So, we all know we have one. We all know that our credit score is a determining factor of how much we are going to pay in interest when we apply for a loan. We especially know how hard it is to get a loan when we have a low credit score. So what is it that we do about it? We’ll explore the topic of your credit score and what it means to you today and see what we can come up with. Let’s get on with it, what is a credit score?
Let us first start out by saying that your credit score is an arbitrary number between 300 and 850 that is supposed to give a weight to your credit worthiness. Essentially the higher the score the lower the risk for the lender. There are three primary credit agencies that keep track of your credit history and they are the ones that individually score you, thus the reason for the wording “arbitrary.” These three credit agencies are as follows:
Now, as I said, these three companies give you a credit score that is specific to the credit history that they have for you and what history they have and the score that they give you will differ from agency to agency. So if they have three different scores how do you know which one will be used, well the answer to that is none of them and all of them. Generally speaking when someone is talking about their credit score they are usually referring to is their FICO credit score. For the purposes of this article we will not go into what your FICO score is other than they are a third party who takes the information as provided to them from these agencies and combines them in a proprietary way to give you a single credit score. It is this number that plays such a pivotal role in your dealings with lenders.
So now we know generally where your credit score is derived from; now we need to know what it all means.
Equifax is the oldest and largest of the three credit unions and when you go and apply for a credit card at your local retail store more than likely they will just refer to Equifax. They will pull up your history and review it looking for certain indicators beyond just your score to determine if they want to risk lending money to you and at what interest rate they feel the risk is mitigated. These indicators could include your propensity to pay your bills on time. Timely bill payment is probably one of the best things you can do to keep your credit score high. There is something you need to be aware of when it comes to timely bill payment and that is that most lenders will not report a late payment to the credit agencies until you are greater than 30 days past due. This isn’t a way to game the system, you still have to pay, but know that if you are a few days late on your payment you are more than likely safe from an adverse effect on your credit score. However, I would not suggest testing the patience of your lender if you can avoid it. If your lender notices that you are consistently 15 days late they may not be so willing to let you slide but if you are always this late you would be following our advice of calling your lender to renegotiate your payment terms now wouldn’t you?
Timely payment is import, we know that, but what else is a factor in determining how much of a risk lending money to us is? Next your potential lender is going to look at the amount of your current debt and compare it to your stated or verified income. If you make 45k a year and owe 30k in credit card debt you are going to be a very high risk. Think of it in these terms, if your brother in law came up to you and asked to borrow 100 bucks and will pay you back in a week but you know that he already owes 100 bucks to your uncle this week and he only makes 250 a week, it probably is not a safe bet that he’ll pay you back at least not when he says he will. This same principle applies to your lender if you owe a significant amount of your income it is not in their best interest to lend you money because the chances of you paying them back is small because more than likely you won’t be able to afford to pay them back. If by chance you do find a lender that is willing the interest rates will probably be astronomical, your credit limit will be very low and you’ll be forced to pay only the interest and little to none of the balance. All of this actually has a name and it is called your debt to income ratio. This is calculated by taking the amount of debt owed and dividing it by the amount of income so using the previous example of an earner making 45k a year and having 30k in debt that is 30k / 45k equals a 66.66% debt to income ratio. As a reference point, and this may be different now with the economic crisis the world has just gone through, most conventional mortgages allowed up to a 45% debt to income ratio to qualify. So the previous earner would have to lower his/her 30k in debt to approximately 20k to be able to qualify and more than likely they will have to have money down and a co-borrower since they are right at top of the allowed ratio.
After determining your debt to income ratio they are going to look at how many revolving debts compared to how many installment debts you are carrying. This provides them a perspective on both your spending habits and your risk of abandoning your obligations as a debtor. Revolving debt is debt where the amount due could change month to month due to a variety of reasons such as increased spending, change in interest rate, etc. For typical households their revolving debt is primarily in credit cards. Creditors feel that if you have a large amount of revolving debt you tend to rely heavily on your credit cards and that you have a greater chance of walking away from your financial obligations to them. Installment debt is debt where there is a fixed payment that is paid until interest and balance are paid in full. Once again for most households their installment debt is their mortgage and their auto payments. Debtors with high installment debt compared to revolving debt are deemed to be a much lower risk because there is a tangible asset that can be recovered if the debtor does not pay. Furthermore, it is felt by creditors that debtors will try not to abandon installment debt because they are more likely to pay those debts before revolving debt so that they don’t lose shelter or transportation. Even if you are not carrying a balance on any of your credit cards but you keep quite a few open this can throw up red flags because they see a potential for heavy debt to be incurred. Then again they do not like to see no credit cards because this could indicate that you are not responsible with them so you don’t have any among a multitude of other reasons. You could ask 10 different people and you would get 10 different answers to the number of credit cards you should keep open at any given time, I don’t know the magic number but in my household we keep 5 open between my wife and I but have no balance on them. Some credit card companies charge you or close the account for inactivity, so check your terms and conditions or call to find out what their procedure is for long periods of inactivity. You may just have to fill up your tank every now and then and just pay it off every month.
We are starting to get a pretty good idea of the things they are looking for. So what else might they use to determine your score? Lenders will also look at your credit application history. Every time a lender looks at your credit report it is logged on your credit report. How long these inquiries stay on is different between agencies and they don’t release that information to the public but having reviewed my credit report a few times a year it is usually only 6-12 months. If a lender sees that you have aggressively applied for credit recently they will be more weary to lend to you under the suspicion that there is something going on in your life that you suddenly need immediate access to credit. They also might see that you have been denied thus causing them to be more cautious since others have denied you. I personally have known of more than one person who was pre-approved for a mortgage but shopped around at other banks and when they went to get their mortgage they were denied due to the excessive credit requests. Be careful, research rates before actually running your credit, it can seriously hurt you by shopping around and applying for credit at multiple lenders.
While there are numerous other details lenders use to scrutinize your credit report the last one we’ll talk about today is the length of your credit history. This criteria alone is why younger individuals have a proportionately harder time acquiring credit than older individuals. Lenders operate under the premise that the longer you have been borrowing money and repaying it the more responsible you will be. While this may or may not be correct it is common practice across all agencies. If you have less than 10 years of credit history you are automatically subject to further scrutinizing. It really doesn’t matter if your credit history is impeccable this single criteria at times will serve to cause a lender to not lend money despite all other indicators being in the green. I am sure they all have statistics to provide justification for this methodology but at times it seems unfair when being denied even for the smallest of loans. There isn’t much you can do to affect this criteria other than possibly speaking to the lender and advocating on your own behalf the quality of debtor that you are.
Finally I will close with how important it is to keep a close eye on your credit report. My wife and I check our credit reports 3-4 times a year. In America the government has said that every citizen is entitled to 1 free copy of their credit report from each agency once a year. This credit report is very basic and will not even provide you what your score is. Monitoring your credit report yields you two very big advantages. First, you keep a close eye to ensure that your lenders are updating the agencies promptly with you payoff information. Second, you can catch any anomalies that can show up from things such as identity theft and incorrect information being reported. I can not advocate checking your credit report multiple times a year enough.
I hope this sheds some light on what your credit score is and how it is determined. Knowledge is power and you need power to get yourself out of debt and to play on an even playing field with your lenders.