What makes up your FICO credit score? Where does it come from? What actions make it better or worse, and what does this mean to you? Let’s dive into the most common questions about credit scores:
A FICO score is a credit rating developed by the Fair Isaac & Company in the late 50s. It’s now widely accepted by lenders, insurance companies, employers and landlords. FICO scores are three digits and they run from 300 to 850.
A person has three different credit scores from three different credit bureaus. Equifax, Experian and TransUnion all produce a number based on scoring models and algorithms. Each of these scores is slightly different because the calculations at each one of these companies is a little different.
When considering extending credit, most lenders use the middle score. They’ll throw out the low one and the high one and they keep the middle one or they’ll just use FICO which distills all your credit information into a different score.
Everyone wants to know whether or not you’re going to pay your bills. Your credit score comes into play when you try to rent an apartment, buy a house, buy, lease or rent a car or establish cell phone service. Your credit score may even determine whether or not you get a certain job, because employers now check your credit history!
The biggest thing that makes up your credit score is payment history. If you pay your bills late, it has a negative impact on your credit score. The severity of a delinquency also matters. There’s a difference between paying a bill 3 days late versus 60 days late. The longer your bills have gone unpaid, the worse it affects your credit score. If you want to improve your credit score, the first thing you need to do is pay your bills on time.
The length of your credit history is also important. You may not have a credit history if you have never borrowed money and don’t have any credit cards. Having no credit history is not necessarily good when you go to borrow money. It’s better to have a little history than no history at all.
It also matters how long your accounts have been open, and how long it’s been since you had activity on those accounts. Sometimes people open a credit card but don’t use it for a while. The credit history starts developing when the activity on the account starts.
The next biggest thing is the amount of money that you owe. This number also includes the amount of money you could borrow tomorrow. For example, when you have a revolving line of credit, like a credit card, you may not have a balance today, but you could easily charge it up tomorrow. The relation of how much money you owe (or could owe) versus how much money you earn is your debt burden.
The proportion of credit lines used is also important. A rule of thumb is to try to stay at 40% or below. For example, if you have a $1,000 line of credit, you’ll want to stay at about $400 in terms of your balance. You don’t want to charge it up to the full $1,000. That starts to have a negative impact on your credit.
The proportion you have left to pay on your installment loans is also a factor. An auto loan or personal loan are both considered to be installment loans. Any loan that has an equal monthly payment over a period of time is considered an installment loan.
The types of credit that you have also get factored into your FICO score. A mortgage or car loan has collateral. They’re viewed a little differently than a revolving line of credit that doesn’t have any security or personal loan that has no security.
The presence of adverse public records also negatively affects your credit score. Your credit can really be hurt by things like bankruptcies and liens, and they stay on your credit report for 7 or more years.
Be careful not to inquire or apply for too many loans, because that can negatively affect your credit. If you apply for a personal loan at the credit union, an auto loan at Bank A, and a credit card from Bank B, that would negatively affect your credit, because it would count as 3 different inquiries.
In contrast, if you are buying a car, you may visit 5 different banks to compare rates and fill out car loan applications. That process would not negatively affect your credit, because the car purchase would be viewed as one inquiry, and you’re allowed to compare and research before finally taking out a loan.
When you receive a “pre-approved” credit card offer in the mail, those companies are not pulling your full credit report. Most of the time they’re pulling what’s called a “soft pull”, and that doesn’t affect your credit.
When you open a new credit card or loan, you probably will see your credit score drop initially just because you add an additional credit, but that will quickly change. Your credit score changes in real time and is constantly in motion!
Financial institutions and creditors typically use your credit score to determine your interest rates. Typically lenders use “risk-based” pricing. So as an example, if you see a company advertising a rate of 1.99% for an auto loan, not everybody qualifies for that rate. It’s typically the people who have the higher credit scores, such as 800 or higher. Basically, as your credit score number goes down, the interest rate you’ll pay goes up.
Imagine the amount of extra money you could pay over the lifetime of a longer debt, like a 30-year mortgage. The payment for one range of credit scores might be $1,300 each month, but someone with a lower credit score might have a payment of $1,500 each month for the same amount of money borrowed. The person with the lower credit score would be paying $200 more each month for 30 years. That’s a long time, and a lot of money! This is one of the major reasons you’ll want to keep your credit score high.
According to the Federal Fair Credit Reporting Act, a company has the right to obtain credit reports and use that information when considering a candidate for a position in which the information may be applicable. For example, a job that requires an employee to handle a significant amount of money or deal with sensitive information.
The company may want to know a person’s debt situation and compare that to the salary it’s offering. If they see that a person is not earning enough money to manage their debt, they may not want to give that person access to money because they may be desperate enough to take that money.
Companies may keep in mind the possibility that credit reports may contain errors. There’s a lot of identity theft and erroneous crossing of information these days. Because of the possibilities for errors, you’ll want to review your credit at least each year.
You should get your credit report each year and review them. You can get your report free from any one of the bureaus once a year. You’ll want to make sure someone else with a similar name doesn’t have information that was mistakenly added to your report. You can also use free online tools such as CreditKarma.com to monitor your credit.
If you don’t have any credit, a good starting step is to establish a utility account or cell phone service in your name. You could also apply for a credit card and use it responsibly. You may want to take out a small loan with a co-signer, a secured loan or Credit Builder Loan and pay it on time as agreed.
Merrimack Valley Credit Union offers a simple Credit Builder Loan, which is great for kids coming out of high school or college who have no credit and limited funds. We’ll lend between $1000 and $3000 for one or two years as long as there is evidence of the ability to repay it. With a credit builder loan, you don’t get the proceeds of the loan right away. The proceeds of the loan go into a CD that actually secures the loan. We take your monthly payments directly from an account, which helps build your credit history. After the loan is paid off, you’ll have a savings fund you could use as a down-payment on a car, a deposit on an apartment, etc.
It’s very easy to damage your credit, and it can happen very fast. Paying your bills late or missing payments is the easiest way to hurt your credit. You’re much better off contacting a credit card company and trying to work out a payment plan with them before you stop paying your bill completely or delay paying for months. Using credit irresponsibly, such as charging up several accounts in a short period of time, can also hurt your credit.
One of the things that can negatively impact your credit report is having too many store charge cards. If you have a lot of old store lines that you really don’t use, you’ll want to start getting rid of them. But don’t just dump them all at one time, it’s better to close them out one at a time over a period of time.
You also don’t want to play the debt-shifting game—where you pay one credit card down by taking another one and drawing that one down. Over a period of time, it becomes pretty obvious that you’re shifting money and that hurts your credit score.
When you have a lower credit score, you’re going to qualify for loans and credit cards with higher interest rates. Having a poor credit score generally limits your borrowing options. Banks and credit unions may not be able to help you if your credit score is very low, and you may need to resort to more costly alternatives such as a payday lender.
As a service to our members who need help with financial management or credit counseling, Merrimack Valley Credit Union has partnered with Greenpath Financial Wellness, a non-profit, financial wellness organization that has been empowering people to lead financially healthy lives since 1961.
Greenpath offers assistance with:
GreenPath’s financial experts are professional, compassionate and committed to your success. Call 877-337-3399 or go to www.greenpathref.com for assistance. The call is free.
Category: Borrowing Money
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