All About Credit Scores

Good Credit ScoreYou should be reviewing a copy of your credit report at least every year.  (Click here for how to review it for free three times a year). 

You'll know after reviewing your credit report just how big and full of information they can be.  Once upon a time, the person who gave you a loan at the local bank was a loan officer.  This wasn't just a title, it was a real position that took training and skill.  The primary skill?  Being able to decipher those credit reports. 

FICO Score

A company called Fair Isaac & Co. (hence, FICO) developed a system for grading those long detailed credit reports and returning a simple number.  The simple number meant that you didn't need special training or experience to determine if someone was credit worthy or not.  There was no need to judge whether it was a good thing or a bad thing that someone had eight credit cards but no balances on them.  All you had to do was look at a number and see if it was higher than a certain minimum.  This is why when you go into your local bank or credit union these days, anyone can help you with a loan, not just certain people.  It is also why the cashier at any big box store can issue you a credit card in five minutes.

The FICO score was developed solely for use by financial institutions and not for the general public.  As such, FICO scores are deliberately shrouded in secrecy.  It is a pretty good assumption that if Fair Isaac and the banks had their way, no one would even know there was such a thing as a FICO score.  This is one reason why interpreting scores isn't very straight forward.  The difference between a 630 and a 660 isn't very clear.  That confusion is partly, to keep credit issuers from having to explain why your "good" credit doesn't qualify you for the "good" interest rate.

The biggest area of secrecy is in how the FICO score is calculated.  The secrecy isn't as much of a conspiracy as you might think.  In the old days (mid-1990s) on the Internet, search engines ranked websites based on how many times a word or phrase appeared on the page.  The theory being that a web page that had "credit score" on it twenty times probably had more information about credit scores than a web page with "credit score" on it four times.  Of course, once this knowledge got out it wasn't long before good guy web page owners were trying to use the words as much as they could in there articles (never saying it or them for example).  And bad guy web page owners, well, they would put the words over and over a hundred times or more at the bottom of the page usually hidden by making the text the same color as the background.  So the search engines came up with new methods of ranking pages including how many links there were to a web page.  So, people put up web pages with thousands of links.  Eventually the search engines stopped saying exactly what they were doing.  In theory this keeps people from doing something just to get a higher ranking.

The same idea applies to your credit score.  If you knew that having six credit cards with a combined limit of $40,000 and a balance of $10,000 you would of course have six cards, and make sure no one ever raised your limit.  Then, your credit score would be higher.  But this kind of tweaking also makes the scores less accurate for the banks.  So, the only verifiable information is the vague information released by Fair Isaac, and the various generalizations deduced by those work work extensively with credit scores.

How Is Your Credit Score Calculated?

Again, the only official information we have is deliberately vague.  I through in some unofficial information later, and more importantly show you how to work the scores specifically for you.

According to Fair Issac, your credit score is made up of just five factors. 

  • Payment History (35%)
  • Amounts Owed (30%)
  • Length of Credit History (15%)
  • New Credit (10%)
  • Types of Credit Used (10%)

Payment History (35%)

The biggest factor in calculating a credit score is Payment History. 

This makes sense.  After all, the best possible predictor, absent a working crystal ball, of your likelyhood to pay your bills on time is whether or not you have done it in the past. 

Think of it this way.  You have two friends who want to borrow money.  One, has borrowed money from you before and has always repaid you right away.  The other has also borrowed money before.  However, he always takes a long time to pay you back. Which one would you be more likely to lend money to?

Obviously the key to this part of your credit score is paying your bills on time every time.  Every slip up can cost your credit score valuable points.

Inside Tip: Although you'll notice your credit report has a value for being 30 days late on a payment.  However, most companies won't bother to report you for just being one month late.  After all, things happen and more importantly it can anger a good customer. 

Bills that are one month overdue are not likely to show up on your credit report.  However, it is important to remember that they CAN be reported.

Someone you pay late all the time is more likely to report than someone you just miss once. So, don't use this fact to be sloppy in your payments, but do keep in mind there is probably no need to worry if you have a slip up.

The disturbing part is how little payment history actually counts for.  It's just over one-third of your credit score. 

Amounts Owed

The most confusing of all the factors is the Amounts Owed factor.  Keep in mind this is not a straight number.  A multi-millionaire is likely to have a higher mortgage than a working stiff, but isn't necessarily a bigger credit risk.  Also, there are sub-factors included here that don't specifically relate to the amounts owed.

First "amounts owed" refers to a ratio of how much current debt you have relative to how much credit you have available.  In other words, if you have a balance of $8,000 and your credit limit is $10,000 then you have used up 80% of your credit. 

From a bank's perspective someone who needs more credit because they have used up all of what they already have is a bigger risk.  Maybe they are getting in over their heads and that is why they need another loan.  Whereas, someone who hasn't used much of their credit is probably applying for non-troubling reasons: getting a better deal, buying a new car, and so on.

In addition to an overall number, the same kind of ratio for each kind of debt is analyzed.  Maybe your overall numbers are fine but you've used 95% of your credit card time credit.  That will lower your score.

If you've been following along really closely you've probably spotted a couple of flaws. 

First, is the uncommon but not rare breed who doesn't use credit at all.  Ironically, this is probably because they are very responsible.  Such people save up for everything before they buy it so they never use credit.  These types may not have any credit cards, student loans, or car loans. 

When they go to get a mortgage their credit score will be lower than someone who does have credit cards and always makes on-time paymets. 

The second flaw is the  is the big gotcha. 

On one hand having more credit cards with higher limits means that your debt to credit ratio will be lower and therefore your credit score will be higher.  But, having too much of one kind of credit like credit cards will lower your credit score. 

Where is the right place to be then?  No one knows for sure, but read How to Work Your Credit Score for how to find out.

 

All About Your Credit Score - Continues on Page 2

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