These days, a good credit score is essential to get the best interest rates on home, car, and student loans. In some cases a bad credit score may even be used to disqualify you from certain jobs. But what is a good credit score? Credit score information has become the basis of critical financial outcomes that affect us, yet most people have no idea what factors positively or negatively affect their credit score.
To clear up at least some of the mysteries of the credit scoring system, this article will cover common questions regarding credit score information such as: the factors affecting your credit score, what your credit score means for you, common misperceptions, how to access your score, and tips on how to improve your score.
Your credit score is a summary of your credit history that essentially analyzes and ranks your credit worthiness against that of the rest of the population. It's called a FICO score because the software that analyzes the numbers was developed by Fair Isaac and Company. The three credit reporting bureaus (Equifax, Experian, and TransUnion) use the FICO credit score information and report this information to lenders who inquire about your credit worthiness.
Your credit history is on file with the credit bureaus. They have access to every loan you've taken and every credit card you've had and they have a detailed history of your payments. If it's financial and it has your social security number attached, you can rest assured that the credit bureaus know about it. This information is fed into the FICO software and you are ranked accordingly.
While FICO credit score information isn't the only score in the marketplace, it is the most commonly used and considered extremely reliable by lenders.
According to MyFICO.com, there are five factors which are weighted most heavily in determining your credit score:
The percentages are the approximate weight that each factor has in determining your credit score. As you can see, payment history and the amount you currently owe on lines of credit (credit cards, loans, etc.) make up 65% of your score and therefore deserve most of your attention.
It's important to stay current with credit card and loan payments because a late payment may be reported by the lender to the credit bureau (some lenders will wait until you miss two payments to report the delinquency). Adverse credit history remains on your credit report for about seven years. Accounts that are sent to collectors or loans on which you default (or if you declare bankruptcy) are viewed most adversely and more recent problems are weighted more heavily than ones in the past.
For amounts owed, FICO takes into account not only the total amount owed, but the proportion of debt to available credit. For example, $15,000 in credit card debt is high number, but if your available credit is $150,000, your FICO score won't suffer very much. The "magic" number seems to be around 20%. If your debt stays below 20% of your total credit, your score typically isn't adversely affected.
The remaining 1/3 of your FICO score is determined by the length of credit history, new credit inquiries, and types of credit. Creditors like to see that you have a long history of managing your credit wisely. Maintaining such a history indicates that you spend wisely and do not overextend your finances.
Lenders also like to see that you aren't opening up too many lines of credit. While it may seem a bit unfair to penalize you simply for opening accounts (as opposed to actually using them), lenders get nervous when you open too many lines of credit. Only "hard" credit inquiries from new creditors (i.e., lines of credit you request) affect your credit score, not "soft" inquiries (inquiries from potential creditors in order to send you offers for pre-approved lines of credit).
Finally, banks like to see that you have different types of credit. Having a healthy mix of credit cards and loans (student, home loans) will typically reassure lenders. Of course, if your loan amounts are too high, then it will negatively affect your score.
FICO scores range from 300 to 900. While 900 is the highest, it's generally not a realistic score to achieve for most people (it's a bit like hole in one -- possible but highly improbable). According to FICO, the median credit score in the United States is 723. That means that 50% of the population has a score above 723 and the other 50% is below it. Anywhere above the mid-700s is considered excellent. If you're above 720, you're "very good". From about 670-720 is "good" and for scores 650 and below, it starts a downward slide with questionable credit possibilities. It should be noted, however, that credit scores are not the only factor in obtaining credit, though it is becoming more important.
A "good" score used to get you a moderate to low interest rate. However, with today's credit crunch, to get the best interest rates, you will likely need to be solidly in the very good to excellent range to get the best rates. If you don't have a very good or excellent score, it doesn't mean you can't get credit, but it means that you'll likely be paying a higher interest rate.
As you've seen, the biggest factors in your credit score are 1) payment history and 2) amounts owed. Therefore, best ways to increase your credit score is to avoid late payments and reduce the amount you owe.
These days missed payments can be easily eliminated by logging into your credit card online and choosing their minimum payment option. This option automatically pays your minimum balance directly from your bank account (you'll have to link the accounts) on the day your payment is due. By signing up for this free service, you protect yourself against those times you simply forget to make a payment. And because it's just the minimum payment you don't have to worry about a huge amount being debited from your checking account each month.
As stated earlier, try to keep your balances low -- 20% or less of your available credit if possible. If that's not possible, try to make more than the minimum payment each month. Making only minimum payments typically doesn't even cover the finance charges and interest, and will cause you to take years to pay off the debt. With new credit card laws coming into effect in February 2010, your credit card bill will state clearly how long it will take you to pay off the debt by making only minimum payments. The hope is that this information will help shock some people into paying their debts off sooner rather than paying a king's ransom in finance charges and interest over the long term.
Another way to improve your score is to not close open credit card accounts. When you close an account, you lower your available credit and increase the proportion of debt to credit. If you have open credit cards, make a small purchase each month and pay it off completely, so that you aren't charged dormancy fees or the card is automatically closed by the lender. For example, if you have two credit cards you never use, purchase gas once a month with each card and pay the entire bill each month.
Also, get copies of your credit report at regular intervals (more on this below) to make sure there are no mistakes. If there is a mistake on your credit report, your FICO score obviously suffers, so it's important to remain observant.
By law, you are allowed one credit report each year from each of the three credit bureaus at not cost. This means you can get up to three free reports each year, and you should take advantage for the reasons outlined above. The FICO score process is mystery enough, don't let it be even worse by allowing mistaken information enter into the equation. Go through your credit report carefully and dispute any information that you feel is wrong.
You can also sign up for a number of monthly credit reporting services, though these cost about $10 to $15 per month.
To get a copy of your credit report, visit www.annualcreditreport.com, a site run by the three credit bureaus. And for more information on FICO scores, visit www.myfico.com.
