Credit Info

A Credit Score Primer

fico credit score distribution

If you’re like any other good young professional, you would have noticed a particular type of commercial at three in the morning. Their tag lines may include the following:

“Bad Credit Score? No Problem!” — “Low Credit Score Okay!” — “No FICO Score Required!”

Just what is this magical credit score that’s often mentioned in these entertaining and informative late-night infomercials?

In the United States, a credit score is a number usually between 300 and 850. These numbers are generated based on an analysis of a person’s credit history, and are thus a representation of your creditworthiness (or put more simply: are you going to pay the man or not?). The higher the number, the higher your creditworthiness and thus the lower the risk you are to lenders. Having a high credit score is one of the best money saving tips we can give you.

Because of their use as a measure of creditworthiness, credit scores can affect your ability to acquire many things: an auto loan, a mortgage loan, even insurance. Whether you like it or not, you will most likely have your credit score examined and prodded at many points in your life. Besides the ability to acquire credit, credit scores can also affect your interest rates — especially that of your mortgage loan. For example, a high credit score that obtained a low rate of 5% versus a low credit score that obtained a high rate of 7% will amount up to thousands of dollars in extra interest (and monthly payments) over the course of a mortgage term. (On a $300,000 mortgage, you would fork over $418,526  in interest over 30 years with a 7% interest rate, compared with $279,767 with a 5% loan.)

Without a doubt, it’s crucial to get a clear understanding of how credit scores work, what general factors make up a credit score, and how you can improve your scores (if necessary).

The Basics

Credit scores are based on credit histories that are compiled and sold to creditors by the three major consumer credit reporting agencies: Equifax, Experian, and TransUnion. Because your credit report may differ from one credit bureau to the next (most creditors don’t report activity to all three bureaus), so will your credit score. If your credit file from Experian includes an account that has had a few late payments, but the creditor doesn’t report this account to TransUnion, for example, your Experian credit score will be lower than your TransUnion score.

If you thought that was a headache, consider this: a credit score from one source can be vastly different from another– and even irrelevant, depending on the company that calculates it.

That’s because in addition to the so-called FICO scores — the most widely-used credit scores calculated by the Minneapolis, Minn.-based company that goes by the same name — there are a slew of so-called educational credit scores that may give you a fair idea of your credit standing, but are not used by any lenders whatsoever. These scores may differ widely from the three-digit number of your FICO score because they use different algorhithms and ranges. To keep things simple and relatively sane, we’ll focus on FICO scores.

FICO Who?

Just as you can’t compare an ACT score to an SAT score (although both are a measurement of your academic performance), you cannot compare a FICO score to other types. After all, they’re computed by different companies, with different formulas, and often using different information.

Although how FICO scores are computed is a closely guarded secret, Fair Issac has given a general guideline to the make-up of a FICO Score.

Here’s a breakdown of the main factors used to calculate a FICO Score:

35% – Payment History: How you pay your bills significantly affects your credit score. Paying on time and paying the required amount is imperative! The difference between paying a bill 60 days late versus 90 days late can also have an effect. So does the number of past-due accounts in your credit report versus the number of on-time accounts.

30% – Types of Credit Used: FICO likes to see a mix of different types of credit — including credit cards, installment loans (student loans fall into this category), mortgages, and consumer finance accounts.

15% – Amounts Owed: The proportion of used credit vs the available credit you have for each revolving account, as well as the same ratios across all revolving accounts.

10% – Length of credit History: The longer you’ve been using credit, the better for your credit score.

10% – New credit: Your brand-new Hello Kitty credit card will fall into this category, which includes the average age of your various credit lines, as well as how soon you opened a new line of credit. The credit inquiries made on your credit files will also affect your credit score. (An inquiry hits your report whenever you give permission for a third party to check your credit history in order to obtain credit or service, but not when you check your own credit or a third party does a so-called soft inquiry to pre-qualify you for “preapproved” credit offers).

Other factors: Those include bankruptcy, foreclosure and judgments, which affect scores significantly. Most will stay on your report 7 years or longer.

Things that do NOT affect your score: Your employment history and your income. So yes, you might have better credit score than Bill Gates. Though on second thought, he probably doesn’t need consumer credit.

Although your income and your employment history aren’t factors in a FICO score, they may still come into play when you’re applying for credit: after all, banks generally enjoy lending money to people who have the income to repay the loan.

How to Improve Your FICO Score

Now that you know what makes up a FICO score (and generally, most credit scores), you can most likely guess how to make sure your FICO score is in the best shape possible.

Pay on time. Even if you can’t afford to pay in full, send in that minimum payment on time. (Don’t just pay the minimum, though, or you’ll hardly get anywhere.)

Vary your types of credit and limit unnecessary credit accounts. A healthy credit report will have a good mix of revolving accounts (credit card accounts) and installment loans.

Don’t max out your credit card. When you use up your credit limits and affect the available credit ratio, your score will be affected negatively. Keeping your balances low will not only reduce the interest incurred, it will also improve your credit score.

Don’t go on an account-opening binge. As you open up new accounts, you will be lowering your average account history length. Generally, the longer you’ve had an account with a good payment history, the better your credit score. Thus, you should never close a credit card account unless it is costing you money (though high annual or other fees).

Don’t apply for too much credit, either. A large number of credit inquiries placed on your credit file will lower your score. You should note, however, that when you shop for a mortgage inquires made by mortgage lenders within a 30 day period will all be counted as one inquiry (a good thing too, since most people should carefully select their mortgage loan).

The Ever-Changing Scores

Credit scores change daily, as information on your credit report is updated daily. Generally, you will see more changes from month to month, as your account balances update and various information gets computed into the score (for example, an inquiry or late payment falls off the credit report).

Even if you have bad credit or a low credit score right now, fear not. With due diligence and time, you can improve your score by making sure you follow the steps outlined above. Just starting out? Even better. Take the proper step now to ensure you don’t damage your credit.

Remember, it takes months and years to build up good credit — but it can take as little as a day to ruin it.

This post was written by Cap of StopBuyingCrap.com.