After years of delays, the credit industry finally agreed to give consumers access to their personal "credit scores." This is important, because lenders use credit scores to determine who to give credit to and at what rates. Knowing your credit score can be empowering-if it's low you can take steps to improve your credit worthiness and if it's high you may be able to use it as leverage when shopping for a loan.
Usually referred to as a FICO score (named for Fair, Isaac and Company, the business that develops the most widely used credit scoring formulas), your credit score is simply a numeric summary of your credit history compiled by the three major credit bureaus-Equifax, Trans Union, and Experian. Using mathematical models developed from the behavior patterns of millions of borrowers, credit bureaus assess the likely risk of a extending you credit or lending you a sum of money. The formula looks at such things as your outstanding balances, total available credit, late payments, and the age of your accounts. The more traits you share with people who have proven to be good credit risks, the higher your score.
FICO scores range from 300 to 850 points-the higher the score, the lower the predicted risk to creditors. Because every lender has a different model of what's acceptable, so there is no standard scale. As a general guideline, the median FICO score (half of consumers score above, half score below) is about 725. To qualify for the best loan rates, borrowers generally need scores above 760. Consumers with scores below about 620 will pay significantly higher rates and fees to obtain a loan.
Keep in mind that lenders look at many things when making a credit decision, including your income, how long you have worked at your present job, and the kind of credit you are requesting. Since they factor in additional information and sometimes consider special circumstances, lenders may give you credit even if your score is low, and may refuse you even though your score is high. Still, your credit score counts heavily in your ability to get credit on good terms. What the FICO Score Measures
The five main categories of information that the FICO score evaluates, along with their approximate weightings, are:
Forewarned is Forearmed
- Payment history (35%)-Aside from extreme events, like bankruptcy or tax liens, late payments have the greatest negative impact on your score. Recency and frequency of late payments count too. In other words, even though a 60-day late payment is not as risky as a 90-day late payment in and of itself, a 60-day late payment made just a month ago will count more than a 90-day late payment from five years ago.
- Outstanding balances (30%)-Evaluation of your total balances in relation to your total available credit on revolving accounts is one of the most important factors in the FICO score. Owing a great deal of money on many accounts or "maxing out" on various credit cards can indicate that a person is overextended, and is more likely to make some payments late or not at all.
- Length of credit history (15%)-Your score takes into account how long your credit accounts have been established in general, how long specific credit accounts have been established, and how long it has been since you used certain accounts.
- New Credit (10%)-Research shows that opening several credit accounts in a short period of time does represent greater risk-especially for people who do not have a long-established credit history. Multiple requests will reduce your score because it looks like you are either trying to get a high amount of credit (possibly because of a cash flow problem) or that you are being rejected by lenders and having to apply elsewhere.
- Types of credit (10%)-The score will consider your mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. Your score takes into account what kinds of credit accounts you have, and how many of each. The score also looks at the total number of accounts you have.
Early numbers show that many consumers recognize the relationship between their credit score and their purchasing power. Craig Watts, consumer affairs manager for Fair Isaac Corporation, reports that there were 40 million unique visits to www.equifax.com
. (where you can order your score, plus your credit history, for $15.95). Based on e-mail messages Fair, Isaac has received from consumers visiting the site, it looks like many customers obtaining their scores are in the early stages of hunting for a mortgage or auto loan. Some have indicated that they plan to use their scores as leverage with prospective lenders.
Rick Harper, director of National Foundation for Credit Counseling (formerly known as Consumer Credit Counseling Service) of San Francisco, agrees that awareness of scores empowers consumers in general, and is particularly important for hopeful homebuyers. "The more the public understands scores, the more confident they can feel about the home-buying process and the less likely they are to become victims of predatory lending. Know your score before shopping for a loan and ask prospective lenders what the minimum acceptable score for the very best rate is. Armed with this information, the consumer can shop around for loan terms more effectively."
While scores may be particularly important to homebuyers and other borrowers, they should be of interest to all consumers. Even if you don't plan to borrow money, you may find yourself in a situation where you need credit-perhaps to take advantage of an opportunity or to get through an emergency. And it's not just lenders who look at your credit history to make decisions. Some employers, insurers, and landlords also refer to credit reports when qualifying applicants.
Knowing where you stand allows you to build an action plan to improve your credit record. Consumers with a good credit history and, accordingly, a high credit score, have many more options available for achieving their financial goals. And isn't that what financial freedom is all about? How to Improve Your Credit Worthiness
Your credit score is a "snapshot" of how risky you appear to be at any particular point in time. The snapshot changes as new information is added to your bank and credit bureau files. That's good news for consumers with less-than-perfect credit: Even if you've mishandled credit in the past, you can gradually improve your credit worthiness by handling credit more responsibly now and in the future.
The best and fastest ways to improve your credit worthiness are to pay all bills on time, pay any delinquent bills, and lower your total credit card debt.
How to Get Your FICO Score
- No matter how many cards you carry, it's a good idea to keep the ratio of outstanding balance to total available credit as low as possible. Credit scores look at how much of your available credit you've used. When you're close to the limit, you look out of control. From a score-lowering perspective, debt reduction should start with the cards on which you're closest to your credit limit (though from the point of view of shrinking the overall amount of your debt, it's best to pay off your highest-interest-rate cards first; see ASK SUZE on DEBT, pages 78-85, or THE ROAD TO WEALTH, Pages 27-32.) Be aware, however, that paying off a collection account or a judgment will not remove it from your credit report. It will stay on your report for seven years.
- Research shows that consumers with longer credit histories have a lower risk of default than those with shorter credit histories. However, even people who have not been using credit for a long time may get high scores, depending on how the rest of the credit report looks.
- Don't close unused credit cards as a short-term strategy. In fact, owing a fixed amount but having fewer open accounts may lower your score. Conversely, don't open a number of new credit cards that you don't need, just to increase your available credit. This approach could backfire and actually lower your score.
- Every time someone requests your credit report from a credit bureau, an "inquiry" notation is made in your file. Too many inquiries on your credit report can signal looking for new credit and may lower your score. You should apply for credit only when you need it and wait before applying for more. FICO scores can usually identify "rate shopping" in the mortgage- and auto-lending environment, so that you are not penalized with multiple inquiries related to one credit transaction. To be safe, it is a good idea to do your rate shopping for a given loan within a short period of time. (Note that if you order your credit report from a credit reporting agency to check it for accuracy, it will not affect your score, as it is not an indication that you are seeking new credit.)
- Someone with no credit cards tends to be a higher risk than someone who has managed credit cards responsibly. Still, it is not necessary to have one of every type of account, and it is not a good idea to open credit accounts you don't intend to use.
- You don't improve your credit worthiness by carrying balances forward from month to month (as opposed to paying each bill in full), but lenders may be more likely to offer credit to people who carry balances because they have a history of paying interest on their accounts.
- If you are having trouble making ends meet, contact your creditors or see a legitimate credit counselor. (To find a credit counselor near you, call the National Foundation for Credit Counseling at 800-388-2227 or look for them on the Web at www.nfcc.org.)
You can get all three FICO scores and credit reports at www.myfico.com
. You can also try to get your score by asking a lender you've submitted a loan application with; some will reveal it and some won't. Correcting Errors
Consumer organizations advise people to review their credit report every year or two, particularly before making a large purchase like a house or a car. This makes it possible to correct any inaccuracies before applying for credit and/or to catch any fraudulent activity using your identity. If your score seems surprisingly low, check for inaccuracies in the credit report that generated the score.
If you do find errors in your credit report, contact the credit reporting agencies directly: