Credit Score
You 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 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
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. Those five factors are: Payment History (35%), Amounts Owed (30%), Length of Credit History (15%), New Credit (10%), and Types of Credit Used (10%). Let's start with just these official factors.
Payment History
The biggest factor 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 if 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. In fact, one time you asked him about paying you back and he acted like he never borrowed money from you at all. 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 all the 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 this actually counts for. Just over one-third of your credit score is how well you have paid your bills. So what is the rest of it?
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 need 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 really use credit. Ironically, this is probably because they are super responsible. They 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. Read: How to Work Your Credit Score
Length of Credit History
A full 15% of your credit score supposedly comes from the length of your credit history. You can't go back in time and make your history any longer, but you can make a common mistake that will make it shorter. The length of your credit history depends some on how long you have had credit, basically the length of time since your first loan of some kind. But, just as important, and maybe more important is the age of your OPEN accounts. That credit card you've had for twenty years counts as a twenty year length. Close it, and that length goes away and moves to your next longest card which might be shorter. There is no reason to keep a card that is charging you an annual fee if you don't use it, but if the card is free, don't close it. Stick it in your safe or firebox and forget all about it. As long as it is open, you get credit for it's length.
As a side note, if you have children, open a credit card for them as soon as possible. Most of the time you have to be 18 to get a card, but there can be exceptions if a parent co-signs (especially if they are a student). It is not good enough to add them as a user on your card. That does not put any credit into their name. What you need to do is open a new account in your child's name. The easiest way to make this happen is to pick up an application on campus for a student credit card. All you need is a copy of the student id, so they don't have to be a full-time student. If they are just taking a class they can still probably sign up. Some of the offers are so open that it doesn't say "college student" it only says "student". If so, sign you child up the day her or she turns 18 even if they are still in high school. Make sure it is a card with no annual fee. You don't need rewards or anything because you won't be using it. Worried about giving your child credit that they aren't ready for? Good for you. Just because they have an account in their name doesn't mean they have to have the cards. Sign up for the account preferably through a national bank of some kind (Chase, Citibank, Capital One, etc) and put your address on it. When the cards arrive, you keep them under lock and key. Pull them out every once and a while to buy something, Christmas presents, books, hockey lessons whatever. Make sure to pay the bill on time every month. Once a year, charge a small amount and PAY THE MINIMUM. Why? Believe it or not, there is a difference between having credit and using it. Technically, it isn't a loan payment unless there was a loan. A loan involves interest. Yes, you'll pay a small amount of interest, but it will go onto the credit report as an installment payment which will help the credit score. Pay it off the next month and then sometime the next year do it again. What you are doing is starting the clock ticking on your child's Length of Credit History which will help their score for the rest of their life. DO NOT co-sign or open a joint account with your child. That makes you liable for the account for as long as it is open. Since the whole point of doing this is to leave the card open forever, you don't want to have any responsibility for the card. If your plan is to remove yourself as a joint owner later, don't bother. Most places consider that opening a new account which means you'll be closing the original account.
New Credit - 10%
Part of your score is based upon what is called new credit. Ironically, this section is the one that people worry about most when it is a very tiny percentage and what they are worried about doesn't matter. This is where people get the mistaken impression that "pulling their credit" will hurt their score. It is important to understand that the people at FICO are not dumb and they understand how the world works. It is not their mission to give you a lower score. That doesn't help their clients, the banks, get and keep the best customers which are those with the highest credit scores.
Pulling your credit is not a one size fits all kind of thing. When someone pulls your credit for a job application, or for an apartment lease, or for qualifying for insurance, these are known as soft pulls. These informational only looks at your credit score do not count against you in anyway, NO MATTER HOW MANY TIMES your credit gets pulled. Also in this category are credit pulls that happen from companies that you already have accounts with. These do not count against you either (mostly because they usually happen without your knowledge.)
When you are shopping around for a loan, people are going to want to pull your credit in order to quote you a rate. Again, these people are not dummies. They do the same thing when they shop for loans. If ten different banks pull your credit over a three week period in order to quote you mortgage rates or home equity loan rates this will not hurt your credit score in anyway.
What does hurt your credit score is opening a bunch of new accounts. The idea is something like this. Let's say that either you are getting into trouble, or you are planning to do something that will cost you a lot more money than you are used to handling that is a greater risk and therefore your credit score should be lower. So if you plan to start a new business and you are going to open twenty new credit cards "just in case," they want your score to be lower. Note that this is not setup to penalize the ordinary course of your financial life. If you open a new Target card to get the 10% off and then a month later you open a new Conoco card there should be very little effect on your credit score (at least for this area, keep in mind that you are increasing the number of open accounts and your total credit available which affects other factors in your score.)
Types of Credit Used - 10%
Here is where what kind of credit you have comes into play. For example, a person with $100,000 in debt that is all on credit cards is a much bigger risk than someone who has $100,000 in debt on a first mortgage. In general, mortgage debt is considered better than student loan debt, which is considered better than car loans, which are considered better than credit cards, which are considered better than personal loans. So $50,000 in student loan debt might count as much as $10,000 in credit card debt.
How To Raise Your Credit Score
There are dozens of services out there that claim they can increase your credit score. They can't. All they can do is make suggestions for things they think MIGHT help. No one knows exactly how credit scores are determined. The best thing you can do is get a service which allows you to view your credit score on a regular basis and then watch it go up or down. If it goes down, undo what you did (close an account, re-open the one you closed). If it goes up, then great. Depending on what it was you did you might try and do it again. See How to Work Your Credit Score Like a Pro for details.
Now What?
People worry way too much about their credit scores. Pay your bills on time all the time is the best advice you can get. Everything else should fall into line. If you are on the borderline for a better rate, check around. Different institutions draw their lines in different places. It might take a 740 to get the best rate at one bank but only a 715 somewhere else. Don't worry about shopping around, it won't hurt your score, and it is the smart thing to do.
You might want to read Your Credit Report if you haven't already for information on where all the information to calculate your score comes from.