In a world where the fate of your employment, housing, insurance rates, and ability
to get a loan is often based on how good your
credit score is, it is important to understand the various scoring systems
and what steps to take to improve
your score.
It would be nice if everyone used the same credit scoring system. However,
multiple scoring systems and models are used by potential employers, landlords,
and lenders. And, unfortunately, consumers only get access to a few of these
available scores, which generally don't even match the scores creditors see.
The only exception is one of the mortgage industry's models offered by the Fair
Isaac Corporation. And since the mortgage industry does use other scoring
systems, even in this case what you see will not always be the same as what the
lender sees.
We recommend when purchasing
credit scores that you pick one system or product and stick with it (there
are several options currently available, including a couple of free credit score
offers that may be of interest). Don't try looking at multiple scoring systems
because there is no way to compare the two when you don't know what the specifics
are from one to the next. And there is just no way of finding that information
out either since the credit scoring companies keep this information confidential.
To demonstrate how scoring works let's look at the auto loan model. An auto
lender scoring system is going to look at all consumer
credit reports containing auto loan accounts. The scoring scale created
is based on this group of credit reports. They look at credit trends prior
to, during, and after the auto loan. When you apply for a loan with them,
they compare you to the sample group to see if your score matches their requirements
for a good auto loan customer. Every industry has customized scoring systems
that categorize groups of people which they use as a base to compare the scores
of potential customers.
Following are the basics of what is shared with consumers. This is not all
of the equation by any means, but rather a guide for improving your personal scores
with the hope that it has the same affect on lender scores.
About 35% of your score is affected by your Payment History.
For example, late payments, collections, charge offs, bankruptcies, judgments, and
liens will hurt your score. And it is all time based. The older the
information, the less it contributes to your scores. Usually the two most
recent years hurt credit
scores the most. Also, one type of derogatory listing is usually not
more harmful than another type. For example, a five year old collection item
will affect your score less than a 30 day late payment a month ago.
About 30% of your score is affected by Utilization. It is
better to have several accounts with low balances distributed among them than it
is to have fewer accounts maxed out (at or near the credit limit). Use the
following equation to determine your utilization.
Your Current Balance / Your Credit Limit = Your Utilization Percentage
The lower the percentage the better and lower than 30% is recommended per account.
By far the fastest means for increasing your overall
credit score is either paying down
debt or increasing your existing credit limits to more than what you are
actually using.
About 15% of your score is affected by your Established Credit History.
The longer you maintain open accounts with creditors the better. When you're
first starting out this is not easy. One effective method to establish credit
is to be added as an Authorized User to another person's established credit account.
It is important that this person has an account that has a long credit history,
clean payment record, high credit limit, and low balance. You also need to
check with the creditor to ensure they have a policy to report authorized user accounts
to all three major credit reporting agencies.
When establishing these accounts, I recommend you turn over the extra credit card
to the owner of the account. There is no reason to be using this account and
you should respect the individual helping you out in this matter.
Credit Tip! Authorized user accounts are a great way to establish
credit since you are not legally responsible for the
debt as would be the case with Joint or Co-Signer accounts. You will
eventually want to end your relationship with these accounts as your own credit
improves and as you apply for major loans like mortgages. The reason for this
is that mortgage lenders commonly make the mistake of figuring these accounts in
the debt to income
ratios, which can hurt your chances of getting approved for a mortgage.'
About 10% of your score is affected by Credit Inquiries & New Credit.
Don't apply for credit unless you know you can get it or that you need to get it
because unnecessary credit inquiries are going to hurt your scores' especially if
your overall credit file is small to begin with or you have
bad credit history existing
on the file.
Credit Tip! When applying for credit, pull your own
credit report first (this is called a soft inquiry and won't hurt your scores).
With your credit report in hand, go visit local banks or credit unions. Show
them the reports and don't allow them to pull a credit report of their own unless
they can say for sure you will be approved. This way you save unnecessary
pulls on your credit report if they decline you. If they say you are approved,
then they will need to pull a credit report to seal the deal.
The mortgage industry has the following special rule for inquiries: all applications
for credit resulting in pulled
credit reports within a 14 day period of time will only count as one inquiry
and will be suppressed from affecting
credit scores for 30 days.
The auto industry also has a special rule for inquiries: all inquiries will be suppressed
from affecting credit score for 30 days.
About 10% of your score is affected by your Mix of Credit. Use
different types of credit (revolving, installment, auto, mortgage, etc.).
Average recommended revolving accounts is no more than 3 or 4 credit cards.
If you know you have too many revolving accounts, then it is a good idea to open
up an installment loan to extend the type of credit used. I recommend no more
than 2 or 3 installment loans.
Keep in mind how much these different factors affect your scores. And if you
can get more for your efforts by breaking smaller rules, then it may be in your
best interest to do so.
For example, having more than 3 or 4 credit cards can be beneficial (mix of credit
only accounts for 10% of your score) if you have good utilization on the existing
accounts (utilization accounts for 30% of your score). Don't be afraid to
resort to trial and error to improve your
credit!
Also, remembering the advice your lender gives is useful for getting a loan, but
not always good for your
credit scores. If they tell you to consolidate and close accounts,
be careful how you go about this. People's compliance with lender's advice
often results in dropped credit scores because they are shrinking their overall
available credit limit versus balances. Remember you don't want to hurt your
utilization by consolidating and closing accounts.''
The best advice is to:
Make financially sound decisions.
Go with companies which provide the best rates.
Avoid personal finance companies if at all possible. They usually charge higher
rates then banks and credit unions.
Credit reporting agencies sell many different scores produced by them as well as
other companies (Fair Isaac being one of the biggest). Here are the common
scoring systems each agency resells from Fair Isaac:
Experian - Fair Isaac
Equifax Beacon
TransUnion Emperica
Now it gets even more complicated than this because each of these companies break
the scores down further into industry specific models. Each model is tailored
to meet a specific industry's needs based on key financial information that affects
their business. Examples include mortgage lenders, personal finance companies,
credit card companies, auto dealerships, and insurance companies.
This does not mean you can't utilize your scores and build upon them. Each
time you view your credit
scores, you will normally see negative items listed that are hurting your
scores. Focus on improving those particular areas and check your scores regularly
to monitor your progress.
Finally, when
monitoring your score, you should give yourself a 50 point cushion to be
on the safe side of what a lender might see. Sometimes lenders will see a
higher score than you will, but not often.