Your credit score is an all-important number in the world of borrowing. Those three little digits help lenders decide whether to loan you money and on what terms. The higher your score, the lower your risk profile appears to prospective lenders. This, in turn, means you’ll generally have a better chance of receiving credit, along with lower interest rates on loans and credit accounts.
Your credit score is determined by a number of factors that are collected in your credit report, which is a summary of your past and current financial activity. This report can have a big impact on your credit score … and your future.
How Your Credit Score is Calculated
Your credit score(s) reflects how you handle financial commitments. Credit-related actions show up on your credit reports, which include records of how you’ve managed borrowed money and loan repayment in the past. Three major credit bureaus — Equifax®, Experian® and TransUnion®— collect your financial data and assemble that data into your credit report; that information is used to create your credit score. Understanding how your score is calculated and knowing what lenders see as risky behaviors can help you make smarter decisions and avoid big mistakes that can damage your scores for years.
Credit scores are calculated based on these five factors:
1. Your track record of payments: Making your payments on time, every time, will help increase your score.
2. How much you owe: You can’t build your credit score without using credit, but there’s such a thing as too much credit. If you owe more money than you can reasonably afford to pay back, it will negatively affect your credit score.
3. How long you’ve had established credit: The longer you maintain credit accounts with a strong history of prompt payments, the higher your credit score is likely to be.
4. Whether you’re taking on or requesting new credit: Requesting a variety of new credit accounts, particularly within a short period of time, can lower your score.
5. The types of credit accounts you have opened: Car loans, major credit cards, mortgages and college loans are weighted differently in determining your credit score.
More than One Score
Be aware that this all-important number, which ranges from around 300 to around 850, can vary depending on the scoring model used by credit agencies and lenders. You may be surprised to learn you could have multiple credit scores.
Your score is calculated by taking the information held at a credit bureau (i.e., Equifax®, Experian® or TransUnion®) and running it through a scoring model. Although these models may be different, they all share a common purpose: They examine your current and past credit behaviors to predict whether you are likely to pay back money that a lender is contemplating loaning to you.
Here’s why you could have a variety of credit scores:
• Different creators: The FICO® score, which is used by many lenders, ranges from 300 to 850. Often, “FICO score” and “credit score” are used synonymously, but that’s not entirely accurate. It’s good publicity for FICO, the company that created credit scoring, but it’s somewhat like calling all soda Coke®.
Recently, another big player entered the fray: VantageScore®. The credit bureaus, in an attempt to tap into the big bucks of credit scoring (and cut what they pay to FICO), created this new form of credit scoring.
• Different databases: Different information coming in causes different scores to come out. Any of the three credit bureaus could supply the raw data that go into a particular credit score. But not all lenders report the same information to each bureau, so your score may be different based on which database is used.
• Different purposes: There are different models for different types of lending. There’s a score designed to determine how much of a risk you are in general, but there are also scores for lenders who want to gauge your risk specifically for a car loan, credit card or mortgage.
• Different versions: Over the years, credit scoring has gotten more and more sophisticated. However, some lenders may not want to pay for the latest and greatest scoring version when they’re already using an older (and less expensive) method to calculate your score. This means they save some money while you have yet more possible credit scores.
Despite the potential confusion created by all of these different scores, there’s good news. Whether you have three or 30, you can be laser-focused in your effort to build or maintain a top-notch score. Do the right things and everything will fall into place, no matter how your score is calculated.
Establishing a Credit History
“The only way to build a credit history is to use credit,” explains Maxine Sweet, vice president of public education at the credit bureau Experian. Using it wisely is the key.
You need credit to get credit, which presents a common financial predicament for many young people who are just starting to establish a sound fiscal record. But even if you’re older and have been through some credit-wrecking havoc in your life, you could face a similar problem.
Here are six basic steps to help get you started:
1. Know the Score: Figure out what credit history you’ve established. Even if you’ve never had a loan or credit card, there’s a good chance you have information on your credit reports that has been compiled by the three major credit bureaus. For instance, Experian now collects rental payment histories, so some landlords submit reports to credit bureaus, notes Sweet.
Under federal law, the three credit agencies are required to provide you with a free report every 12 months. J.J. Montanaro, a Certified Financial Planner™ practitioner with USAA, suggests taking advantage of your free annual report from AnnualCreditReport.com. Your credit scores aren’t included in your free annual credit report, however, and you’ll have to pay $10 to $20 to view them. You can get your scores from myFICO.com or you can also purchase the VantageScore with a free report at annualcreditreport.com. By law, lenders must provide you a credit score for free whenever you apply for credit and are turned down or not approved at the best rate.
2. Research Your Choices: If you have little or no credit history, your choices for loans or credit cards may be limited, says Montanaro. However, retail or gas cards, and loans secured by property, such as furniture or a car, may be easy to get. Montanaro also suggests asking someone with good credit to co-sign on a low-limit credit card with you.
Your bank or credit union may provide another alternative. Sometimes they offer special programs for customers who need to establish credit. “USAA offers a secured credit card program that is linked with a CD rate,” says Jennifer Adams, executive director of product management at USAA. “It can be a great way to help build credit history.”
3. Establish a Track Record: Once you have some credit accounts, it’s important to use, but not abuse, them. “It’s counterintuitive, but if you don’t use credit, you won’t be able to build a solid history,” explains Montanaro, who suggests using your card to make small purchases and paying off the balance each month. For credit newbies, a secured card might also be a good way to get in the game. (See sidebar about secured credit cards on page 24.)
“By charging a small amount on at least one card and paying the balance on time and, ideally, in full, you will show that you can manage credit without charging more than you can afford to pay,” adds Sweet.
4. Use Credit Wisely: If you want to be a credit superstar, you must follow two basic rules: Pay on time and don’t go over your credit limits. For those of you just starting out, this is critical.
“It is important to start carefully — at this point, you don’t have a long and distinguished track record that can help alleviate the impact of a small mistake, so tread carefully,” says Montanaro. “Using credit responsibly means you use and pay off your cards monthly, make payments on time every time, do not apply for numerous accounts and check your report periodically.”
5. Don’t Make These Mistakes: Gina Jordan, assistant vice president of product management at USAA, recommends steering clear of these common blunders:
Submitting too many applications: Applying for several lines of credit and loans within a short period of time can give lenders the impression that you’re in desperate need of money and may have trouble paying back the debt. Keep your number of applications at a minimum and only go for the opportunities that offer the best deal for you.
Maxing out your accounts: Part of your score is based on the amount of credit you have available but aren’t using. The lower your balance (in proportion to the credit limit), the better.
Closing accounts: If you decide you no longer need a particular account, don’t close it. The age of your accounts affects your score, so keep the oldest ones to show as long a credit history as possible.
6. Keep an Eye on Your Reports: Once you’ve established credit, get in the habit of keeping an eye out for fraudulent activity, as well as any reporting mistakes. Jordan recommends services such as USAA’s CreditCheck Monitoring® through Experian to protect your credit and guard against identity theft.
Improving Your Credit Score
Once you’ve established credit, it’s important to responsibly manage different types of debt: car loans, major credit cards, mortgages and college loans. The tips for improving credit scores aren’t much different than those offered for establishing them.
• Be on time: Payment history affects about 35% of your credit score, so you’ll want your payment history to be impeccable. The habit of not paying on time will really hurt you. Never, ever be late with your payments. Better yet, pay early. Pay all of your bills on time, every time.
“Your score reflects a pattern of behavior and represents your overall body of credit work, but it also reflects the notion of ‘what have you done — or not done — for me lately?’” Montanaro says. “If you continue to use credit and demonstrate that you are managing it well over time, your scores will begin/continue to climb.”
• Be debt-averse: Keep your credit card balances low. You can demonstrate creditworthiness by demonstrating restraint. Backward though it may seem, if you use too much of the credit extended to you, you will hurt your score. So don’t carry balances on credit cards or lines of credit, and if you do, keep the balance to less than 20-25 percent of what’s available. You have to be in the game, but not all in.
• Be patient: Credit history includes the word history for a reason. Potential lenders want to know that you’ll be a good borrower in good times and bad, and building or rebuilding that image of reliability takes time. Being a good borrower over a few years or a decade is a bigger deal than a good payment history of only a month or two. This is one reason that keeping older credit accounts and avoiding the establishment of new ones is a good idea.
Even if you change bad financial behaviors, it takes time to improve your credit history. (See page 26.) Although late payments may remain on your credit report for seven years, generally if you clear all past-due debts and pay on time from then on, your score can improve quickly. Additionally, the further in the rearview mirror bad things are, the less they impact the score. A single late payment should stop affecting your score in six to 12 months, if your credit report is otherwise pristine.
What If You’re Already in Trouble?
What if, either through bad circumstances or bad management, an elephant-sized pile of consumer debt now sits on your chest? It’s heavy, it’s stressful and you can’t imagine how you’re ever going to get out from under it. Many folks in this situation consider a consolidation loan or maybe a balance transfer to help solve the problem. Scott Halliwell, title, recommends doing a couple of other important things first, before you consider such steps.
“First and foremost, fix the cause. Life is full of cause-and-effect relationships. And when you’re trying to fix a problem, you’re more likely to find success if you focus on the cause,” says Halliwell. “With debt, this means asking yourself how you got in debt in the first place. Was it bad luck? Be honest with yourself. Or was it the result of bad decisions?”
Whatever the reason, unless the cause of your indebtedness is addressed and you take action to stop it from happening again, it’s often a matter of time before you will find yourself in an even worse situation. At a minimum, this means establishing (or reestablishing) a budget, diligently following it and limiting or cutting off your use of consumer debt.
Second, Halliwell also suggests stashing some cash. This can be difficult when you have a pile of bills to pay. And it may even seem counter-intuitive when savings accounts are currently paying less than 1 percent when credit card companies are charging an average interest rate of 14.9 percent*. If you’re already in credit trouble, you may be paying closer to 22.5 percent on your credit card debt.
“I’m completely aware that my suggestion makes no sense mathematically,” Halliwell acknowledges. “Earning less than one percent on money that could be used to pay off debt that’s accruing interest at 15 percent or higher is pure lunacy from a mathematical perspective. But for many people, fixing this problem really isn’t about doing the math. It’s about setting themselves up for success and changing behavior. Having a little cash in the bank when something unexpected happens can go a long way toward getting there.
“Trust me, the unexpected will happen. And when it does, if you’re like most people, you’ll pull out your credit card to deal with it, which just adds to the problem. That’s why your first step, even if you have a bunch of credit card debt, should be to set aside a small emergency fund. That way, when you need cash for a crisis, you have it. Just be sure to replenish your fund if you’re forced to use some of it.”
An American Way of Life
Financial choices you make today and made yesterday have a direct and often lasting impact on the credit options you have available to you tomorrow. Borrowing money to buy a home, car or other major purchase is a common practice for most Americans and it’s critical to understand your current credit score and take steps for securing your financial health in the future.