Chapter 9: Credit Score

What is a credit score? Why is it important?

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, that action generates a report to one of the credit bureaus. Your credit action is factored into a formula that generates your credit score.

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 take when giving you a loan. The higher your score, the lower your perceived risk of default and the lower your interest rate. Your credit score is used not only for all types of loans (credit card, mortgage, auto, etc.); insurance companies and employers during the job interview process may also use it.

For a number that is so important to your financial well being, credit scoring is a bit of a mystery that varies with each agency. It is difficult to predict with complete certainty exactly what your score will be and how you can change it. There is no way to predict how every action will affect your score, or how quickly.

Using FICO scores as an example, a FICO score above 720 indicates very good to excellent credit and should be the score that you aim for. A high credit score saves you money through 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. A score of around 620 is the cutoff for lenders; if your score is below that, you fall into the difficult world of sub-prime lending.

Saving money or paying off debt is easy to talk about, but difficult to put into action if you don’t have a realistic plan and goal. A good place to start is with your credit score. Households with a low credit score and high debt probably have high interest rates on credit cards, mortgages, and auto loans, and even higher insurance rates. If you make the effort to raise your credit score, these rates will come down and leave you with more money to either save or use to pay down your debt. If you ignore your credit score, you could pay thousands more in interest over the life of your loan.

Check your score? What does it mean?

Getting a copy of your credit report twice a year from all three credit bureaus is a good idea. The credit bureaus charge a fee (typically $5 to $10) for each report. Experian (888-397-3742), Equifax (800-685-1111), and TransUnion (800-888-4213) issues credit reports.

There are two types of credit scores: VantageScore and FICO. This table describes what your credit score means using VantageScore:

Score Grade Comment
901–990 Grade A Excellent rating. Should have an easy time getting loans with the best rates.
801–900 Grade B Good rating. Should have an easy time getting loans with good rates.
701–800 Grade C Moderate risk. Lender will take a closer look at you.
601–700 Grade D Higher risk and higher rates.
501–600 Grade F Highest risk. Credit options will be limited or not available.

This next table describes the meaning of your FICO score:

Score Grade Comment
Over 750 Excellent Should have an easy time getting loans with the best rates
720 or higher Very good Should have an easy time getting loans with good rates
660 to 720 Acceptable Lender will take a closer look at you
620 to 660 Uncertain Higher risk and higher rates
Less than 620 Risky Credit options will be limited or not available

Understand the formula for your credit score

The credit score formula has several variables that affect its calculation. The following are such variables. Understanding these is important in helping you manage your credit score.

Variable Weight in Formula Comment
Payment History 35% Do you pay all of your bills on time? Making late payments, having bills go to a collection agency, or declaring bankruptcy all adversely affect your credit report.
Amounts Owed 30% If the amount you owe is close to the limit for any of your accounts, it will drag down your credit score. Keeping your debt at lower than 35% of your credit limit is a good idea.
Length of Credit History 15% This variable measures the length of time you have had each account. A long credit history indicates stability and lower risk. Having paid your mortgage on time for years is a good boost for your credit score. On-time payments and consistently low balances can offset a short credit history.
New Credit 10% Applying for multiple new accounts may drag down your credit score, as it reflects a higher possibility of overextending yourself, increasing your risk of default. The bureaus keep track of all inquiries into your accounts. The inquiries can hurt your score if you have a short credit history or few accounts.
Types of Credit Accounts 10% This variable factors in the types of credit accounts that you have, including credit cards, auto loans, mortgages, student loans, business loans, etc. A mix of loans, such as credit cards and a mortgage, and a good payment history, may help your score. You score is reduced if the majority of your accounts are with credit card and finance companies.

Who uses your credit score?

Credit scores are a fast and easy way for all types of businesses to make a quick judgment about you. Creditors use the score to determine whether they will give you a loan and how much interest to charge you for that loan. Having bad credit costs you more in insurance premiums. Some employers review credit reports and factor that into their assessment of you as a possible employee.

According to a recent survey released by Visa USA, the majority of Americans do not know that a bad credit score can keep them from getting the job they want. In the survey, only 20% of Americans knew that it is legal for employers to refuse to hire job applicants with low credit scores. Credit score checks join drug testing and criminal background checks as part of the interview process.

Tips for maintaining a good credit score

  • Pay your bills on time. Late payments, the most common piece of negative information appearing on credit reports, are often responsible for significant drops in credit scores. Make at least the minimum payments on your credit cards and loans on time 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 several new accounts all at once because they will lower your average account age. Opening too many accounts during a short period looks risky if you don’t have an established history.
  • Having a variety of loans that you pay on time each month, such as a mortgage or car loan, helps 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 continue to transfer them to another card or loan. If you are having trouble paying your 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, at http://www.nfcc.org.
  • If you are closing a credit card account, write a letter to the issuer telling it to close your account. Tell the issuer to notify the credit bureaus that the account has been closed at your request. Keep copies of these letters. In 45 days, double-check to make sure that the account has been closed.
  • Bankruptcy and late payments can quickly lower your credit score; however, improving your score will take time. Although improving your credit score takes a plan, discipline, and organization, it is worth the effort and is the most important step to improving your finances and building a secure financial foundation.

The effect of credit scores

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

Score Interest Monthly Payment
760–850 5.86% $1,275
700–759 6.08% $1,306
680–699 6.26% $1,331
660–679 6.47% $1,361
640–659 6.90% $1,423
620–639 7.45% $1,502

Reasons for a bad credit score

There are several reasons why you may have a bad credit score.

  • The amount you owe is too high. 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 on your credit cards.
  • You have too many accounts with a balance. Limit your response to credit card offers. Each time you apply for a card or a loan, the credit card issuer pulls a copy of your credit report. Even if you don’t get the card, responding to the offer shows up on your credit history, which is a red flag for creditors if you have more than four or five during a six-month period. However, making multiple inquiries for auto loans or mortgages during a short period does not affect your score, as these are usually treated as a single inquiry.
  • Your 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. Pay down your balances to reduce your debt ratio, or pay off your balances altogether. If paying down your debt will take a while, then try to increase your credit limits to reduce your debt ratio. Just be careful not to use this as an excuse to charge more and increase your debt.
  • The length of time your accounts have been in existence is too short.
  • You have too many delinquent accounts. Serious delinquencies stay on your record for seven years.
  • Filing bankruptcy. Since doing so stays on your record for seven to ten years, avoid filing bankruptcy if possible.

Improving your credit score

Improving your credit score takes time and planning, but it is worth the effort because it works and will save you money.

Here are a few tips for raising your credit score:

  1. Get a copy of your credit report from all three credit agencies. Getting a copy of your credit report should be at least an annual event because U.S. residents are entitled to one free copy of their credit report from each credit reporting agency once every 12 months. That means you can request a free credit report once every 4 months as long as you stagger your request so they go to a different agency each time. This information is found by calling 1-877-322-8228 or at Annual Credit Report. If any of the information on a report is incorrect, contact the agency to correct it. Incorrect information should be corrected or removed within ten to thirty days, and doing so may give your score a quick boost. Your credit score is usually NOT shown on the free annual credit report. There are paid options that will allow you to see your credit score.
  2. Pay your bills on time. This is the single most important factor in your credit score. Even if you only pay the minimum, pay your bills on time because late and missed payments are the easiest ways to lower your credit score. Even unpaid parking tickets and library fines may be reported to the credit agencies.
  3. Pay off your debt. High balances and high debt ratios drag down credit scores. Your debt balance should be less than 35% of your available credit. If you have a good payment history, contact your creditors and ask for lower interest rates. Then use what you saved in interest to pay down your balances.
  4. Build a long-term relationship with the accounts you have. A long history of good payments on a car loan, a mortgage, or credit cards increases your credit score. Keep older accounts or credit cards open, even if you are not using them, because you are rewarded for a long, positive credit history. If you review your credit report and discover that you have many accounts that you no longer use, close the newest ones first.
  5. Limit your credit applications. Too many new accounts can lower your credit score. Each time you apply for a loan, the application shows up on your credit report. A significant increase in inquiries signals that you are desperate for money and are a credit risk. The exception is shopping for a mortgage or a car loan, as multiple inquiries for the same purpose in a reasonable period are considered a single inquiry.
  6. Get a checking and a savings account.
  7. Do not co-sign for a loan for someone else. This shows up on your credit report, and a missed payment or a maxed out credit card by the other person will affect your credit score.

Hard inquiries vs. soft inquiries

Hard inquiries are requests from vendors, banks, rental agencies, etc., for your credit history. You initiate them and they happen when you shop for a mortgage or a new credit card. Try to limit hard inquiries because if you have new or poor credit, too many hard inquiries in a short period can actually downgrade your overall credit rating. Certain situations, such as looking for a mortgage or an 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 a single 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). Such inquiries are shown only on the credit report that you request directly from the credit bureaus, are not seen by potential creditors, and do not affect your credit rating.

How to get a free credit report

You are entitled to receive a free credit report each year. While many companies advertise free credit reports, the only place you can receive one is through Annual Credit Report.

Despite the advertising, be aware that no one else can offer a free credit report. For example, http://www.freecreditreport.com advertises free credit reports and is named as such, but in the fine print you will find that “When you order your free report here, you will begin your free trial membership in Triple Advantage Credit Monitoring. If you don’t cancel your membership within the 30-day trial period, you will be billed $14.95 for each month that you continue your membership.”

Errors in your credit report

Checking your credit score with all three credit bureaus at least once a year is very important. It is possible that errors or closed accounts are on your report, which may hurt your score and cost you money. Your score is continually updated and may fluctuate by a few points each month. The credit bureaus charge a fee (typically between $5 and $10) for each report. You can call them: Experian (800-Experian), Equifax (800-686-1111), and TransUnion (800-916-8800).

Having an error on your credit report is not uncommon. It is up to you to monitor your report and dispute the errors. Errors in your credit report may result in a lower credit score, higher rates, and penalties and fees. Errors may also result in you being turned down for jobs or loans.

The following areas on your credit report may contain errors:

  • Personal information that is misspelled or incorrect
  • Information for someone else with a similar 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 incorrect payments

If you find an error on your credit report, contact the credit bureau to report it. Tell the credit bureau in writing what you think is inaccurate. Include copies (not originals) of paperwork that support your position. Your letter should include details about each item you dispute and why you are disputing it, and request that it be corrected or removed. Circle your disputed items on the copy of your report. Send your dispute by certified mail with “return receipt requested” so that you have the date of receipt for your records. Make and keep a copy of all correspondence. If you talk with the credit bureau by phone, make notes of the date, the time, and the contents of the discussion.

The credit bureau must respond to your claim within 30 days or remove the information that is incorrect or can’t be verified. They will send information about the dispute to the company that provided the information. The information provider must review the dispute and report back to the credit bureau. If the information provider verifies that the information is incorrect, it must notify all three credit bureaus so they can correct your information.

After the investigation is over and the dispute results in a change, the credit bureau must give you your results in writing, along with a free copy of your updated credit report. You can ask the credit bureau to send notices of the corrections to anyone who had received your credit report during the last six months or to anyone who had received a copy of your report for employment reasons during the past two years.

If your dispute isn’t resolved, ask the agency to include a statement of dispute in your file and in future reports. The bureaus may charge a fee for this.

If the negative information is accurate, it can only be removed through time. Negative information can be reported for seven years and bankruptcies for ten.

Here is a sample dispute letter from the FTC:

Date

Your Name
Your Address
Your City, State, Zip Code

Complaint Department
Name of Company
Address
City, State, Zip Code

Dear Sir or Madam:

I am writing to dispute the following information in my file. The items that I am disputing are circled on the attached copy of the report that I received.

This item (identify item(s) disputed by name of source, such as creditors or tax court, and identify type of item, such as credit account, judgment, etc.) is (inaccurate or incomplete) because (describe what is inaccurate or incomplete and why). I am requesting that the item be deleted (or request another specific change) to correct the information.

Enclosed are copies of (use this sentence if applicable and describe any enclosed documentation, such as payment records, court documents) supporting my position. Please investigate this (these) matter(s) and (delete or correct) the disputed item(s) as soon as possible.

Sincerely,

Your name

Enclosures: (List the items that you are enclosing)