How Credit Scoring Works
What is Credit Scoring?
It is common knowledge that different people have a different reputation in the credit world based upon their past uses of credit. And most people know that this can have a large impact on the rates that you receive on a loan or credit card, or if you can even get that loan or card. Anyone who has ever used credit for any reason has a credit score. This is a number that reflects all of your credit history and communicates to lenders how much of a risk you are. By your score, a potential creditor knows how high of a risk it will be to lend to you. Credit scores range between 300 and 850, with 300 being a very bad score and 850 being an excellent score. Understanding the dynamics behind this number can save you both money and reputation.
How is a credit score calculated?
A person’s credit score is calculated using complex algorithms that are kept under lock and key by the major credit scoring agencies. But with the following general guidelines, you can understand the basic concepts behind your credit score and how it is affected by your lifestyle and relationship with credit. The standard credit score accepted in the US is the FICO score. FICO (Fair Isaac Corporation) is a company that calculates credit scores and provides them to business and credit agencies. The score from FICO is what most potential lenders will look at when considering your application. Several different factors are taken into consideration when making this score, and certain factors weigh more heavily than others. The breakdown of the FICO scoring components is as follows:
- 35% - your history of payment
- 30% - the money you owe compared to your available credit
- 15% - The length of your credit history
- 10% - Any new credit that you have recently acquired
- 10% - The types of credit you use
History of Payment
The best credit scores always belong to people who consistently pay their bills on time. This includes always paying off credit card balances on time and never defaulting on a loan. A person’s character and reliability can usually be judged fairly accurately by their faithfulness to pay off credit on time, so this is naturally the factor that affects your credit score the most. Even one late credit card payment can result in damage to your score.
A creditor wants to lend money to those that show a high promise of paying that money back on time. If a person already owes a lot of money, they appear to be a high risk customer and incur higher rates. The risk is not calculated merely on the amount of money owed, but by how much of a person’s credit is used. A person who has a credit line of $1,000 and owes $700 will look a lot more risky (and will have a worse credit score) than someone with a credit line of $10,000 that owes $2,000.
Length of Credit History
The longer that you have been using credit (and using it well), the more stable and trustworthy you appear. This is a factor that you cannot really change, but one that does affect your score. Thankfully you can still have a good score without a very long credit history.
Someone who has recently acquired a few new credit cards appears to be in financial trouble and looking for ways out. Having recently picked up a new card can reflect negatively on your credit score. However, unless this is done to a large extent the damage will not be significant. To be safe, you should not seek new credit shortly before applying for a large loan.
Types of Credit
Using a variety of credit types (i.e. a mortgage, car loan, credit card, etc) makes a person seem to be more experienced in using credit well. They present a lower risk, and so receive a higher credit score.
Hard and Soft Inquiries
Inquiries into your credit score show up on your credit report and affect your score. For this reason, you do not want to inquire into your score often. But not all inquiries are equal, and not all will harm your report. Hard Inquiries are those that are initiated by you. When you apply for a loan or a new credit card, the creditor will look into your credit report. Each of these inquiries appear on your report and deduct a few points from your score. Hard inquiries will disappear from your report in two years and usually do not harm your score enough to be noticed. But when they occur often, they can be damaging; and several of them appearing shortly before you seek a major loan could discourage a potential lender. Soft Inquiries are those made without your knowledge. These may be conducted by your credit company when they determine if they could give you a higher credit line or by lending agencies that are seeking to solicit your business. A soft inquiry usually does not have any effect on your score and you will not even know that it happened. These general guidelines can allow anybody to take control over their credit score. However, while these guidelines are usually accurate and reliable, they are not completely universal. Some people are scored slightly differently because of miscellaneous factors that only FICO knows. Errors also sometimes occur in the compilation of a credit score. It is recommended that you check your report annually so that you can correct and report any errors. This can also alert you to any possible identity theft that you would not otherwise notice.
How can I find out my credit score?
The Fair Credit Reporting Act is a United States Federal Law that mandates that each of the three consumer reporting credit agencies- Equifax, Experian and TransUnion - give you a free copy of your credit report every 12 months. As this program is administered by the federal government, you will not have to enter your credit card information. You can get your report for free either by:
- Ordering it online by going to annualcreditreport.com.
- Filling out the Annual Credit Report Request Form and sending it into Annual Credit Report Request Service, P.O. Box 105281, Atlanta, GA 30348-5281.
- Or call 1-877-322-8228 and request it over the telephone
You will receive your credit report 15 days after you request it by phone and mail. You can get it instantly if you order online. You cannot get your free credit report by contacting the agencies directly. You can only order one free copy every 12 months with the methods stated above. To get your free credit report you will need to provide the following:
- Your Social Security number
- Your current address. (If you have not lived at your address for at least two years, then you will have to provide your previous one as well).
Fake Free Credit Report Sites
Many websites say they offer free credit reports, but you will have to enter your credit card info and if you do not remember to cancel a monthly fee will be charged. There is nothing free about these free credit reports websites as they inevitably come with strings attached. If you find an online website that says they are part of the free credit report program and they clearly are not, you can report them to the FTC at email@example.com. Also, the Annual Credit Report website will not send you any emails requesting personal information. If you receive such an email, do not reply, just send it to the email listed above. You are also eligible for a copy of your free credit reports if you have been denied credit, insurance or employment, if you are on welfare or have been a victim of identity theft or fraud. If you've already requested a copy of your credit reports for the year, but you need copies of your most recent ones, you can them directly from the agencies. Each report will run you around $11. Equifax:1-800-685-1111; equifax.com Experian: 1-888-397-3742; experian.com TransUnion: 1-800-916-8800; transunion.com
How Can I Improve my Credit Score
The most important thing to know about improving your credit score is that there is no quick fix for bad credit. In fact, according to myFICO, the consumer division of FICO, these efforts tend to make matters worse. The only way to repair bad credit is to keep current on your payments, reduce your debt and give the bad credit time to move off your credit report. There are several steps you can take to start your journey to good credit:
- Check your credit report. You are entitled to one free report from each of the three credit reporting agencies each year. Armed with this information you can verify whether the bad marks against your credit are valid. If you find an error, dispute it with the credit bureau and the institution or agency that reported it. You can read more about disputing errors on your credit history at myFICO.
- Pay your bills on time. If possible set up automatic payments through your bank so you are not late with your payments. If that isn’t possible, leave a marked calendar of payment dates in a visible location and set reminders on your phone or computer. Your payment history counts for 35% of your credit score. Improving this area will have the greatest effect on your score.
- Reduce your overall debt and lower your debt ratio. This is probably the hardest step and takes the longest to accomplish. Concentrate on paying those debts with the highest interest rate first and if you have extra cash in the budget pay more than the minimum. Your debt ratio counts for 30% of your credit score. Each month that you reduce your debt principal, you improve your debt ratio.
- Avoid applying for new credit, especially at high risk finance companies and payday loan organizations. Recent credit applications and types of credit applications each account for 10% of your credit score and are the easiest for you to control. Even short term finance purchases of furniture, electronics or other household goods can trigger a request for a credit report and the finance companies stores use aren’t always among the most respected in terms of credit scoring. In general, having finance companies that offer credit to high risk borrowers listed on your credit history, can have a negative effect on your score.
There are a few things you do not want to do:
- Do not give money to anyone who says they can fix your credit. There is no fast way to fix bad credit and you are wasting money that could be used to pay down your debt. There are legitimate credit counselors who can help you manage your debt with the goal of improving your credit history. The US Department of Justice has a state-by-state list of approved counselors.
- Don’t close paid off accounts. Closing accounts too soon after paying them off may actually hurt your credit score. If you have borrowed close to the maximum on your other accounts, having the unused credit of recently paid off accounts in your available credit totals may help your score by lowering your debt ratio.
- Don’t open unnecessary credit accounts in order to decrease your debt ratio. Having additional unsecured debt on your record will more than likely do more harm than the good done by the change in debt ratio. Correct debt ratio issues by paying down your debt rather than opening new accounts. In the eyes of a lender, having available credit from accounts you have paid off is better than having available credit from accounts you have recently opened.
- Don’t move credit around. Pay off your balances instead of simply shifting from one card to another.
Paying off a collection item does not remove it from your credit history. According to Experion, late payments, loan defaults, judgments and other negative public records stay on your credit record for seven years. Credit inquiries stay on your record for two years. It may take time to move negative items completely off your credit history, but your score will increase as you pay your debts on time and reduce the overall amount you owe.