Your Credit Score

Did you know what the MEDIAN credit score in the US is?  it is:

• Where do you fall relative to that number? 
• Have you ever wondered what goes into these scores? 
• Who is responsible for calculating them?
• Is there anything can I do to improve them?
• How do I get mine?

Today, we are posting the next installment on our series or posts dealing with credit and will be discussing Credit scores.

These scores are calculated from the various data contained in your credit file, or credit report.  In the United States, the three main credit reporting agencies are Equifax, Trans Union and Experian and they all use a different formula to arrive at your score.  We generally advise our customers to purchase thier scores when the visit www.annualcreditreport.com and secure a copy of thier credit report.   See our post here for more information.  The cost ranges from $5 to $8 at each site.  You will see that the score have different names and may be different numbers, which we will discuss further below.  Many lenders, including ALTA, will generally look at the middle score, so if your scores are 765, 798 and 804, we call you a 798.

Fair Isaac is the company that developed the credit scoring formulas (FICO scores) that most lenders, and increasingly, employers, utility and insurance companies use to determine a consumers creditworthiness.  More information on Fair Isaac can be found at myFICO.com and also by clicking the links at the bottom of this post. 

Generally speaking, the information contained on your credit file is assessed as follows:

1. Payment History - 35%
2. Amount Owed - 30%
3. Length of Credit History - 15%
4. New Credit - 10%
5. Types of Credit Used - 10%

As one might expect,  the exact formulas and algorithms used to calculate credit scores are closely held proprietary information by Fair Isaac, so the above mentioned weights are about as close as we will get, and truthfully, they serve as a great guide as we begin to understand how the scores are calculated.  Scores can range from 300 to 850.  Also, Fair Isaac sells several different products to its customers, including the FICO, Beacon and Empirica brand names that you will likely see at the different credit reporting agencies. Each of these products is slightly different, which results in much of the same information begin scored differently at each site, but overall, when you consider that the ranges of each product are slightly different, the difference is minimal.  If you see a large difference, over 50 points, perhaps a closer inspection is warranted of the informatin contained in your report.  It may simply be a case of the timing that data was proivded, collected or reported.

When we begin working with our Real Estate and especially our mortgage customers, the first thing we ask them is if they are aware of the information contained in their credit file and what their credit score actually is. Because this information is used by lenders to determine their risk in a given situation, the higher the score = the more favorable rates and terms.  Many lenders have a tiered system of pricing loan products and the 2 point difference between a score of 698 and 700 can mean thousands of dollars to a borrower due to a different rate/term schedule.  It never fails to amaze me just how little most people understand these scores when you consider how important they can be.  Lets take a look at those criteria listed above...

1. PAYMENT HISTORY - with a 35% weight, this is obviously the single most important factor in determining a score.  Lenders want to know your history of making payments on time so that they can forecast the potential risk in extending you credit.  It should be noted, however, that one or two late payments of no more than 30 days will generally not have an extreme impact on an otherwise strong file. 
2. AMOUNT OWED - this may be the single most misunderstood factor, and at a 30% weight, begs a bit more education.  Because demonstrating that one can manage credit responsibly is very important to prospective lenders, effectively understanding this factor and making decisions consistent with the criteria is not only a good way to increase your score, but can serve as a good guidepost for future credit decisions.    Your score will take into account the amount owed on specific types of accounts.  In general, once an account balance exceeds 50% of the available credit limit, the account may be considered 'maxed out'.  For this reason, it is usually advisable to keep balances (on revolving credit)  at or below 40% of the limit.  On installment products, showing the ability to make payments on time, over time, is paramount, as not much can be done if a new car loan or mortgage account has just been opened.  Also, the number of accounts open and the number with outstanding balances are considered when determining whether or not a potential borrower is overextended and may have trouble making payments on time or at all.  It is important to note that arbitrarily closing accounts is not a silver bullet to increase a score.  In fact, it may even have an adverse effect as it could decrease your ratio of used credit to available credit. One last very important thing to look for when calculating balances/limit amounts on a credit report, and an item that gets very little notice, is whether  or not the credit information provider provides the credit reporting agencies with a high limit.  Capital One is a popular credit provider that does not provide a limit in all cases, but others do it as well. The result is that the score calculating software will look for a number to use when calculating the amount of available credit, and generally substitutes the high BALANCE for the high LIMIT.  Consider the following scenario:  Your credit card has a credit limit of $5000 and your first purchase after opening it is $2000, which puts you at 40% used/60% available, not a bad place to be, and not an unfavorable impact on a score.  However, if the vendor does not provide the credit reporting agencies with the high limit, the software may substitute the high balance of $2000 for the  limit and calculate your available credit as 0%, and even after several months of on time minimum payments (always a good thing) your ratio of used to available credit will still have an unfavorable effect on your score.  We will cover this again when we discuss reading your report, but always check to see that a high limit is provided and it is correct.  IF you find that you have an account like this, at least you now know to keep your balance at less than half of the high balance! 

3. LENGTH of CREDIT HISTORY - Generally speaking, a score takes into account how old your oldest account is, how new your newest account is, and the average of all of your accounts.  While not much can be done about this, a couple of things bear mentioning:  Most mortgage lenders will require at least three open trade lines, so it does no good to have only 2 open trade lines just to keep from opening a new account.   Also arbitrarily closing one or more seldom or non-used accounts can have a negative impact on this factor as well, if the accounts closed are older and have an unfavorable effect on the length of history.

4. NEW CREDIT - According to myFICO, research has shown that people opening several new credit accounts over a short period of time represent a greater risk, more so with people that do not have along or established credit history.  Multiple requests can have an unfavorable effect also, however, the scoring mechanisms are designed to differentiate between someone who is rate shopping for a specific product (car/mortgage) over a relatively short time frame and ultimately opens a new trade line consistent with the types of inquiries made, and someone who is consistently denied and continues to apply for credit.
5. TYPE of CREDIT USED - Last but not least, lenders (and the scoring models) like to see a healthy mix of credit types to demonstrate that one can manage different credit options.  This may or not have a large an impact if your history shows a number of products, but if one only has revolving accounts, it may be more important.  What they are looking for is a healthy mix of installment (auto/mortgage/equity lines) and revolving (credit cards/store cards)  Our Mortgage underwriters tell us that in a perfect world, they like to see at least one or two installment products, at least one major bank credit card and perhaps a few department store cards, of course with the balances and payments as discussed above.

Whew! that was a bit more than I had originally intended, but there is a lot to know!  As I said, the links below will go into more detail, including what is NOT included and/or considered in your score.  Please do not hesitate to contact us with any questions or comments

• Your Credit Score
• Understanding your FICO Score

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