Credit Scores

What is a Credit Score?

Your credit score is a representation of your credit report and payment history. Every time you apply for a loan, use a credit card, miss a payment, or go over your credit limit, a report is generated by that action to one of the credit bureaus. It includes a record of your on-time and late payments, past and present credit accounts, accounts charged off, or accounts referred to collection agencies, negative entries over the last seven years, bankruptcies over the last 10 years, public records. Your credit action is factored into a formula that generates your credit score.

There are three credit bureas, Experian, Equifax, and Transunion. They are independent agencies and your information will not be indentical with each one. They monitor your payment activity, record your payment history, and give you a credit score that they sell to other institutions.

Lenders use this credit score to help determine how likely you are to pay a loan when it is due. It is their way of planning for the risk they will take by giving you a loan. The higher your score, the lower the perceived risk of default, and the lower your rate will be. It is not only used for all types of loans (credit card, mortgage, auto, etc.), but it can also be used by insurance companies and employers during the job interview process.

A score above 760 indicates very good to excellent credit, and should be the score to aim for. A high credit score will save you money with better loan offers with lower interest rates. If you have a low credit score, you will be charged high interest rates for all loans and credit cards. If your credit score drops, credit issuers may increase your interest rates, even if you still pay on time.

If the error is a late payment or billing issue, you can contact the creditor directly. You must be able to provide the paperwork to support  your claim. They should report the correction to the credit bureaus, but it is a good idea to follow-up to make sure it has been reported and corrected.

Your credit score also determines your credit limit. The lower your score, the lower your limit will be. If your score is less than 650, expect your credit limit to be less than $1,000.  It it is less than 600-500, expect a low credit of $200-$300 (if you are approved).

 

Example Showing the Effect of Credit Scores

Here is an example from FICO showing the affect of credit scores on interest rates on a $216,000 30-year fixed mortgage. The lowest score pays $227 more per month than the highest score.

760-850 score     5.86% interest rate       $1,275 monthly payment
700-759 score     6.08% interest rate       $1,306 monthly payment
680-699 score     6.26% interest rate       $1,331 monthly payment
660-679 score     6.47% interest rate       $1,361 monthly payment
640-659 score     6.90% interest rate       $1,423 monthly payment
620-639 score     7.45% interest rate       $1,502 monthly payment

It is very important that you check your credit score with all three credit bureaus at least once a year. It is possible that there are errors or closed accounts still lingering on your report. An error on your report could hurt your score and cost you money. Your score is continually updated and may fluctuate a few points each month. The credit bureaus will charge a fee for each report. The credit bureaus are: Experian (800-Experian), Equifax (800-686-1111), and TransUnion (800-916-8800).

You can get a free annual credit report from https://www.annualcreditreport.com/cra/index.jsp. This is the only place to get a free credit report. Beware of advertisements with a promise of a free credit report because it may be a scam.

 Your credit report contains the details of how much you have borrowed, payment history, personal information, and requests from other creditors for your report and employment history. It also contains public records like alimony, tax liens, and bankruptcy.
Here is what’s in your credit score: bill payment history accounts for 35% of your score, level of account balances accounts for 30%, length of credit accounts for 15%, new credit accounts for 10%, types of credit accounts (credit cards, mortgage, auto loan, etc) for 10%.

 

Reasons for a Bad Credit Score

  • Amount owed is too high.
  • Too many accounts with a balance.
  • Ratio of balances to credit limits on revolving accounts is too high. A high debt ratio indicates a higher risk of default on one of your loans.
  • Length of time accounts have been established is too short.
  • Number of accounts with delinquencies is too high. Serious delinquencies stay on your record for 7 years.
  • Filing bankruptcy. This stays on your record for 7-10 years. If possible, avoid bankruptcy.
Carrying a lot of debt will pull your score down. Creditors view you as a risk of default if you are close to the limit with your credit cards. Pay down your balances so that your debt ratio will be small or pay them off altogether. If it will take a while to pay down your debt, then try to increase your credit limits which will also bring the debt ratio down. Just be careful not to use this as an excuse to charge more and increase your debt trouble.

Limit your response to credit card offers. Each time you apply for a card or loan, the credit card issuer pulls a copy of your credit report, even if you don’t get the card. Just responding to the offer shows up on your credit history. This activity is a red flag for creditors if there are more than 4-5 of these during a six-month period. However, your score is not affected by multiple inquiries for auto loans or mortgages during a short time period. These are usually treated as a single inquiry.

 

Hard Inquiries vs. Soft Inquiries

 Hard inquiries are requests from vendors, banks, rental agencies, etc., for your credit history. These are initiated by you and happen when you shop for a mortgage or a new credit card. Try to limit these because if you have new credit or poor credit, too many hard inquiries in a short span of time can actually downgrade your overall credit rating. Certain situations such as looking for a mortgage or auto loan may cause multiple lenders to request copies of your credit report. To compensate for this, the credit score counts multiple inquiries in any 14-day period as just one inquiry. Don’t allow anyone to pull your credit report unless you initiate it and want the loan or the offer.
“Soft” inquiries include personal credit checks, pre-approved credit offers, inquiries used in making employment decisions, and inquiries for tenant screening (done by a landlord when you apply for housing). These inquiries are shown only on the credit report that you request directly from the credit bureaus, and will not be seen by potential creditors. These do not affect your credit rating.

 

Tips for a Good Credit Score

 Pay your bills on time. Late payments are the most common piece of negative information that appears on credit reports and are often responsible for significant drops in credit scores. For credit cards and loans, make at least the minimum payments in a timely manner each and every month.
  • Pay down your credit cards and close newer accounts that you don’t use and will not use in the future. It is a good idea to maintain your oldest accounts because longevity with these long-standing accounts looks good on a credit report. If these cards don’t have a good rate, contact the issuer and request a lower rate.
  • Keep your debt-equity ratio under 30%.
  • Use your credit card regularly and pay it off each month.
  • Keep your bank record clean; an insufficient funds problem with your bank could show up on your credit report.
  • If you have a good credit card, keep it. Maintaining a card and building a good payment history helps build your credit score. Creditors want you to have a long, dependable credit history.
  • If you are just getting started, don’t open a lot of new accounts all at once because they will lower your average account age. Fast account buildup looks risky if you don’t have an established history.
 Have a variety of loans, such as a mortgage or car loan, that you pay on time each month will also help build your score. Get into the habit of paying all bills including mortgage and utilities before the due date.
Pay off your balances; don’t just transfer them to another card or loan. If you are having trouble paying bills, contact your creditors to work out a payment plan, or see a legitimate credit counselor. This will help you manage your credit and improve your score over time. A good place to start is the National Foundation for Credit Counseling, http://www.nfcc.org/.
If you are closing a credit card account, write the company a letter telling them to close your account. Tell them to notify the credit bureaus that the accounts were closed at your request. Keep copies of these letters. In 45 days, double-check to make sure the account has been closed.
Improving your credit score takes a plan, discipline, and organization, but it is worth the effort. It is the most important step to improving your finances and building a secure financial foundation.

 

Fixing your Credit Report

It is not uncommon to have an error in your credit report. It is up to you to monitor your report and dispute the errors.  Errors in your credit report can result in a lower score, higher rates and penalties and fees.

Here are areas to look for errors in your credit report:

  •  Personal information that is misspelled or incorrect
  • Someone else’s information who has a simliar name or Social Security Number
  • Incorrect balances or incorrect amounts owed
  • Closed credit accounts that are still listed as open
  • Accounts that are not yours
  • Balances owed or payments that are incorrect

If you find an error on your credit report, contact the credit bureau to report it.  They must respond to your claim in thirty days or remove the information that is incorrect or can’t be verified. You can make your dispute by mail, telephone, or online. Disputing an item on your credit report will take some persistance and record keeping. It is a good idea to mail in the explanation of your situation and a copy of the credit report with the error. Keep copies for yourself. Keep a record of the details of any phone conversation.