Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu
If credit reports are like receiving a “report card” in school, credit scores are similar to a grade point average. They are a three-digit number, ranging from 300 (lowest) to 850 (highest), used to measure the risk that borrowers will become delinquent or default on their debt obligations. Credit scores are based upon information contained within credit reports. Thus, consumers will likely have different credit scores from each of the three major credit bureaus (Equifax, Experian, and TransUnion), just like they have different credit reports. This is because the information upon which they are based varies. Not all creditors report to every credit bureau.
Negative events, such as late payments or charged-off debts, will cause credit scores to drop. Conversely, a sustained record of on-time debt payment will raise your credit score. The higher the credit score number, the better, because it will help borrowers qualify for credit and obtain the most favorable terms. Conversely, “subprime” borrowers with low credit scores pay higher interest rates to borrow money, if they are approved at all.
The exact threshold for the best credit terms varies among lenders but is generally somewhere in the mid-700s (e.g., 760) today as a result of higher lending standards resulting from the 2008-2009 financial crisis and subsequent “credit crunch.” Not too long ago, a credit score of 680 might have been considered high enough for the best credit terms. Keeping your credit score as high as possible can save thousands of dollars in interest payments, particularly on long-term loans such as a home equity loan or mortgage.
Credit scores are a mathematical gauge of a person’s creditworthiness. Most lenders do not know many of their borrowers personally so credit scoring helps them make objective decisions and determine the amount of risk associated with lending to a particular borrower. Credit scores are determined by statistical “risk models” and are often referred to as FICO scores. FICO is an abbreviation for Fair, Isaac, and Company, a California company that develops the credit scoring models used by a majority of U.S. banks and mortgage lenders. After the state of California mandated the disclosure of credit scores in 2001, Fair, Isaac, and Company began selling FICO credit scores to consumers for a fee.
What factors determine a person’s credit score? Below are the five most important factors affecting FICO scores and their weighs as a percentage of the total score. Note that almost two-thirds of a credit score comes from the first two factors alone.
• Previous Payment History (35%)-This is most important factor in determining credit scores. On-time payments enhance a person’s score while late payments subtract points. The more credit accounts that have late payments (e.g., three creditors versus one), the later the payments (e.g., 90 days late versus 30 days), and the more recent the negative information in a credit report (e.g., a year ago versus five years ago), the more negative the impact on a consumer’s credit score. To raise your credit score and/or keep it high, pay at least the minimum amount due on or before the due date.
• Amounts Owed Relative to Credit Limits (30%)-Often referred to as a “credit utilization ratio,” this is the percentage of a consumer’s credit line that is borrowed against. For example, $3,000 of debt on a credit card with a $10,000 maximum limit results in a credit utilization ratio of 30%. To raise your credit score, the lower the credit utilization ratio percentage (e.g. 20% versus 40%), the better. Many credit experts recommend keeping it below 20% and 10% is better still. To boost your credit score and/or keep it high, keep credit card balances low. If the ratio occasionally rises above 50%, pay off debt as quickly as possible.
• Length of Credit History- (15%)-Credit scoring models give more weight to people who have successfully used credit for long periods of time. To raise your credit score and/or keep it high, keep your oldest credit accounts open (even if they are used infrequently) and avoid opening lots of new accounts, which will lower your average account age.
• Types of Credit Used (10%)-Credit scores increase when consumers have a mix of different types of credit (e.g., mortgage, home equity loan, car loan, and credit cards) instead of just one. This does not mean that you need to intentionally take on new forms of debt for the sole purpose of raising your credit score number. Usually this just happens over time as borrowers get older. To raise your credit score and/or keep it high, the most important thing you can do is make full payments on time for existing debts.
• New Credit (10%)-Credit scoring models take points away from people who have applied for a number of new credit lines within a short time period (e.g., six months to a year). “Promotional” inquiries made by creditors in advance of a pre-approved offer, however, are ignored and do not count against you. To raise your credit score and/or keep it high, avoid opening new credit accounts at the same time.
Credit reports generally do not include a credit score. Since credit bureaus are not mandated to provide credit scores to consumers for free (as they are with credit reports), consumers generally have to pay a fee for the score. To purchase your FICO credit score, see www.myFICO.com. There are also some Web sites that provide free credit reports. These will provide a rough estimate of your credit status but are not the score that most lenders will see. You may be able to get a FICO score for free through lenders that you are applying for credit from. Ask them for your credit score, especially if you paid a loan application fee that includes a credit check.
Sometimes, factors outside your control can lower your credit score. Beware if your creditors lower your credit limit – – which will, in turn, lower your credit utilization ratio. For example, if you owe $1,000 with a credit limit of $10,000, your credit utilization ratio is a healthy 10% ($1,000 divided by $10,000). If the credit line gets trimmed to $4,000, however, the ratio will then be 25% ($1,000 divided by $4,000). What to do? Pay down debt as quickly as possible. Another possible strategy is to apply for additional credit, which will increase your overall credit limit. Doing this might lower your credit score immediately afterwards but should provide a credit score boost over time.
Credit scores are not just for credit cards and loans. In all but a few states (CA, HI, MA), insurance companies use a specially formulated credit score to issue policies (or not) and set premium rates. They claim that policyholders’ bill-paying history can predict their risk of filing an insurance claim. Currently, insurance companies are not required to provide these scores to consumers or describe their scoring methodology.
So, if you thought your report card days were over, think again. Your credit score is a “snapshot” of your credit history at a particular point in time and you are constantly being “graded.” Paying bills on time and not becoming overextended are the two best ways to raise your credit score and earn an “A.”