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Understanding Credit Scores


What's the big deal?

If you lend someone money, you want to be sure you get paid back, right? The same is true when you borrow money; whoever might lend you the money wants to know how likely you are to pay them back on time before they give it to you. A good way of predicting the chances that you’ll hold up your end of the deal is to look at how you’ve handled borrowed money (credit) in the past – your credit history.

Any credit you’ve been issued in the past gets reported to a Credit Bureau along with your payment record. The Credit Bureau compiles all that activity into a Credit Report, which is then run through a complex algorithm created by Fair ISAAC to compute your credit score. The better you are at paying back money at the agreed upon terms, the higher your score. If you aren’t so good at handling borrowed money … your score goes down. A lower score doesn’t necessarily mean you can’t get a loan, but the lower it is the more difficult it will be (and the more expensive it will be!) to get someone to lend you more money.

The information below will give you a closer look at the nature of a credit score and how vital it is to your financial health, along with tips to build, maintain and improve your score as well as how to address inaccurate information that might appear in your report.

How Do Credit Scores Work?

In the United States and Canada, when people refer to a credit score they are typically talking about your FICO score, developed by Fair Isaac Corporation. FICO scores are the most widely used and accepted credit scoring system and ranges from 300 to 850, with most people landing in the 600 to 700 range (the higher the score, the better). There are three different Credit Bureaus that gather, score and sell this information. They are Equifax, TransUnion and Experian.

Components Of FICO Score

When gathering and analyzing your credit activity, there are five areas that make up your score. They are:

1. Your payment history – about 35% of a FICO score
2. How much you owe – about 30% of a FICO score
3. Length of credit history – about 15% of a FICO score
4. New credit/credit inquiries – about 10% of a FICO score
5. Other factors – about 10% of a FICO score

Payment History – 35% The first thing a Lender wants to know is whether you’ve paid past credit accounts on time. Late payments, bankruptcies and charge-offs will certainly hurt your score, though the impact of each blemish diminishes as time goes on; the more recent the problem, the more significant the impact on your score. A regular history of on-time payments helps improve your score.

How much you owe – 30% FICO scores look at the total amount you owe on all accounts, how many of those accounts are carrying balances and what your total credit limit is. The closer you are to maxing out the credit available to you, the more your score will be pushed down.

Length of credit history – 15% Generally the longer your credit history is, the better. However, even a short but good credit history can contribute to a higher score.

New credit/credit inquiries – 10% Opening several new accounts in a short period of time represents a credit risk, which will negatively affect your score. FICO scores do a good job of recognizing and distinguishing between a search for multiple new lines of credit and rate shopping for a certain loan. So, if you are looking for a specific loan for a house or a car for example, it’s best to do so in a short period of time, such as 14 days.

Other factors – 10% Your credit “mix,” or the different types of credit you are managing, will have a small impact on your overall score. While not necessary, showing that you can manage Installment Loans (mortgage or auto loans) as well as Revolving Accounts (credit cards and retail accounts) is helpful.

Are FICO Scores Only Measure Used To Determine Whether I Get A Loan?

No. While FICO scores are very helpful, they don ’t paint a complete picture, so most Lenders will look at a variety of other criteria before making a credit decision. Some of these other factors include your employment history, current employment and income, the amount of debt you currently carry relative to that income, as well as specific underwriting guidelines. Taking a look at the complete financial picture may allow for someone with a low score to be granted a loan while someone with a higher score may not. The focus of this booklet however, is the FICO score.

While all three Credit Bureaus calculate your score in a similar manner, not all creditors report to all agencies. Since they don’t all have the exact same information, your score will vary somewhat from one Bureau report to another. Certain Lenders may look at your score from just one Bureau; however for a mortgage loan all three will usually be compared.

What’s NOT In Your Scores?

Your FICO scores will never include information about your race, color, religion, national origin, gender or marital status. In fact, it is against the law for a Lender to consider any of this type of information when making a credit decision, based on the Equal Credit Opportunity Act. FICO scores are designed to be a non-biased method to determine the likelihood of a person repaying a debt, and independent research has confirmed this fact. In other words, at any given score minorities and non-minorities are equally likely to repay a debt at agreed upon terms.

Are There Other Implications To Having A Low FICO Score?

Yes. Even though you may still be able to get a loan if you have a lower FICO score, that loan will cost you more money… potentially a lot more money. Let’s look at an example of how much a 30 year mortgage for $250,000 will cost you per month and over the course of the loan, based on your credit score:

As you can see in this particular example, a difference of less than 200 points in a FICO score added up to an additional $200,000 to the borrower over the life of the loan. It pays to pay attention to your credit!

“The FICO score has become the single most important indicator used by Lenders to predict whether you will repay [a loan].” – New York Times

You Can Check Your Own Credit Report

Now that you understand the significance of your credit score, let’s take a look at how you can check to see how you measure up, and what to do if you don’t agree with what you find.

Regardless of whether you’re about to ask for a loan for a large purchase such as a car or a home or not, you would be wise to review your Credit Report at least once per year.

Requesting your own Credit Report directly from the Bureaus will not affect your credit score, and each Bureau will provide you with one free report per year (remember to check with all three agencies). For more information on your free annual report, contact the Annual Credit Report Request Service at:

P.O. Box 105281
Atlanta, GA 30348-5281
1-877-FACT-ACT (1-877-322-8228)
www.AnnualCreditReport.com

If you want to order additional copies of your Credit Report within a given year, they can be purchased at www.MyFICO.com or directly from each of the Bureaus at:

EquiFax 1-800-685-1111 www.EquiFax.com

Experian 1-888-EXPERIAN www.Experian.com

TransUnion 1-800-916-8800 www.TransUnion.com

What's In The Report – How To Red A Credit Report

Each Bureau’s report will be slightly different, but each will have the same basic sections of information.

Consumer identifying information
Summary Information
Credit History
Public Records
Inquiries
Creditor Information

CONSUMER IDENTIFYING INFORMATION is simply that; information about you. It might include current and previous residences, phone numbers, employer, driver’s license number, etc.

SUMMARY INFORMATION includes the total number, balances and payments for each of the 5 different types of accounts listed below. Additionally, it will give the total number of accounts that are current, delinquent and derogatory, plus a count of those that don’t fall neatly into one of those categories. The 5 types of accounts are:

Real Estate – Mortgages (both first and second mortgages)

Revolving Credit – Credit that has variable payment terms, such as a credit card

Installment – Debts with fixed terms of repayment, such as a student loan or an auto loan

Other – Those accounts that don’t fall into one of the above categories. An American Express account is one example.

Collection – Accounts that are seriously past due which may have been reported to a collection agency or an attorney.

CREDIT HISTORY is all your current and past accounts; also sometimes called trade lines. Each account will show the name of the Creditor, the account number and the type of account. It will distinguish whether it is held as an individual or a joint account, the date the account was opened and whether it is currently open or closed. Additionally, information is provided on the following:

Balance and Limit – how much you still owe compared to the maximum limit or highest balance on the account.

Payment and Terms – what is the minimum monthly amount due, or the number and amount of monthly payments scheduled (for an installment loan).

Past Due/Charge Off – the amount of payment overdue as of the most recent reported activity, or, if it’s been written off by the Creditor as bad (called a “charge-off”).

While some reports have a summary written in plain English (such as “never pays late,” or “typically pays 30 days late”), other reports will use codes ranging from 1 to 9 with the lower number representing a good payment history. For example, R1 shows a good record for that Revolving Credit Line, while an I9 would show the opposite track record on an Installment payment.

PUBLIC RECORDS is a section you hope to see completely blank. Any publicly available information relating to your finances (it will not list arrests and/or criminal activity) will be listed here, and there is nothing good that gets recorded (for example, you won’t find your charitable contributions listed). What you will find are things like tax liens, judgments against you and bankruptcies.

INQUIRIES is a list of everyone that has requested to see your credit history, along with their name and the date the inquiry was made. An excessive number of inquiries, especially in the recent past, may negatively impact your score (though this is still a relatively small portion of your overall score). However, multiple inquiries for the same kind of credit (such as an auto loan or home mortgage) made within a 14 day window will only be counted as a single inquiry. The scoring system recognizes that you are shopping for the best rate on one loan as opposed to looking for multiple new lines of credit.

CREDITOR INFORMATION is the final section and it lists all the Creditors listed in your credit history as well as all potential Creditors that have submitted inquiries about you. The contact information, including phone numbers when available, are also listed here in the event you want to contact them.

IDENTITY THEFT – A GROWING CONCERN

Identity theft occurs when someone uses your name or other identifying information for their personal gain. By carefully looking over your Credit Report on a regular basis you can help protect yourself against identity theft. Identity theft is a growing concern as thieves acquire personal information such as credit card numbers or social security numbers to make unauthorized purchases, open new accounts or even take out loans in your name, making you ultimately responsible for the payments. If, after examining your Credit Report, you find suspicious, unauthorized activity, there are four basic steps you should take.

Contact the credit reporting agencies to place fraud alerts on your account.

Close any accounts where you see fraudulent activity happening.

File a report with the local police.

File a complaint with the Federal Trade Commission (www.FTC.gov).

Be sure to keep records of all your communications with these various agencies during the process, in case you need to refer to them later.

Mistakes In Your Credit Report

Aside form identity theft, you still may find some inaccuracies in your Credit Report. The following section will help guide you through the process to follow to address these issues. To ensure that your concerns are addressed as quickly and thoroughly as possible, you will want to send letters of dispute (it is recommended to send the letters by certified mail, return receipt requested, so you can document that the Credit Bureau received it). Send letters to both the reporting entity (the Creditor who is listing inaccurate information) as well as the Bureau(s) to which it has been reported. Be prepared for this to take some time because while the Bureaus are required to investigate disputes, they have 30 days to do so.

When writing your letter to the Credit Bureau(s), you should be sure to include the following:

Your complete name and address
A copy of the report with the disputed items circled or high-lighted.
Copies (NOT originals) of any documentation that supports your dispute.
An explanation of why you are disputing the information on the report, using facts to support your position.
A request for either deletion or correction of the information.

Be sure to keep copies of your dispute letter as well as copies of all materialsv you submitted with it.

You should send the same letter and information to each of the Creditors who reported the inaccurate information (their contact information can be found in the last section of the Credit Report). In addition to the above material, you should also request that the provider copy you on correspondence they send to the Bureau(s) (this may take up to 90 days). If they continue to report the matter to the Bureau, there will be a note on your Credit Report indicating the information is currently in dispute.

Helpful Tips And Information

Pay your bills on time. This is one of the most critical pieces of establishing a good score. A 30 day late last month is more detrimental than a 90 day late from a few years ago. If you have missed payments, get current and stay current.

Have credit cards, but manage them responsibly. Keep balances low. The best bet to improve your score is to pay off, or at least pay down, your Revolving Credit Debt. If you’re unable to do so, you might consider spreading your debt among multiple existing cards, trying to keep them below 50% of their limit. However… please note the next point:

Only apply for and open new accounts when you need them. Don’t get seduced by point of purchase offers to save a few dollars only to find you have far too many lines of credit open.

Don’t close old or unused credit cards as a short term strategy to help improve your score. Having “aged” accounts can be beneficial by showing you’ve managed credit for some time as opposed to being new to the world of debt management. At the same time, don’t open a lot of new accounts too quickly; it lowers the overall age of your accounts and may appear like you currently need to borrow a lot of money to just get by. Not a good thing for a potential Lender to suspect.

If you are looking for a large loan, for a car or home, for example, do your rate shopping in a focused time period, preferably 14 days. This will minimize the impact of multiple inquires to your credit history, and therefore your overall score.

Be aware that closing an account on which you have a late payment, or paying off a collection account, will not remove the information from your Credit Report.

Follow the suggestions in this article to monitor your Credit Report on a regular basis and take effective action as soon as possible if needed. Remember, ordering your own Credit Report will not affect your FICO score as long as you order directly from the credit reporting agencies or from an organization authorized to provide reports to consumers, such as www.MyFICO.com or www.AnnualCreditReport.com.

      

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