With the recent credit crisis, it has become much more difficult to obtain credit making your credit history and credit score more important now than ever. I have always wondered, what exactly is a credit score? How is it determined? What can I do to improve it? I figured some of you might have similar questions as me so I decided to research the topic and share my findings.
Last week, I decided it was time for me to pull my credit history and make sure there are no signs of identity theft. We have all been warned about the increasing risk of identity theft with technology advancing. It had been over a year and a half since I looked at my credit report and I remember that being a trying process. I had been misled by the ads of FreeCreditReport.com, the ones with the obnoxious lyrics that get stuck in your head! I mistakenly thought that it was actually an easy process to get my “free” report. Everything went fine until I saw a charge of $14.95 on my credit card statement. Of course I called the company and after getting very firm, they agreed to remove the charge. I later found out that other friends of mine had the exact same experience. In fact, there have been multiple lawsuits concerning those advertisements.
This time around, I decided to research the ways to get a copy of my report and came across the Federal Trade Commission’s link to AnnualCreditReport.com. I read about my right to receive a copy of my credit report from each of the three reporting agencies, Experian, Equifax, and TransUnion, once every 12 months due to the Fair and Accurate Credit Transactions Act of 2003. I had heard about this rule before, but didn’t know the best way to go about getting my report. This website was clearly where I needed to be. I chose one agency and looked over my report and everything appeared to be fine. But one thing was noticeably absent from my report, my FICO score. Of course, you have to pay for that feature!
So what exactly is a credit score? It its most general sense, a credit score is a number used by lenders to estimate the likelihood that a person will pay his or her debts. This number not only impacts whether or not you are approved for credit, but can also impact the interest rate you receive when you finance a purchase. The most widely used credit score is the FICO score, an acronym for the creators of this score, the Fair Isaac Corporation. This score takes into account various factors in five areas: payment history, current level of indebtedness, types of credit used, length of credit history, and new credit. Mathematic models are used to calculate a number between 300 and 850. Generally, a score above 650 indicates an individual has very good credit history.
So as I mentioned, there are 5 areas that are evaluated in determining your FICO score. I’d like to give a little insight into what each of these encompasses and which ones have the biggest impact on your score. Payment history is the biggest component, making up 35% of your score. But the definition of a late payment warrants further explanation. The credit bureaus are only notified if your payment is more than 30 days late. Payments that are between 30 and 60 days late can lower your credit score, but the negative impact is generally temporary and only harms your score for a couple months, assuming only one or two payments are that late. Payments over 90 days late severely hurt your credit score and can damage your credit for up to 7 years.
The second biggest component is current indebtedness also known as credit utilization, making up 30% of your FICO score. This is the ratio of current revolving debt (such as credit card balances) to the total available credit limit. It is perhaps the most interesting component. You can improve your FICO score by paying off debt and lowering this ratio OR by applying for and receiving a credit limit increase. Closing existing revolving accounts typically has a negative impact on your score. This is kind of a Catch-22 as it in a way encourages individuals to obtain unnecessary credit and leave inactive accounts open, which is not a very safe practice due to identity theft.
Length of credit history is the third most important component, making up 15% of your total FICO score. This includes time since accounts were opened and time since account activity. A longer credit history provides more information and offers a better picture on long-term financial behavior, which hopefully is a good thing and will help your score! It is impossible for a person who is new to credit to have a perfect credit score and in fact, many new college graduates have a very difficult time getting a credit card or financing a purchase at first because they have no credit. This is one instance when student loans actually help you!
The fourth and fifth components each make up 10% of your FICO score. There are several types of credit and you can benefit by having a history of managing different types. Some examples are installment, revolving, consumer finance, and mortgage. The last component is new credit. Credit inquiries for new credit can hurt your score, but inquiries that were made yourself to check your credit, by your employer for employee verification or by companies initiating prescreened offers of credit or insurance do not have any impact on your credit score. They will still show up on your credit history report. Also, individuals shopping for a mortgage or auto loan over a short period will likely not experience a decrease in the scores of these types of inquiries. That being said, it is a good practice to avoid opening too many credit cards in a short time frame because such behavior could suggest that you are in financial trouble and need access to a lot of credit. You should especially avoid opening new lines of credit if you are in the midst of buying or refinancing a home or financing some other large purchase.
While the actual formulas used to calculate credit scores are not public information, this breakdown of the 5 components and their allocations was disclosed by FICO. Each of the three credit bureaus mentioned above, Experian, Equifax, and TransUnion, have a slightly different method of calculating FICO scores and thus your score may vary slightly between the three.
To conclude, I definitely think it is a good practice to check your credit history report at least once a year. There are two main reasons for doing so, protection and accuracy. You need to make sure that there are no signs of fraudulent activity and that everything listed on your report is in fact credit you applied for or at least are aware of. Also, it is not uncommon for incorrect information to be reported that could potentially harm your credit. The only truly free and federally sanctioned website for requesting your credit report is www.AnnualCreditReport.com. On any other sites, you really need to read the fine print. The same goes for obtaining your credit score which is not part of your free credit report.
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