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 GaramChai.com >> Finance
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on Credit History
Anatomy
Of A Credit Score
More companies are looking at
ratings -- so managing them is crucial
During a shopping spree a few months ago, I opened several
retail credit-card accounts to take advantage of an immediate
10% discount on that day's purchases. Surely this familiar
offer was risk-free as long as I paid my bills on time, right?
It wasn't until I reported this story that I found out my
credit score could have been negatively affected by the spate
of new accounts I opened in such a short time. I had no idea.
Many people are ignorant of what their credit score is, how
they can hurt or help that score, and how it can be used against
them. Some 49% of 1,013 consumers polled do not understand
that credit scores measure credit risk, according to a 2005
survey by the Consumer Federation of America and Fair Isaac
Corp., the company that created the most widely used credit
score formula called FICO.
Lenders have used these scores for years to determine whether
to grant you a loan and what interest rate you'll pay. "Credit
scores are very powerful predictors of consumers' future [bill-paying]
performance," says Mike Fratantoni, a senior research
director at the Mortgage Bankers Assn. But with the rise of
technology that can automatically assess consumer creditworthiness
while you wait, FICO scores are now requested by insurance
companies, cell-phone providers, utilities, landlords, and
even prospective employers. That's a reason to make managing
your FICO score a priority.
But first, just what is a credit score? To come up with one,
Fair Isaac uses 22 pieces of data collected from the three
major credit bureaus (Equifax, Experian , and TransUnion)
to calculate a credit score -- 300 is the lowest, 850 the
highest. The final number is a composite that comes from individual
ratings in five categories: payment history (35% of the rating);
length of credit history (15%); new credit (10%); types of
credit used (10%); and debt (30%). Income is not a factor.
"A person can have a very high income and never pay their
bills," said Craig Watts, public affairs manager for
Fair Isaac.
Fair Isaac calculates a FICO score based on the data provided
by each credit bureau. It's not uncommon to see up to a 50-point
differential between ratings. The reason: Bureaus collect
data at different times of the month, or one bureau may have
inaccurate information.
The higher the score, the lower the risk you are to a creditor
-- and the less interest you'll pay. Only 13% of the population
has FICO scores of 800 or above; the median is 723. There
is no single cut-off for loans, and it varies from industry
to industry. But generally borrowers with scores above 740
receive the best rates.
To see how a change in your FICO score affects how much you'll
pay, consider this example. On a $350,000, 30-year fixed mortgage,
you'll pay 6.24% in interest, or $2,153 a month if you score
between 720 and 850. If your score drops to between 620 and
674, your interest rate jumps to 8.05%, and your monthly cost
rises to $2,581. You will pay an additional $154,131 over
the life of the loan, according to a calculator on myfico.com.
WATCH YOUR WORTHINESS
Want a peek at your FICO scores? Many people think they can
get their FICO scores from their credit reports. They can't
-- but it's still a good place to start. The Fair & Accurate
Credit Transactions Act of 2003 entitles you to a free credit
report from each major credit bureau once a year. I ordered
my reports by telephone from annualcreditreport.com and received
them all within 10 days. It's smart to request a report from
a different agency every four months so you stagger the reports
over a year. That way, if there's bad information in one,
you'll spot it sooner.
When you request a free credit report, each bureau will offer
to calculate a credit score for $6.95. Experian and TransUnion
use proprietary formulas; Equifax uses FICO scores. Pass up
these offers because the information is not as comprehensive
as you'll get elsewhere, and lenders are less likely to look
at these scores.
For the most detailed explanations on your FICO scores, go
to myfico.com. A score from one credit bureau costs $14.95,
all three are $44.85. It's useful to buy all three because
large lenders either average the scores or take the middle
one. You'll want to check your FICO scores once a year or
several months before you apply for a loan.
The negative factors that bring your score down remain on
your credit report for seven years and can adversely affect
your FICO score. But lenders typically look back only in the
past two years when they make credit decisions. One 30-day
late payment shouldn't make a difference. Lenders look for
trends.
I paid for three scores and anxiously waited while the computer
calculated them on the spot. Within seconds, I was relieved
(not to mention a bit proud) when 771, 751, and 738 popped
up on my screen. Still, I wondered why I wasn't in the 800-plus
range. To find out, I reviewed the various strategies credit
experts recommend to raise FICO scores.
Pay all bills on time. This is probably the most important
factor in the FICO calculation. If you're consistently 30
days overdue, your score can drop by as much as 100 points,
depending on how long the account has been open and how long
ago the late payment took place. To avoid late payments, consider
automating your bill-paying process. I got high marks in this
arena.
Think twice before closing accounts. Lenders are looking for
consumers with long credit histories that have been managed
well. But because of the increase in identity theft, you don't
want too many open accounts that you don't use. "Be judicious
about the accounts you have," says Norm Magnuson, public
affairs officer for the Consumer Data Industry Assn. In an
effort to consolidate our finances, I canceled an American
Express account I had for 20 years to become an authorized
user on my husband's account. While I benefit from his 20-year
credit history on that account, it was still a mistake to
eliminate my own. I have a few cards in my name only, but
the history isn't as long.
Minimize credit-card applications. Bingo. That was cited as
a problem on all three of my FICO scores. On average, a consumer
has a total of 11 credit obligations, of which seven are credit
cards and four are loans. I had 21, of which six had balances.
Each time you apply for credit, a lender requests to view
your report. This inquiry is noted and can reduce your overall
score. Don't apply for unnecessary credit, and if you're in
the market for a big-ticket item that requires a loan, avoid
credit applications for 18 months prior to your purchase.
Keep balances low. The FICO score evaluates your total balances
in relation to your available credit. This is known as credit
utilization. Credit cards that are "maxed out" can
lower your score. Try to spend only 30% of your credit limit.
If you have a $10,000 limit on one card, keep the balance
near $3,000. My credit utilization was too high. It helps
that I pay off my balances every month, but it is better to
spread the spending.
While my FICO reports said that "most lenders would consider
consumers in this score range as extremely low risk,"
the competitive spirit in me wants to get over the 800 mark.
To that end, I recently refrained from signing up for a Target
Stores credit card to get $10 off on a $100 purchase.
Article source: BusinessWeek
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