Your Credit Score

YOUR CREDIT SCORE

Cash may be king – but without a certain credit score you can’t even open a bank account. Credit scores are used by every single sector of our economy today.  Without a “good” score you can’t buy a car or home, rent an apartment or obtain a credit card.  There are whole industries devoted to those who don’t have that good credit score and low scores will cost you more for everything from auto insurance to cell phone service. 

What Is A Credit Score?

A credit score is a numerical value assigned you based upon a variety of factors and sub-factors discussed in more detail below.  It is designed to give would-be creditors and lenders an idea of how likely you are to keep an account current or repay a loan.  The numerical score ranges from a low of 350 to the highest possible value of 850.  Sometimes these are referred to as your FICO score after the company Fair-Isaac who was instrumental in developing the methods and algorithms used for credit scoring. Currently, the national average is 692 (November 2009)*. 

Three Sources

There are three companies that compete and each has their own proprietary variations of FICO for scoring: Equifax, Experian and TransUnion, respectively.  Most would-be lenders and creditors will pull at least one and many will pull all three scores to be sure they are getting an accurate picture.  If they pull all three, they’ll usually use the middle score to make their decision. 

Credit Scores & Home Loans–What’s the Minimum These Days?

With the recent economic downturn having some of its roots in sloppy and over permissive lending standards – most lenders today will not make a home loan with a score under 620 (December 2009)*.  However, the most preferential rates and terms are not given until the score exceeds 740 (December 2009)*.   These requirements are some 50 - 80 points higher than just a few years ago*.  In addition, in today’s economy, amendments, changes and new requirements are implemented, often without warning or notice.

Five Factors Affect Your Score

There are five basic factors that make up a credit score. Below is each along with their relative influence in ascending order: 

a. Recent inquires by Would-Be Lenders or Creditors:  Approximately 10% 

b. The mix and makeup of the types of credit you have: Approximately 10% 

c. The age of your open credit accounts: Approximately 15%

d. What you owe versus the total you can borrow:  Approximately 30% 

and, the largest factor, 

e. Your payment history:  Coming in at approximately 35%

Let’s take a closer look at each of these factors in more detail.

Recent Inquiries – approximately 10% of your score

Inquiries made by various entities will impact your score for about a year after the inquiry is made, but the specific impact will lessen as it ages.  Checking your own credit will have no impact. 

Inquiries cause a negative impact because the system parameters are conservative – it assumes that each inquiry is going to result in some sort of account or debt in the near future.  In addition, many inquires close together is a flag that you may be in financial trouble and trying to obtain credit or cash any way possible – true or not. 

Many home loan lenders will question you about the inquiries even if they are minimal.  They are trying to determine whether or not there is really an issue or were you just making a large, but affordable (for you) purchase – like a car or boat (note: certain type inquiries like car loan inquiries within 45 days of one another are usually lumped together as one inquiry for scoring purposes).

The Mix of Credit Types – approximately 10% of your score

There are basically three types of credit: installment, revolving and real estate loan mortgage.  An example of installment credit is a car loan.  Revolving accounts are generally credit cards and lines of credit that act like one.  The last type deals with real estate loans secured by real property mortgages. 

Just as you would in an investment portfolio, try to keep your credit diversified over the variety of these types.  A good mix is positive while a concentration in revolving accounts will generally be more negative.  You will be impacted most by having too many revolving accounts since these are not secured by any underlying asset (like a car or house).   Having an existing home loan mortgage which is current will help significantly when you are considered for a home loan.

Open accounts – even when they are not being used or are at a zero balance will still impact your score because they are available to you – but this doesn’t mean you should close them as you will see in the next two sections.

The Aging of Your Accounts – approximately 15% of your score

This factor refers to how long your respective accounts have been open and in use.   The longer each has been open and current, the more positive the impact on your score.   Generally, it is better to keep open long-standing accounts with little activity or zero balances – simply because they are older and give you more payment history.

Your Balance vs. Your Limit – approximately 30% of your score

This factor is strictly based upon math.  It takes what you have outstanding and compares it to what your limits are and forms a percentage ratio.  The lower the percentage the more positive the impact to your score.  For example:  A person with a $50,000 limit with $20,000 owed is using 40% of his or her available credit, whereas a person with $20,000 of credit available with balances totaling $12,000 is using 60%.   The latter situation will have a more negative impact than the former.  The optimal percentage is 25 - 35%. 

Thus, keeping open older accounts with little activity or near-zero balances can be better than closing them out.  Also, this dictates that generally, it is better to have more accounts with smaller balances than just a credit card or two that concentrates your aggregate balances.

Your Payment History – approximately 35% of your score

This is the largest single factor in determining your credit score.  Making your payments on time and keeping all of your accounts current is the single most important thing you can do to keep a good credit score. 

One of the single most negative items is a late payment on your home loan mortgage within the last 12 months. Inversely, making your home loan payments on time has the most positive affect on your score when being considered for a home loan.

Other negative items will be late payments on other accounts, collection accounts – where collection agencies have been called in,  charge-off accounts – where the debt is outstanding but simply no longer pursued and judgments – legal recordings of a debt owed. Judgments and liens may have to be paid prior to obtaining a home loan – particularly those which include Federal Tax liens.

Bankruptcy

One of the most negative and long lasting items affecting your credit score is a bankruptcy.  A bankruptcy is a court ordered discharge of the unsecured debts owed.  A bankruptcy proceeding is serious and complex and only an attorney competent in this area of law can handle the procedure. Generally it will affect your score for at least 7 years.    

Exception or Rule

Other sub-factors weighed are if the late payments were the rule instead of the exception and whether they were 30, 60 or 90+ days late.  Occasional late payments will have less of an effect if they are not consecutive and there are no other negative flags or marks. 

In addition, it is not unusual for a would-be creditor or lender to ask you to explain something on the report – like a single late or other statistically infrequent item.

Just Two of the Factors Account for 65% of Your Score

It must be noted that by keeping your balances between 25 and 35 % of your available credit and making your payments on-time you have covered approximately 65% of what can ultimately lead to a good score.  

While this might seem like an obvious connection for would-be borrowers – there are many individuals who may give the first three factors more weight than they are due.

This article contains general credit score information.  It is meant for informative and educational reference only regarding the overall generalities surrounding the credit scoring system.  It is NOT meant to serve as advice on how to fix your credit or deal with creditors or lenders or the credit bureaus regarding your score.   For advice on dealing with credit repair, lenders, creditors and the credit bureaus you should consult your financial advisor, accountant and attorney-at-law. 

*These numbers are deemed reliable but are not guaranteed and may change at anytime with or without notice.  They were obtained by consultation with known lenders at the time this article was written.  You should not assume that these thresholds are still current and you should consult with your loan officer, financial planner and advisor, your accountant and/or your attorney-at-law when considering a loan and/or mortgage.