Your Credit Score Revealed

Apropos of nothing, I thought I’d write today about something that I’ve known for years, but many Americans don’t: what credit scores are composed of. As some of you know, I’m a trainer at a credit union. I’ve worked with loans and credit reports for years. Credit reports and credit scores remain a mystery for many people, so I thought I’d share a few things.
FICO Score
Fair, Isaac and Company (FICO) was one of the pioneers in developing a credit scoring system, starting up in 1956. (They have since renamed themselves as Fair Isaac Corporation.) Sometimes I call credit scores your “FICO score” or simply “FICO.” Essentially, FICO developed a scoring model which generates a number, typically between about 430 to 850 (worst to best, respectively).
Scoring Models and Uses
There isn’t just one FICO score. Over the decades, FICO has developed a number of different scoring models, intended to be used for different uses. They have a scoring model that is used by auto dealers, one for insurance companies, another for mortgage lenders; another for employment, and so on.
The credit union I work for uses the FICO2 model, which is fairly typical for general banking use. FICO2 is intended to predict how someone will make their loan payments in the next two years, although we use it partially as an indicator of a person’s character as well, to qualify them for a savings or checking account, what kind of credit card they might qualify for, and so forth.
Credit Bureaus
There are three major competing credit bureaus in the United States, Experian, TransUnion, and Equifax. Most consumer lenders rely on one bureau to make the majority of its decisions for consumer loans. Most mortgage lenders rely on all three bureaus. The credit bureaus have the market share of lenders in different parts of the country. Equifax serves the majority of the South. Experian serves the Midwest and western states, including Arizona. TransUnion serves the northern and eastern states.
Most lenders send reports every 30 days to all three bureaus on the status of each loan they have on their books, including what type of loan it is, what the original balance was, what the current balance is, what the minimum payment is, whether is current or delinquent, and how the payments have been made for the entire life of the loan.
There are strict regulations in place (chiefly the Fair Credit Reporting Act of 1970) which state how long information can stay on file, what the bureau has to do with disputes, and so on. For example, if you are more than 30 days late on a loan payment, this derogatory piece of information will stay on your credit report for seven years from the month it happened. Good payment history stays on your report for 10 years (at least, with Experian it does).
ABC BANK                   9-12       $21,424-O              OPEN     DELINQ 30
46461164 BI AUT 59   12-12      $19,814     10-12    ( 6)         1CCCCC
6484440004                               $400           $400
A typical auto loan on a credit report
Generation of Credit Scores
Nobody has a credit score that magically hovers above their head like they show in the commercials. Credit scores are real-time, meaning that when you apply for a loan, your credit score is generated based on that exact snapshot in time. Your credit score can fluctuate dramatically from one month to the next, based on a number of factors. More on this in a minute.
Risk Based Lending
As I mentioned, credit scores usually range from 430 to 850, and they are assigned letter grades based on ranges. Usually the grade is called “paper” (as in, “your loan is B paper”). Every lender has their own range definitions, but they go something like this:

FICO Score

Grade 

680 – 850

A

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640 – 679

B

600 – 639

C

430 – 599

D

 
The vast majority of lenders employ risk based lending, the practice of giving the best loan rates to those people with the best credit score, and the worst loan rates to those with the worst credit score.
F’rexample, you have a 670 credit score and pop round to a car dealer to buy that shiny new Mini Cooper that you’ve always wanted. If you opt to apply for financing, the dealer will send out your application for a handful of lenders, known as “indirect lenders” (because you are not applying directly with the financial institution). The indirect lender will look at your application and determine your interest rate based on a table that looks something like this:

FICO Score

Grade 

APR

680 – 850

A

1.99%

640 – 679

B

<div style="text-align: center;margin: 0in 0in 0pt” align=”center”>5.00%

600 – 639

C

8.00%

430 – 599

D

18.00%

 
So your 670 credit score means you get 5.00%. The dealer will get all the offers back, tell you about the best one, and try to get you to sign at the dotted line.
What if you could make your credit score 680 though? Ten points higher, and you could have a 1.99% loan and suddenly pay less monthly for the same car.
The Composition of a Credit Score
So what makes a credit score, and how can you make it better? How FICO arrives at a credit score—the exact formulae used for FICO’s scoring models—is a company secret. However, FICO has released some information about what goes into a credit score, mostly in terms of percentages. Here we go, in order of importance.
Payment History – 35%
An obvious predictive factor of whether you will make your payments in the future is how you’ve made your payments for the last seven to 10 years. More weight is given to current pay history than payments made ages ago, but generally, they are looking at if payments were made on time vs. delinquencies.
Approximate credit weight for each year:
–          40% = Current to 12 months
–          30% = 13-24 months
–          20% = 25-36 months
–          10% = 37+ months
 
My advice: Try to make all your monthly payments, even if it’s the bare minimum payment. Don’t get into debt you can’t afford.
Credit Capacity – 30%
Credit capacity is the percentage of your revolving limits that you have available. The lower the capacity, the more “maxed out” your revolving lines are.
F’rexample, if I have a $10,000 limit credit card and I have a balance of $3,000, my capacity is 70%. I’m only using 30% of my available revolving limits.
Credit capacity happens to be the most volatile thing about your credit score. Depending on when your credit card company reports your credit card balances every month to the credit bureaus, it could show you as “maxed out,” even if you pay off your credit card balance to zero every month.
The ideal credit capacity is 70%, meaning that you are using your credit cards, but you aren’t living off them.
Also, if you think you have too many credit cards and close all but one out, this can kill your capacity.
Example:
I have two credit cards, one with a balance:
–          $5,000 limit credit card with $3,000 balance
–          $5,000 limit credit card with $0 balance
–          My capacity is 70%.
If I close out my $5,000 limit credit card with $0 balance, I am left with:
<div style="text-indent: -0.25in; margin: 0in 0in 0pt 0.5in”>-          $5,000 limit credit card with $3,000 balance
–          My capacity drops to 40%.
My advice: Try to keep your credit card balance no higher than 30% of your limit, even if it means you need to make multiple payments a month.
Length of Credit – 15%
The longer you have your credit lines, the better. The people who “don’t believe in credit” and pay for everything with cash usually have low or no credit scores, and this is partially why.
My advice: don’t close out credit cards if you can help it, especially your oldest one, unless you never use it and want to prevent potential fraud, or if they start charging an annual fee. Paying off your auto loan in a short amount of time might make sense financially, but try to keep it for at least a year.
Accumulation of Debt in the Last 12-18 Months – 10%
This plays into the Length of Credit category a little. If you apply for a ton of store cards in the same month and get a ton of new trade lines all of a sudden, your credit score will take a nose dive. They look at the opening dates of every trade line, and they also look at the number of inquiries you’ve made.
Regarding inquiries, if you apply for an auto loan or mortgage within a 14 day period, it will only count as one inquiry. However, every inquiry stays on your credit report for 24 months.
There are also two types of inquiries, hard and soft (insert penis joke here). When you apply for a loan yourself, it will be a hard inquiry. Hard inquiries affect your credit score. Soft inquiries are made usually without your request. When you apply for auto insurance, for example, usually they will do a soft inquiry to look at your score. When you start a job, usually your employer will also do a soft inquiry on your credit. Soft inquiries don’t affect your credit score.
My advice: Don’t apply for loans or credit cards too often. Space out the applications. If you’re denied for a loan request, try to figure out why you were denied and try to fix it, rather than just applying at more and more places. Five inquiries aren’t going to kill your credit score. Thirty inquiries will.
Mix of Credit – 10%
The final piece that comprises your credit score is what kind of trade lines you have. Installment loans (like auto loans, mortgages, etc.) are better than revolving loans (like credit cards, lines of credit, HELOCs, etc.). Finance company loans can lower your score too.
My advice: If you’re in a lot of credit card debt, try to refinance it into a secured loan. You could refinance your auto loan and get additional cash out to pay down your credit card debt. Even a signature loan will most likely be a lower interest rate and also will shift your revolving debt to installment debt.
What Doesn’t Affect Your Credit Score
Income – Income doesn’t affect your credit score. I’ve seen people earning $200,000 a year who have low 600 credit scores. Income does have a vast indirect effect on your credit score, in whether you can afford to make your payments every month, if you can afford to get a mortgage, and so on. But it does not directly affect your credit score.
Debt ratio – Your debt-to-income (DTI) ratio doesn’t affect your credit score. It is, however, one of the biggest factors on whether you will be approved for a loan or what kind of terms they will offer you.
Length of time at residence – again, this might affect your loan application, but it doesn’t affect your credit score.
Length of time with employment – Employment has no direct effect on your credit score. You could be unemployed and have an 850 credit score.
Final Thoughts
Your credit score is important because it affects how much you will pay for loans, insurance, your employment opportunities, whether someone will rent to you or give you a mortgage, and so much more.
You can look at your credit reports (not your credit score) for free every rolling 12 months by going to http://www.annualcreditreport.com. You should review it periodically and make sure it’s accurate. Dispute anything that’s not correct. This is a good way to see whether your identity has been stolen too.
Always pay your loans on time, if you can help it. If you can’t make a payment, talk to your lender and see if you can make a deal before it goes delinquent more than 30 days.
Be careful with your credit cards. Credit cards aren’t evil—but they can have a major impact on your credit score. Don’t max them out. Make them work with your budget.
If you don’t have a credit score and you’re over 18, it’s time to start! Try getting a small pledge loan or a share secured credit card.
Ask for advice from someone knowledgeable. Many credit unions have experts who can pull your credit reports and go over them line by line with you.