Secrets of Your Credit Score
For most people, having perfect credit means maxing out your credit score. The FICO scores used to measure credit range from a low of 300 to a high of 850 -- perfect credit, at least as Fair Isaac measures it.
Each of the three major credit reporting agencies has a partnership with (F)air (I)saac (Co)rporation. ("FICO" -- get it?) Assuming your credit report is identical at all three agencies, your score should also be the same at all three. Often, however, the various agencies have different (and sometimes conflicting) information about you, which will lead them to report slightly different, and in some cases widely different, credit scores for you.
In addition to using the FICO method of scoring, each credit reporting bureau uses its own proprietary scoring methods for various purposes, depending on the lender and the situation. They are all capable of doing "customized" work for a partner. If you get your score directly from Fair Isaac, you'll know that it's a true FICO number. Other providers' scores are based on different scales and use different information. For teaching purposes, we'll use the FICO score, because it's most commonly used.
What your score means
Simply put, people with higher FICO scores get better rates on loans, and spend less money to buy things, than those with lower scores. To see this in action, check out some typical lending rates for different types of loans, as influenced by FICO scores, with Fair Isaac's Loan Savings Calculator.
Looking at the table, you can see that the very best rates for mortgages and cars are offered to people with a FICO of 720 and higher. Remember, 720 is the typical FICO score for American consumers, so you only have to be typical to get great rates! Better yet, many lenders will knock your rate down even lower as your FICO score rises, because they realize that you can afford to shop around and command the best rates everywhere. Lower rates translate to lower payments and more opportunity to save.
Jobs, apartments, Internet access?
In addition to what we might normally consider "traditional lenders" (banks, credit card companies, mortgage lenders, car financing companies, etc.), more and more companies are finding permissible purposes to access your credit file.
- Employers can do an investigative report to see if you have a criminal record or other transgressions that might speak ill of your character. If the job for which you are applying would entail significant responsibilities when it comes to handling corporate funds, a potential employer can deny you employment based on your credit history.
- Landlords and potential landlords are also allowed to check your credit history; they can deny you a rental if they aren't comfortable with you as a credit risk.
- Insurers also use your credit report as a determining factor on your risk as a driver and homeowner, which absolutely affects your insurance premiums.
- Utilities, cable companies, and ISPs have gotten in on the action, too. They argue that they're fronting you the first month's worth of service -- extending you credit, basically. This allows them to check your report and score to see whether you'll be a good risk -- and possibly deny you service or charge you premiums if your credit scores are too low.
As you can see, the scope of "permissible purposes" and "legitimate business needs" is growing. Absent further legislation to more specifically restrict the uses of your credit report, we can envision most businesses making a case for needing your credit report. Being profit-oriented companies, the credit reporting agencies will want to provide their services to these companies if they believe it's within the letter of the law to do so. Having a good credit score will become increasingly important.
How credit scores are calculated
So how does Fair Isaac come up with your FICO score? What things does it look at? How are various pieces of information weighted to arrive at your score? Read on.
First, understand that Fair Isaac is a for-profit entity, with shares traded on the New York Stock Exchange. Its credit scoring system is the heart and soul of its entire business. In the same way that soft drink companies protect their secret recipes, so Fair Isaac safeguards the exact formula for the FICO scoring system.
While we understand the need to protect the formula, it's particularly unnerving to see remarks on your credit file like "Too many revolving debt accounts" without being able to get a straight answer from anyone about how many is "just right." (Check out this maddening and somewhat humorous account of one man's attempts to get this information out of Equifax.)
Fortunately, Fair Isaac has issued some public information about how your FICO score is calculated. It breaks down as follows:
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- New credit: 10%
- Types of credit use: 10%
Before we get into each category, understand that the FICO model is designed to identify people who are good credit risks. When lenders order your FICO score, Fair Isaac is serving them, not you. Until very recently, consumers weren't allowed to view their scores at all.
In short, some of the things that make for a good FICO score may contradict The Motley Fool's advice regarding good personal-finance practices. For example, always carrying a zero balance on your credit cards is the smartest move from a personal-finance perspective, but it's somewhat frowned upon by credit scorers. Lenders like to see you carry reasonable balances on a manageable assortment of credit accounts, because it means they will make some money from you.
Our advice, when it comes to these potential conflicts, is to worry about your own finances first and your FICO score second. Although there are a few examples to the contrary, prudent financial behavior is usually rewarded with a good score.
Credit score categories
Let's look at each category one by one:
Payment history. As you might expect, this is the most important category. It takes into account your current standing with the debts you owe, as well as your past history. Having a good payment history, with no late payments for any accounts, is your best scenario. Things that will weigh negatively on your score include:
- Civil suits against you
- Wage attachments
- Other types of judgments
These are the most negative items; they will really hurt your score, and they can make you less desirable in the eyes of the lenders (and potential mates, we might add).
Other factors considered include past delinquencies on accounts currently in good standing. If you were 30 days late a few years ago, it'll hurt a little. Recent delinquencies will hurt much more, because they indicate that you're in trouble now and can't pay your debts.
Amounts owed. The major factors here are the number of existing accounts you have open and available to draw credit from, and the amount you owe across those accounts. For installment loans, such as car loans or mortgages, the FICO model will look at how much you owe relative to the initial loan amount or "high credit" number on your report. Lower ratios are good.
It's also important to keep a fairly low ratio between the amount available to you and the amount you owe for revolving debt accounts (credit cards, lines of credit, etc.).
Suppose you have four credit cards, each with a $2,000 credit limit, for a total of $8,000 available to you. If you only owe $200 on each card, that speaks very well of you (though we recommend that you pay it off ASAP, of course). It shows that even though you have lots of credit available to you, you're only using a small amount. You owe $800 out of a possible $8,000, for a balance/available credit ratio of 10%. Overall, you're doing well. But if all of those accounts are close to being maxed out, that's bad news -- it may indicate too heavy a reliance on credit, and an increased risk that you'll miss payments down the line.
Having too many accounts open can hurt your score, but having none is also detrimental. Weird, huh? Remember, lenders like that you owe money and pay it back responsibly. After all, they want to see some indication you'll use the credit they give you so that they can make some money! They just don't want you to have a ridiculous amount of credit at your beck and call.
Length of credit history. Ask yourself this question: Who is the ideal credit risk? One answer might be: "Someone who has had an account for a long time and uses the credit responsibly, but on a fairly regular basis." This kind of enduring relationship, where the customer gradually uses credit over long periods of time, is perfect for a lender. This is why your FICO score benefits from a long credit history.
This portion of the FICO equation is worth 15% of the whole score. The things that matter here are the total length of your credit history and the average length of time your existing accounts have been open. That's why opening too many accounts too quickly can hurt you. It will lower the average length of time your existing accounts have been open, dropping your score.
Finally, once you decide which accounts to keep open, it behooves you to use those accounts from time to time, because the formula also looks at how long it has been since you used the credit. The more frequently you use that credit responsibly, the more favorable you are in a lender's eyes. After all, they do want you to use their credit, so they can make money from you.
We recognize that there is a conflict between the Fool's advice to pay your cards down and the idea that your FICO score can increase if you keep some balances. As a general rule, pay the cards off. It's unlikely that keeping small balances will help your score so much that it will make a big difference in lending rates.
New credit. New credit isn't necessarily a bad thing, but as we mentioned before, getting lots of new credit in a short period of time will hurt your score. If you're trying to establish credit, or reestablish credit after some problems, go slow. Try to wait six months or more between opening new accounts, and only open a few new ones in any two-year period.
If you're shopping for a home or car and trying to get the best rates, make sure you cluster all of your applications for those purchases in as short a period of time as possible. FICO scores recognize that a number of hard inquiries in a short period of time (usually 30 days) probably indicates that you are shopping for good deals, and they will only count those inquiries as one hard inquiry, not multiple ones.
Inquiries will stay on your report for two years, but only those made in the past year will count toward your FICO score.
Types of credit use. This counts for about 10% of your score. FICO scoring models look for a healthy mix between installment debt, revolving debt, store charge accounts, etc. If you don't have a mix of these kinds of accounts, don't go out and open accounts to try to get that mix. It's unlikely to help you much, and it may even hurt your score.
It's commonly known that FICO scoring models favor credit cards and revolving debt. These kinds of obligations are generally more profitable for the lender than other types of debt, and people who use this kind of credit responsibly are attractive potential borrowers, all other things being equal. That doesn't mean you should go out and get five new credit cards, but it might suggest opening up a single account if you don't already have one, using it a little bit, and then paying it off.
Once upon a time, TransUnion had information on its website that indicated what a perfect credit score profile might look like. Please remember that nobody has verified this for us, but we thought you might like to see it. Here goes:
- A few (say, three or four) revolving credit cards, each with very high lines of credit ($10,000+), and very low balances on only one (or maybe two) of them at a time.
- At least one charge card.
- All tradelines (information about each account) at least six months old, and at least one more than three years old.
- No derogatory notations.
- Very few inquiries -- no more than one to three in a six-month period.
- At least one "installment" tradeline in good standing, i.e., a mortgage, auto loan, or student loan.
One more quick point: We have some anecdotal evidence to suggest that the past two years are significant from a lender's perspective, so making sure that you don't have any blemishes in the past 24 months is key. Several mortgage lenders we spoke to mentioned the importance of having a clean credit record for the past two years.
Now that you're armed with the inside scoop on how credit scores are calculated, you'll be better equipped to go forth and forge a spotless credit record -- or repair a slightly dented one.