Your credit score is a numerical value that reflects how well you’ve managed your credit over the last seven to 10 years. Lenders use your score to help them decide how risky you are as a borrower.
When lenders extend credit, their primary concern is that you’re capable and willing to repay the debt. They typically look at several factors to make this determination, including income, employment history, existing debt level, and credit score. Your income and debt levels tell lenders how much discretionary income you have. Your employment history helps indicate how stable you are financially. Your credit score provides insight into your spending and repayment habits.
Lenders use these factors to decide two things-whether or not to extend you credit, and the rate of interest to charge if a credit offer is made.
Riskier borrowers pay higher interest rates. That’s why understanding and managing your credit score is so important-because optimizing it can literally save you tens of thousands of dollars over your lifetime.
What is FICO?
FICO scores, developed by Fair Isaac Corporation, are the most commonly used credit scores. Your FICO score is calculated (by way of highly confidential algorithms) from the information contained in your consumer credit report.
The FICO scale ranges from 300 to 850, with a higher number meaning less risk for the lender. There are no set levels defining a good or bad score; this determination varies by lender based on its underwriting practices. Generally speaking, a FICO score of 750 or above indicates good credit management skills, while one below 650 is in need of improvement.
The information in your credit report is the source data for your FICO score. If you’re motivated to improve your FICO, you should start with a thorough understanding of your report.
There are three main credit reporting bureaus: Equifax, Experian, and TransUnion. These agencies develop and maintain consumer credit reports based on information they obtain from lenders. If you have no credit history, you’ll have no credit report. But if you’ve ever opened a credit card or taken out a mortgage, or a car or personal loan, you can bet that one or more of these agencies has a file on you.
Because not all lenders report to all three bureaus, your credit report might be slightly different from one bureau to the next. That said, the idea behind credit reporting is consistent: Each agency keeps a record of the type of credit you have available, how much you owe, how long your credit accounts have been open, and whether or not you pay your bills on time. The details of each report typically include:
- · Your name, social security number, date of birth, and current address.
- · A summary of each reported account, including lender’s name, type of credit, balance, and payment history.
- · All lender inquiries into your credit history over the past two years.
- · Negative items including missed payments, bankruptcies, tax liens, foreclosures, and legal judgments.
Depending on your background, this could be an extremely complex set of data. That’s why there’s a need for a scoring system-it provides lenders with a scale for making quick, objective assessments on your credit worthiness. If there was no credit scoring system, the debt qualification process would take much longer and the cost of managing debt would be much more expensive.
Checking Your Credit Report
The credit bureaus must provide you with one free copy of your credit report annually. You should take advantage of your free report in order to:
- · Verify that your credit information is accurate.
- · Check for signs of identity theft.
- · Gain a better understanding of how lenders see you.
You can access your free credit reports at www.annualcreditreport.com. Or you can purchase your credit report at any time by contacting Equifax, Experian, or TransUnion directly. See www.equifax.com, www.experian.com or www.transunion.com for further information.
Experts recommend checking your credit report a few months prior to a large debt purchase. That way, you’ll have time to dispute any inaccurate information before submitting your loan application. As you’ll see in Chapter 4, you can also start taking steps to improve your FICO score in the hopes of obtaining a lower interest rate on that big loan.
Fair Isaac Corporation doesn’t publicize its exact computations, but it does outline the factors that affect your FICO score. These are:
- · Payment History: Whether or not you pay your bills on time is the most heavily weighted factor in your score. Recent delinquencies affect the number more severely than late payments did just three years ago, and 90-day past-dues are more serious than 60-day past dues.
- · How Much You Owe: The FICO calculation considers how much you owe on revolving credit versus installment credit, as well as how much you owe in total. Carrying large balances on several different accounts will lead to a lower score. That’s because this often indicates that you may be overextended. Low balances relative to available credit imply that you manage credit responsibly. This has a positive effect on your FICO score.
- · Length of Your Credit History: All else being equal, a longer credit history generally means a higher FICO score.
- · How Much New Credit You Have: Taking on more debt in a short period of time could indicate that you’re struggling to make ends meet. Sudden increases in credit inquiries and new account openings will lower your FICO score.
- · Types of Credit You Use: The FICO score also considers how you manage various types of credit together. These include credit cards, auto loans, mortgage loans, etc. Credit cards have a valid place in a healthy credit mix, if they’re managed conservatively.
Not one, but three
In actuality, you have three different FICO scores. Differences arise for two reasons. First, as noted in Chapter 2, each credit bureau may have slightly different source information about you. Second, Fair Isaac provides each bureau with its own scoring formulation. The term ‘FICO score’ can refer to any one of the following:
- · BEACON-associated with Equifax.
- · Experian/Fair Isaac Risk Model-associated with Experian.
- · FICO Risk Score, Classic-associated with TransUnion.
When based on the exact same source information, the three separate scoring methodologies yield similar results. In other words, assuming your credit information is accurate at all three agencies, there shouldn’t be a significant variance from one score to another.
It’s a good idea to check your FICO scores if you’re planning a major debt purchase, like a mortgage loan or refinance. This information isn’t free, unfortunately, but it’s available for purchase at www.myfico.com. A word of caution: Verify that the information in your credit reports is accurate before purchasing your FICO score. Otherwise, you’ll end up having to purchase it again, once the information is corrected.
Tips for improvement
Big improvements to your FICO score don’t happen overnight; but the sooner you begin, the sooner you’ll see results. Start implementing the following strategies today and you’ll see lower interest rates in the future:
- · Pay Bills on Time: Set up automatic payments for as many of your bills as possible. It’ll save you time and keep you from incurring late fees.
- · Pay Down Your Balances: Be diligent about paying down more than you charge each month.
- · Keep Unused Accounts Open: Don’t close unused accounts-doing so may actually lower your FICO score. It’s better to keep those zero-balance accounts open so that you have more available credit relative to your total debt outstanding.
- · Limit New Account Openings: Only open new accounts when you need them. It’s true that having a larger amount of unused credit can raise your score, but opening several new accounts at once will actually lower it.
- · Shop for Debt Quickly: Lender inquiries affect your FICO score. When you’re collecting quotes for mortgage loans or car loans, don’t drag out your comparison shopping process. When inquiries happen over a shorter time period, the FICO calculation treats them as a search for one new loan, rather than as a search for many. One new loan won’t lower your score, but several will.
Finally, remember that closing an old account will not raise your FICO score or remove delinquencies or negative items from your report.
We now have multiple options in software to assist us in the best possible scoring models to raise your beacon score, who to pay, what to pay and how to pay, this can drastically reduce the time involved in procuring a mortgage loan and close much faster than before.
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