
How
many accounts show no late payments. A good track
record on most of your credit accounts will increase your credit
score.
2.
Amounts Owed (30% of score). Owing money on
different credit accounts does not mean you’re a high-risk borrower
with a low score. However, owing a great deal of money on many accounts
can indicate that a person is overextended, and is more likely to make
some payments late or not at all. Part of the science of scoring is
determining how much is too much for a given credit
profile. This factor takes into account:
-
The
amount owed on all accounts. Even if you pay your
credit cards in full every month, your credit report may show a
balance on those cards. The total balance on your last statement is
generally the amount that will show in your credit report.
-
The
amount owed on all accounts, and on different types of accounts.
In addition to the overall amount you owe, the score considers the
amount you owe on specific types of accounts, such as credit cards
and installment loans.
-
Whether
you are showing a balance on certain types of accounts.
In some cases, having a very small balance without missing a payment
shows that you have managed credit responsibly, and may be slightly
better than no balance at all. On the other hand, closing unused
credit accounts that show zero balances and that are in good
standing will not generally raise your score.
-
How
many accounts have balances. A large number can
indicate higher risk of over-extension.
-
How
much of the total credit line is being used on credit cards and
other "revolving credit" accounts. Someone
closer to "maxing out" on many credit cards may have
trouble making payments in the future.
-
How
much of installment loan accounts is still owed, compared with the
original loan amounts. For example, if you borrowed
$10,000 to buy a car and you have paid back $2,000, you owe (with
interest) more than 80% of the original loan. Paying down
installment loans is a good sign that you are able and willing to
manage and repay debt.
3. Length
of Credit History (15% of score). In general, a longer
credit history will increase your score. However, even people with short
credit histories may get high scores, depending on how the rest of the
credit report looks. This factor takes into account:
-
How
long your credit accounts have been established, in general.
The score considers both the age of your oldest account and an
average age of all your accounts.
-
How
long specific credit accounts have been established.
-
How
long it has been since you used certain accounts.
4. New Credit (10% of score).
Research shows that opening several credit accounts in a short
period of time represents greater risk, especially for people who do not
have a long-established credit history. This also extends to requests
for credit, as indicated by "inquiries" to the credit
reporting agencies (an inquiry is a request by a lender to get a copy of
your credit report). This factor takes into account:
-
How
long it has been since you opened a new account.
-
How
many new accounts you have.
-
How
many recent requests for credit you have made, as indicated by
inquiries to the credit reporting agencies. Be
assured, however, that if you request a copy of your credit report
to check it for accuracy—which is always a good idea—it will not
affect your score. This is considered a
"consumer-initiated inquiry," not an indication that you
are seeking new credit. Also, your score is unaffected by
lender inquiries into your credit report for purposes of making you
a "pre-approved" credit offer, or for reviewing your
account with them, even though these inquiries may show up on your
credit report.
-
Length
of time since credit report inquiries were made by lenders.
-
Record
of recent credit history following past payment problems.
Re-establishing credit and making payments on time after a period of
late payment behavior will help to raise a score over time.
5.
Types of Credit in Use (10% of score). This
factor considers your mix of credit types: credit cards, retail
accounts, installment loans, finance company accounts and mortgage
loans. It also looks at the total number of accounts you have; for
different credit profiles, how many is too many will vary. This
means it is not necessary to have one of each type, nor is it a good
idea to open credit accounts you don't intend to use. The credit
mix is generally not a key factor in determining your score — unless
your credit report does not have a lot of other information upon which
to base a score.
FICO
scores consider a wide range of information on your credit report.
However, they do not consider:
- Your
race, color, religion, national origin, sex and marital status.
US law prohibits credit scoring from considering these facts, as
well as any receipt of public assistance, or the exercise of any
consumer right under the Consumer Credit Protection Act.
- Your
age.
- Your
salary, occupation, title, employer, date employed or employment
history.
- Where
you live.
- Any
interest rate being charged on a particular credit card or other
account.
- Any
items reported as child/family support obligations or rental
agreements.
- Certain
types of inquiries.
- Any
information not found in your credit report.
- Any
information that is not proven to be predictive of future credit
performance.
- Whether
or not you are participating in a credit counseling of any kind.
Your
score may be different at each of the three main credit reporting
agencies.
The FICO score from each credit reporting agency considers only the data
in your credit report at that particular agency. If your current scores
from the three credit reporting agencies are different, it's probably
because the information those agencies have on you differs.
Your
FICO score changes over time and is different EVERYDAY.
Data from creditors is submitted to the credit reporting agencies at
various times during the month. As your data changes at the credit
reporting agency, so will any new score based on your credit report.
This explains why our FICO score from a month ago is probably not the
same score a lender would get from the credit reporting agency today.
Is
My Score Normal?
That
depends on your definition of normal. As the following chart
illustrates, 20% of the population scores in each of the following score
levels:
Where does your
score fall into this chart? If you were to have a score of 745,
60% of the population would have scores lower than yours and 40% would
have scores higher than yours.
Why
Isn’t My Score Higher?
Along with your credit score, you will usually find four “reason codes” listed
on your credit report. Score reason codes explain why your score was not higher
than it is. Score reason codes can be helpful in determining if your credit
report might contain errors and in helping you to improve your scores over
time. Here are the top ten most frequently given score reason codes.
- Serious
delinquency.
- Serious
delinquency, and public record or collection filed.
- Derogatory
public record or collection filed.
- Time since
delinquency is too recent or unknown.
- Level of
delinquency on accounts.
- Number of
accounts with delinquency.
- Amount owed
on accounts.
- Proportion of
balances to credit limits on revolving accounts is too high.
- Length of
time accounts have been established.
- Too many
accounts with balances.
How Can I Improve My Score?
Credit scores reflect credit payment patterns over time with
recent information given more emphasis. In general, a score may improve, if you:
- Pay your bills on time.
Delinquent payments and collections can have a major negative impact on
a score.
- Keep balances low on
credit cards and other "revolving credit." High outstanding debt can affect a
score. Ideally, keep balances at levels of 35% or less of the total limit.
- Apply for and open new
credit accounts only as needed. Don't open accounts just to have a better
credit mix - it probably won't raise your score.
- Pay off debt rather than
moving it around. Also don't close unused cards as a short-term strategy to
raise your score. Owing the same amount but having fewer open accounts may
lower your score. If you must close a card, close the most recently opened
cards as opposed to older, more established cards.
Make sure the information in your
credit report is correct, too. It won't affect your score to request and check
your own credit report. If you find errors, contact the consumer reporting
agency and your lender. By law, the credit reporting agencies must correct any
errors on your report.
If you do have negative
information on your credit report, such as late payments, a public record item
(e.g., bankruptcy, judgment or tax lien), or too many inquiries, you may want to pay your bills and
wait. Time is often your best ally in improving credit.
How long does it take to
rebuild a score?
The length of time to rebuild your score depends on the
reason behind the drop in the score. Most decreases in scores are due to the
addition of a new element to your credit report such as a delinquency or an
inquiry. These new elements will continue to affect your score until they reach
a certain age. Delinquencies remain on your credit report for seven years. Most
public record items remain on your credit report for seven years, although some
bankruptcies may remain for 10 years and unpaid tax liens remain for 15 years.
Inquiries remain on your report for two years. Time heals all wounds.
For more information, you may visit
www.myfico.com.
The Credit Bureaus and their contact
information are provided below.
Equifax
www.equifax.com
Information Service Center
P.O. Box 740241
Atlanta, GA 30374-0241
1-800-685-1111
Experian (TRW)
National Consumer Assistance Center
www.experian.com
P.O. Box 949
Allen, TX 75013-0949
1-888-EXPERIAN (1-888-397-3742)
Trans Union Corporation
www.transunion.com
Customer Disclosure Center
P.O. Box 390
Springfield, PA 19064-0390
1-800-888-4213
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