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Credit and Credit Scoring
Credit scores have become more of a factor in people’s lives than ever could have been imagined. Your credit and credit scores can affect your ability to buy a home, get a car, get a credit card, take out a personal loan, obtain homeowner’s insurance, obtain auto insurance, get overdraft protection at your bank, rent a home, sign up for home utilities (such as gas, cable, phone, etc…) apply for a job and the list goes on and on. Without good scores your applications for any of the above can be turned down altogether, you may be required to place large deposits down, and/or you may have to settle for very unfavorable terms. So therefore you can see the importance at keeping your credit scores as high as you possibly can. However, understanding how the credit scoring process works, is a task that most people don’t understand.
Credit and credit scoring are extremely important in just about everyone's
life, actually probably way too important. Credit and credit scoring are
most important to anyone who will ever need to obtain financing for a new
car, for a new home, or any other major purchase that they simply can not
afford to pay cash for. While some people think it is better to simply never
utilize credit, get credit cards, or buy anything that you can not pay cash
for, this just simply is not a reality for most people. Most people want to
buy homes and for this you need to have credit and a good credit score to
demonstrate that you deserve a good interest rate. While you may be able to
buy a home without having any credit, generally you will not be able to
receive the best rates that are available without a credit history.
Credit scoring is a complicated process and each of the 3 major credit repositories have their own credit scoring models in place to determine a borrower’s credit score. The 3 main credit repositories are Equifax, Experian, and TransUnion. Equifax has credit scores that range from a lowest possible score of 300 and a highest possible score of 850
Experian has a range of 340-820 and TransUnion150-934. Just like computers have upgraded operating systems over the years such as, Windows 98, Windows 2000, and Windows XP, the credit scoring system versions update periodically also. Not all lenders use the same version or the most updated version when obtaining a credit report and credit score for a borrower. Therefore, this is one reason why you may have varying credit scores between one lender and another.
There are five major components or factors that help to determine your credit score. Roughly 35 percent of your credit score is derived from your payment history, 30 percent from how much you owe compared to how much you have available, 15 percent comes from length of credit history, 10 percent from new credit and recent inquiries, and the final 10 percent comes from various other items such as the mixture of credit you currently have. Next we will discuss each of the five components in further detail and explain the basic principals as to how credit scoring works. This information is to be used only to help educate and as a guide to assist with the basic ideas involved in credit scoring.
Types & Mixture of Credit (10%)
Having a mixture of the various types of credit will have a small impact on your credit scores. For a person who has a good mixture of credit such as a home loan, auto loan, 2-4 credit cards and maybe a personal loan this could be deemed a good mixture of credit versus a different person who has 15 credit cards and no other credit. The ideal number of credit cards to maintain is 2-4. Also, other types of liabilities are important to have, such as installment loans and a mortgage loan.
“Knowledge is power” and the most important step to applying for a loan is to understand your credit report, your credit scores and how credit scoring works. It is highly recommended that every person checks their credit report at least once per year to help protect themselves from inaccurate information and from identity theft. A new law was recently passed that permits a borrower to have access to their credit report one time each year for no charge to allow them the opportunity to review their credit history and verify the accuracy of all items listed. You are permitted to obtain a credit report from each of the three credit repositories, TransUnion, Equifax, and Experian. You can get obtain your free report by logging into: http://www.annualcreditreport.com/ and following the directions. When you obtain your free report it will not contain your credit score, but you can pay a small fee if you would like to find out what your score is when you are ordering your free report. It is also highly recommended that you pull a report from each repository individually as opposed to all of them together so that you can dispute any erroneous information to each bureau separately. If you report a problem to only one of the bureaus it will not be fixed among all three of the bureaus. Remember the bureaus are separate of each other and have no communication amongst each other either. Some creditors report to only 1 bureau, some report to 2 bureaus, some report to all three bureaus and some don’t report to any. This is why you must make sure that you check all three credit repositories when you are utilizing your free annual credit report. In conclusion, your credit is very important and understanding the basics of how your credit scores are obtained is equally as important.
New Credit and Inquiries (10%)
The amount of new credit you have opened, will have somewhat of a minor impact on your credit scores. If you have numerous inquiries resulting from applying for a lot of new credit and add many new trade-lines in your credit report, this can have a damaging effect on your credit score. First, it may negatively affect your scores because you have a lot of new, un-established accounts. Second, it can negatively impact your score because you have a lot of inquiries with various lenders for various types of financing over a short period of time. Credit inquiries can affect your credit score, not a ton, but enough to lower your score. This is not to say don’t shop around or don’t have more than one firm pull your credit when looking to buy a car or a home. You definitely should use due diligence and shop between a couple of lenders to make sure you are getting a good deal. When you are comparing quotes however, you should try to do all of your shopping within a 30 day max. period of time. All inquiries that are made when applying for an auto loan or a mortgage loan are treated as only one inquiry when they are done within a 14 day period of time. Therefore if you are ever told to not have anyone else pull your credit or else your scores will lower, this has little truth to it. There is only one type of credit inquiry that counts toward your credit score. That one type of inquiry is when you are making an application for credit: such as a home loan, auto loan, credit card, etc… When you pull your own credit, a creditor you already have an account with pulls your credit, and/or a prospective employer pulls your credit, these do not have any impact on your scores. Understanding this can help you make sure that you do not fall victim to all of the urban myths regarding credit inquiries.
Length of Credit History (15%)
The longer and more established your credit history is, the better and more positive of an impact it can make. Someone who pays their bills on time for a 10 year period of time is a much better risk than someone who only has a 1 year history of paying their bills on time, even if they both carry the same credit score. When you pay off credit card accounts do not close them, keep them open and use them periodically in order to continue to build an established length of credit. Closing your accounts can actually have more of a negative affect on your credit score due to limiting the length of time that particular account was open for. The longer you have established credit accounts, the better it is for you. It is possible to still have a good credit score with a short credit history; however lenders may not approve you for optimal financing options due to the lack of history still.
Revolving Credit Balances to Maximum Limits (30%)
The second biggest factor in credit scoring comes from how you utilize your revolving credit. The credit scoring models are going to look heavily upon how much revolving credit you have available compared to how much you have used. For credit scoring purposes, having all revolving credit or credit card accounts maxed out to their limits is not a good thing, nor is it going to help better your credit scores. You don’t want to pay off all of your revolving credit accounts because that will not show the credit bureaus how well you manage your credit. Your ideal credit ratios should be roughly 20-40 percent usage. What this means is that if you have a credit card with a $1000 limit you do not want to max. out the credit card balance, but you would want to maintain a balance between 200 and 400 dollars. If you do realize that you have borrowed more than 50% of your available credit limit on your card or your balance is getting close to your limit, you should either try to pay your balance down to the 40% mark or call your credit card company and see if they are able to raise your limit. The biggest mistake you can make is to let your balance exceed your maximum credit limit. This will negatively affect your credit score a great amount.
Payment History (35%)
Your payment history is the most important factor of credit scoring. Bankruptcies, collection accounts, slow pays and late payments, foreclosures, judgments, and liens can negatively affect your credit score. However, an established history of on-time payments and a clean credit history will positively impact your credit scores and help to increase them over time. The older any negative credit history or adverse credit factors are, the less they will negatively affect your credit score. Therefore, recent late payments or other derogatory credit will negatively affect your credit much greater than aged bad credit.
Some quick tips for helping to increase your credit score:
Pay all accounts on time and make sure you do not go past 30 days late
Avoid allowing any accounts to go into a collection status
Avoid bankruptcy
Never max. out your credit cards
Keep you balances 40% or lower from your credit limit on revolving credit
When shopping for a mortgage or auto loan try to do it within 14 days so that it only counts as 1 inquiry
Do not close revolving accounts after you pay them off
Don’t go crazy applying for a lot of new credit. Use some common sense
Establish a long history of credit
Don’t think that if you pay for everything in cash and don’t have any credit that this is good for you. It may help your debt to income ratios, but it will not necessarily help with financing for a mortgage or with having a good credit score.
Do not live on credit cards and manage your credit wisely
Be responsible when utilizing credit and don’t over extend yourself
Here is a quick contact list for the 3 main credit repositories:
Equifax Credit Bureau P.O. Box 740241, Atlanta, GA 30374-0241 * (800) 685-1111 * www.equifax.com Experian (Formerly TRW Credit Bureau) P.O. Box 949, Allen, TX 75013-0949 * (888) 397-3742 * www.experian.com Trans Union Corporation (Credit Bureau) Consumer Disclosure Center P.O. Box 390, Springfield, PA 19064-0390 * (800) 916-8800 * (800) 682-7654 * (714) 680-7292 * www.transunion.com
To obtain your free annual credit report, which is highly recommended, visit:
http://www.annualcreditreport.com/ Credit Scoring - How are credit scores determined? What is the highest credit score possible? What credit score do I need for a mortgage? Why do I have three different credit scores? What do my credit scores mean? These questions are all very common questions regarding credit scoring. Read through this web-page and you will discover the answers to the above questions and many more. Your credit score is based on a number of different variables such as your payment history, your credit utilization, variety of credit, number of credit inquiries within a certain period of time, length of your credit history and the amount of credit you have available to you. You wouldn’t believe how common it is! The biggest credit mistake that most of us make is closing our old paid off credit cards. I know that is seems like the right thing to do when you pay off the balance but 15% of your FICO score is made up of your credit history. If you close a credit card with no current balance that you’ve had for years, you are getting rid of a lot of your credit history. The most important factor in determining your credit score is your payment history. Nothing hurts your credit more than making late payments on any of your debt. It is suggested that if you are used to paying off all your credit cards each month but have fallen on hard times, then it is better to make the minimum payment on each card than to make one late payment. You should review your credit report at least once a year to ensure there is no erroneous information on it. Credit bureaus are required by law to issue you one free credit report each year upon request. In order to obtain this report, simply request it in writing from the credit bureau. Many banks allow loan applicants with perfect credit history and high credit scores the convenience of furnishing less or even no income and asset documents such as tax returns and bank account statements. Such conveniences are not offered to home buyers with low credit scores without penalizing them with higher interest rates. Many loan programs have rate adjustments for lower credit ratings. There are some loan programs, such as FHA loans, which are not credit score sensitive but rather look at your overall credit picture. There are three different credit report bureaus. They are Trans Union, Equifax and Experian. Each bureau will report a score based and many variables. If you have a limited credit history you may not have three scores, you may only have one or two. Lenders view your credit report as your financial report card. It tells them your ability to pay back a loan on a timely manner. Review your report annually to correct errors. The most widely used credit scores are FICO scores, which were developed by Fair Isaac & Company, Inc. (hence the initals FICO). Your FICO score is between 350 (high risk) and 850 (low risk). When applying for a mortgage, credit scores are one of the main factors that will be used to determine your eligibility for various loan programs. The higher your score, the more options you will have. If you have a minimum of 20% to 25% equity in your property, in certain cases we can approve you for a loan with no credit scoring based solely on your good mortgage payment history and liquid financial reserves. The three credit bureaus use a credit, or FICO score, as a general estimate of your ability to repay a loan. Lenders will consider the FICO score in determining the interest rate to charge you. To improve your credit score make your payments on time. Also pay down your credit balances. Contact a mortgage broker for more information on improving your credit score.
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Information listed above is to be used for educational purposes only and is not guaranteed
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