Chapter 8 - Credit Scores

Your credit score (also sometimes called your credit rating) is a single numerical evaluation of your credit worthiness. It gives lenders a way to easily compare one borrower to another. If one person’s credit score is higher than another person’s credit score, then lenders will assume the person with the higher credit score is more creditworthy.

Why is credit scoring so important? Put simply, it is your reputation in the financial world. Your credit report and score are public information that companies use to learn about how you handle your money. Your credit score has a dramatic effect on the interest rate you can get on a mortgage, car loan, or credit card offer. The higher your score, the lower the interest cost you will face to borrow money!

Credit scores are not just for lenders anymore. Employers often pull credit scores on potential new employees. Insurance companies do the same. This is why having a good credit score can help you get a job or get a good rate on an insurance policy.

There are many different types of credit scores, the most popular of which are FICO scores and Vantage scores. We will focus on the FICO score, since it is the predominant credit score used by lenders. So what is a FICO score? It’s a credit scoring method developed by the Fair Isaac Corporation. This company opened to the public in March 2001. The FICO score ranges from a minimum of 300 to a maximum of 850. Any score over 660 is considered “good”, while scores over 750 are considered to be “excellent”.

If your credit report and score are poor, then you may not get the job or the apartment that you had wanted. A poor credit score will also increase the interest rate on money on your loans. You can check myfico.com to see an example of your credit score can affect the size of your mortgage payment. This is part of why it is so important to keep your credit report clean and accurate and your credit score high.

What affects the credit score?

The FICO score is a privately held scoring system. They guard the formula for their calculations as fiercely as Coca Cola guards the recipe for its world-famous beverage. However, FICO has released a certain amount of information to help borrowers know how to maintain a high credit score. The information presented in the next sections of this lecture should be interpreted as general advice for keeping a high credit score.

Components of your FICO™ Credit Score

1. Your payment history comprises 35% of your FICO score. This makes it the most important part of your credit score. Your payment history includes payment information on many types of accounts, including credit cards, retail cards, installment loans, and accounts held with financing companies. It also includes your public record information such as bankruptcies, foreclosures, lawsuits, wage attachments, and liens, as well as any accounts that have been sent to collections. Your payment history also includes details on late or missed payments (called delinquencies), and the number of accounts on which you have never had a late payment.

2. The amounts owed on your current loans accounts for 30% of your score. FICO factors in the amount you owe in total on all of your accounts, the amount owed by different types of accounts (for example the total amount of auto loans you have and the total amount of credit card debt that you have), whether or not you are carrying a balance on certain types of accounts, and the number of accounts that carry a current balance. The amount you owe also considers how much of your credit line is currently being used on credit cards and other types of revolving credit. Generally speaking, it is good to keep your loan balances low. FICO also considers the amount you still owe on installment loans (such as mortgage and vehicle loans) as compared to the amount you originally borrowed. This section includes your credit utilization ratio, which is simply the total amount that you owe compared to the total amount of credit you have available.

For example, if you only have one credit card with a limit of $1,000 and you currently owe $750 on that card, then you have a 75% credit utilization rate. Likewise, if your car loan is the only debt you have and you still owe $5000 out of the original balance of $25,000, then you have a credit utilization ratio of 25%. This credit utilization ratio is a very important part of your credit score, because you have control over how much of your available credit you choose to use. FICOs research shows that people who use a high percentage of their available credit limits are more likely to have trouble making some payments either now or in the future. You should always try to keep your credit utilization rate below 30% in order to prevent your credit score from falling.

3. The length of your credit history contributes to 15 % of your credit score. It refers to how long your credit accounts have been established. The FICO score considers the age of your oldest account, the age of your newest account, and the average age of all your accounts. It also considers how long it has been since you used certain accounts. Generally speaking, the longer an account has been open, the better its effect upon your overall FICO score.

4. The “new credit” category contributes only 10% of your total credit score. New credit considers how many new accounts you have, how long it has been since you opened a new account, and how many recent requests for credit you have made, as indicated by your credit inquiries on your credit report.

FICO also considers how long it has been since your last credit inquiries were made, and your most recent credit activities are given additional consideration over more distant activities. The reason that credit inquiries can hurt your credit score is because FICOs research shows that people who open many new credit accounts in a short period of time represent a greater risk. This is especially true for those who do not have a long credit history.

It is also important to keep in mind that FICO does not penalize you for "rate shopping” when you are seeking a mortgage, auto loan, or student loan. To enable you to shop for the best rate, the FICO Score ignores inquiries for similar financing types made in the 45 days prior to scoring. That means all inquiries made during your shopping period are counted as just one inquiry when determining your score.

Checking your own credit report and credit score does not affect your FICO score.

5. The last category affecting your credit score is the types of credit you are using. This section contributes another 10% to your overall score. The types of credit section analyzes what kind of credit accounts you have. Do you have experience with both revolving (credit cards and lines) and installment (fixed loan amount and payment) accounts, or has your credit experience been limited to only one type of credit? FICO also considers how many accounts you have of each type, and the overall mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. Keep in mind that this section of your credit score is relatively minor, and that it is not necessary to have one of each type of account. It is not a good idea to open a credit account you don't intend to use. You can have an excellent credit score with only a few different types of credit in your history.

What's NOT included in the credit score?

The information that is NOT included in your FICO score is almost as important as what IS included. Demographic characteristics such as your race, color, religion, national origin, sex, and marital status are prohibited from being included in your credit score by law. Your age is also not considered in the FICO score, although other scores may include your age at their discretion.

Your employment information does not affect your credit score. Getting a promotion or a raise at work will not improve a credit score. This information will affect your credit worthiness. Lenders frequently consider this information in their lending decisions, but it is not part of your credit score directly. The interest rates on your accounts, any type of family support obligations, and certain types of credit inquiries, such as those that you or employers or insurance companies initiate, or any inquiries lenders make without your knowledge have NO direct effect on your FICO credit score.

Any information that is not included in your credit report also does not affect your credit score. Lastly, any other information that has not been proven to be predictive of your future credit performance is not considered in your credit score.

Definitions:

Credit score: single numerical evaluation of your credit worthiness

FICO score: a credit scoring method developed by the Fair Isaac Corporation

Payment history: payment information on many types of accounts, including credit cards, retail cards, installment loans, and accounts held with financing companies, in addition to your public record information, missed or late payments,and the number of accountson which you have never had a late payment

Credit utilization ratio: the total amount that you owe compared to the total amount of credit you have available