All About Credit Scores
What does a credit score predict?
Which credit score should I buy?
Why is it called a FICO score?
Why is my credit score so important?
Do married couples have a joint credit score?
How is the credit score calculated?
Why are credit inquiries so important?
How many points does a credit inquiry drop a credit score?
Will checking my credit lower my credit score?
Which factors are NOT considered in credit scoring?
Which credit score do lenders use?
Will I pay through the nose if my credit isn't perfect?
Why would my data be different at the three credit bureaus?
How long do negative items stay on my report?
A credit score is a number. This number tells lenders how likely a person is to repay a loan. Credit score has nothing to do with age, race, marital status or income. It ranks a person on one factor and one factor alone—likeliness to repay a loan. Credit bureaus provide credit scores.
A credit bureau is a private company that sells credit information. Here is the way it works. Let's say that you have a charge card at your local department store. You run up a balance on that card buying gifts for your girlfriend, and eventually you miss a payment. A late payment is a payment that is 30 days late. The department store reports your late payment to the credit bureau. The credit bureau adds the information to your file, and your late payment affects your credit score negatively. If you are late again the following month, the department store will tell the credit bureau that you are now "60 days late," which hurts your credit score more than being 30 days late.
The credit bureau then makes money by selling your credit information to lenders. Let's say that you go down to the BMW dealership to buy a new Mini Cooper. You agree on a price with the salesman, and what is the first thing he does next? You guessed it—he pulls your credit score. Car dealerships have agreements to buy credit reports and credit scores at a certain price from a specific credit bureau. The cost to the dealership is usually a few dollars if they do enough volume with the credit bureau. The car dealership basically pays a few bucks to find out if they should offer you a car loan. If your credit comes back as excellent, you'll get a great interest rate and favorable overall terms. If your credit comes back as not-so-great, you'll still get the car, but you'll pay a higher rate. A poor credit rating will mean that you won't get the new car at all.
Anyone can own a credit bureau. You could start your own credit bureau. The problem is that you need data on millions of Americans to have anything to sell to companies looking for credit information. The long and short of it is that there are three major credit bureaus—Equifax, Experian and TransUnion. The big three credit bureaus collect data on individual people and then provide a risk analysis of each person's credit worthiness through the much talked about credit score.
Credit scores range from 300 to 850. The higher the number, the better the score. 620 is a crucial point in looking at credit scores as they pertain to mortgages. Borrowers below the magical 620 mark are considered "sub-prime." Prime borrowers are those who are the best credit risk, so a "sub-prime" borrower is less than completely desirable from a lender's point of view. A 620 or better credit score qualifies a borrower for good rates on a home loan. A credit score over 700 is excellent. 680 to 699 is a very good credit score. 620 to 679 is considered "good" credit, qualifying you for very good mortgage rates and terms. A credit score between 580 and 619 is considered "high risk." You can still obtain a mortgage and other loans, but you will pay a higher rate. A credit score of 579 or below is considered poor credit. A score south of 500 is considered awful credit.
What does a credit score predict?
Credit scores predict the risk of delinquency. Delinquency occurs when a borrower defaults on a loan, files for bankruptcy, or falls 90 days past due on at least one credit account. A credit score predicts a borrower's chance of becoming delinquent.
Which credit score should I buy?
All three credit bureaus sell credit scores to both consumers and lenders. Although all three credit bureaus sell FICO scores to lenders, Equifax is the only one that sells FICO scores to consumers. The other two sell proprietary scores. FICO is a brand name of sorts, kind of like Kleenex or Vaseline.
The credit score used by your lender will likely be a derivative of your FICO score. Big banks take the FICO information, dump it into their own databases and spurt out their very own credit score that they use for internal purposes. Different lenders place different priorities on various credit score factors. For example, mortgage lenders rank certain factors as more important than auto lenders. Each big lender has their own proprietary scoring system that they use to evaluate creditworthiness. This means that the credit score you buy online is a good indicator of your credit, but it's not necessarily the exact score that your mortgage lender will use to evaluate you as a borrower.
You can buy all three scores at www.myfico.com for just under $50. But because Equifax is the only credit bureau that sells the true FICO score to its consumers, the Equifax score is the only score that I would buy. The credit score that Equifax sells to you as a consumer is the very same score that they sell to lenders.
If you go to Equifax's website, you can buy your credit report and FICO score for $15.95. However, by law you are entitled to one free credit report each year from each of the three major credit bureaus. Go to www.annualcreditreport.com. When prompted, choose to only receive a credit report from Equifax. You will be prompted later to upgrade your order by paying $6.95 to add on your FICO credit score. Only the report is free; if you want your FICO credit score in addition to your credit report, it will cost $6.95 from Equifax. In 4 months you can go back to www.annualcreditreport.com and get a free credit report from Experian, and 4 months after that you can go back to the website and get yet another free credit report from TransUnion. Using this system, you can monitor your credit report for free three times each year.
Why is it called a FICO score?
The Fair Isaac Corporation developed the software and the model for the credit score, hence the name FICO.
Why is my credit score so important?
Your credit score is important—real important. Why? So many things are tied to your credit score. The worse your credit score, the higher the interest rate you will pay on a home loan. The worse your credit score, the higher your interest will be for a car loan. Your credit card rate will also be higher. You may not believe it, but you will even pay more for automobile insurance.
Some people are learning about this the hard way. Let's say that you have a solid credit score (or so you thought). You have several credit cards, and you have run up a sizeable balance on one of those cards. The card has a rate of 9% because of your good credit, which is good for a credit card. Sales have been a little slow at work. Your commissions weren't as high as normal, so your paycheck was a little light. As a result, you got behind one month and paid some of your bills 30 days late, including your car payment. You got caught back up the next month, and you thought that all was back to normal. You go to the mailbox, and what do you find? Surprise! Your credit card rate just jumped from 9% to 19.99% even though you were never late on that card.
The way things work in the credit card world is that big credit card companies conduct regular "account reviews" which include pulling your credit on a regular basis. This type of inquiry doesn't hurt your credit score, but it can be detrimental to the terms that you have with your credit card company. If a credit card company finds that you have been late on other payments, have high balances on other cards, or that your credit profile has changed in any way that they deem affects your risk assessment, they will raise your rate.
As if that news wasn't bad enough, you find another letter in the mail from your insurance company. Your auto insurance rates have just jumped 20%. "That must be a mistake," you think to yourself. "I haven't had any tickets or accidents. I'll call my agent tomorrow." Unfortunately, it wasn't a mistake. Your insurance company reviews your credit report too, and they aren't happy about your depressed credit score. Your auto insurance rates have just been raised 20% even though you had no accidents or tickets.
As if your day can't get any worse, you get more bad news. As you make your way into your house after a hard day's work, you notice that you have a message on the machine. It's a call from your soon-to-be employer letting you know that you didn't get the job after all. You nailed the interview, and you were offered the position. The salary and benefits were fabulous, and you told all your friends and family about your new job. You haven't given notice at your current job yet because you were told to wait for the human resources people to contact you about a start date. Unfortunately, the HR people at your new company pulled your credit report, and they weren't happy with your score. They have decided to rescind the job offer. How can a prospective employer pull your credit report? Well, you gave them permission. It was one of the many forms that you signed after being offered the position.
The reality is that most Americans don't even know their credit score, nor do they understand how the scores are calculated. They also don't fully comprehend how their credit score affects their real life. When it comes to a home loan, a marginal credit score can cost $200-$300 more per month in interest over what you would have paid with a slightly better score. Even cell phone companies check credit scores. A person with credit issues might be asked to ante up a down payment to start a cell phone plan. In contrast, people with good credit scores often get 0% auto loans, the best rates on mortgages, the lowest insurance rates, and the list goes on.
Do married couples have a joint credit score?
No. Your credit score is individual.
How is the credit score calculated?
The exact formula for how the FICO credit score is calculated is top secret. There are some things that we will never know, such as exactly how to split an atom, how to mix a batch of Coca-Cola, and how to calculate our own credit score. The reason that this formula is so top secret is because the credit bureaus don't want people to manipulate their credit scores. Fortunately, there are some things that we do know.
Let's start with the five categories that make up credit score. Here they are ranked by importance:
30% - Amount Owed
15% - Length of Credit History
10% - New Credit
10% - Type of Credit
Now, let's take a closer look at each of the five factors that contribute to your credit score.
Payment History (35% of your credit score)
Your payment history is the most important contributor to your credit score. For obvious reasons, lenders want to know if you have a history of repaying your debts. They figure that if you've paid other people, you'll pay them too. Punctuality is key in this category. Pay on time and your credit score goes up. Pay late and your credit score goes down. "90 days late" is also worse than "30 days late." Your credit report will indicate whether you are 30, 60, 90 or more days late on a payment.
The number of accounts is also crucial. A person who has one home loan, pays cash for cars and doesn't have any credit lines is known as a "thin file." That person's credit score won't be very high because of the number of accounts—in this case—one. One mortgage does not a credit profile make. Such a person would have a credit score, but it wouldn't be as high as another person who has had five different mortgages on three homes, six different automobile loans, and a few credit cards with low or no balances, all paid "as agreed." Remember that we're not talking about 6 auto loans at the same time. We're talking about having one auto loan, paying it off, and buying a different car with a different auto loan at a later date. Paid off loans have a positive effect on your credit score.
The number of accounts really does affect your credit score. It's important to realize that "good" things affect your credit, not just "bad" things. Taking out a mortgage, paying the payments on time and then selling the home to pay off the loan has a positive impact on your credit score. That particular account will show a high balance of your original loan amount and a current balance of zero with no late payments. Even if you have a new mortgage on a different house now, the old mortgage that was paid "as agreed" still positively affects your credit. A note of caution, though, is that too many open lines of credit can have a negative impact on your credit score. That means that you don't want to run out and apply for a bunch of new credit cards to try to increase your credit score. In fact, that would actually decrease your credit score. Quality and quantity are both important. Home loans and car loans that are paid "as agreed" positively affect your credit score as do one to three major credit cards with small to zero balances that have also been paid timely. A mixture of credit types positively impacts your credit score. One home loan, two auto loans, and two credit cards is a better mix than six credit card accounts, for example.
The length of your payment history is also crucial—the longer, the better. Lenders want to know that you have a long, long history of paying your bills "as agreed," as it is called on your credit report. They reason that if you have been paying your bills year after year "as agreed" then you will likely continue to do so. This is why parents often have better credit scores than their adult children. If you are straight out of college and have always paid your bills on time—great! However, your credit score probably won't be as good as your parents' credit scores if they too have always paid their bills "as agreed."
An important point here is that you need to establish lines of credit and keep them for a long, long time. Here is a classic mistake. You have had a credit card ever since you were in college. However, you get an offer in the mail for a new credit card that will have your favorite sports team's logo on it. You apply for that card, and you are happy to receive your new Denver Broncos credit card in the mail. Because you have your new Broncos credit card, you decide to call up your old credit card company and cancel your other plain looking credit card because you reason that you really don't need two credit cards. This is a big mistake. Your first credit card had a credit history. Your new Broncos credit card has no history. Remember that old, established lines of credit have a dramatic and positive effect on your credit score. Keep your old, plain Jane credit card and buy yourself a Denver Broncos sweatshirt instead.
Another important factor is the length of time that has passed since your last negative item. The more recent the negative blemish on your credit, the more it impacts your credit score. It's hard to believe, but a home foreclosure 4 years ago won't affect your credit score as much as being 60 days behind on your car payment right now. A lot of people don't even try to buy a home because they think that they won't qualify for a loan due to a bankruptcy or a foreclosure. That is simply not true. People get home loans every day, despite the fact that they previously defaulted on loans or filed bankruptcy. Remember that the most important time period in your credit history is the previous 24 months. Lenders care less about what happened in your financial past aeons ago. They are most concerned with how things are going in your financial life right now and how things have been the preceding two years. If your past two years of credit history is good, you should be able to qualify for a home loan. It is also important to remember that one or two late payments are not an assured score killer. An overall good credit picture can outweigh a couple of late payments.
Public records show up in the payment history category. These include bankruptcies, foreclosures, wage attachments, tax liens, judgments and collection items. These items are considered very serious, but remember that the older items count much less than recent items. Other serious items are accounts that have been "charged off."
One interesting thing about payment history is that multiple missed payments don't affect your credit score as dramatically if your credit report already contained negative items. In other words, if you already have a history of paying bills late, your next missed payment won't affect your score as much as it would if you had spotless credit. The most dramatic negative affect on a credit score happens when a person whose credit report is spotless or relatively clean suddenly starts paying late. The negative effect on credit score in this case can be dramatic.
Amount Owed (30% of your credit score)
We are being asked to walk a fine line. It's good to have credit lines and debt, but it's not good to have too much debt. How much is too much? Yes, that is the question. Owing a lot of money on a lot of different accounts sends up a big red flag in the credit scoring system. It makes a person look overextended. Having a lot of credit cards with zero balances will also negatively impact your credit score, although not necessarily dramatically. Lots of credit cards with zero balances that are paid on time shows that you are responsible, which helps your credit score. However, it also shows that you could go financially crazy tomorrow and max out each and every one of those credit cards, putting yourself in a financially strained situation. As you can see, the total debt and number of credit accounts that are optimal is unknown because of the credit bureau's secret formula for calculating credit scores. The good news is that there are some things that we do know.
Opinions vary on this issue, but it is generally felt that you should have one to three major credit cards (VISA, MasterCard, Discover, American Express). The total debt on those cards should not exceed 30% of your total available balance, and the balance on an individual card should not exceed 50% of that card's credit limit. If you have a credit card with a $5,000 limit, try to keep the balance below $2,500. If you have two credit cards with total limits of $10,000, aim to maintain the total debt below $3,000. Quick tip: to improve your debt ratios without paying down your balances, simply call your credit card company and ask them to increase your credit line.
Another factor in the "amount owed" portion of your credit score is how much of your mortgage or other installment loans are paid off. Take your mortgage, for example. Your credit report shows your mortgage's highest balance in addition to current balance as well as the traditional payment status if you have made your payments on time: "pays as agreed." If your high credit is $307,000, and your current balance is only $159,000, that shows that you have significantly paid down the note. Paying down loans is a really good sign that you are managing your debt responsibly and thereby positively affects your credit score.
Length of credit history (15% of your credit score)
The longer, the better. The key here is to open lines of credit, pay them on time, and keep them for a very long time. Your credit report shows a "date opened" for each credit account. The longer you have maintained an account, the better. If you just graduated from college and have never had an adverse item on your credit report, your score won't be anywhere near as good as that of your parents if they too have a spotless record. The reason is that they have a longer track record, which positively affects credit score. If you pay on time every month over a long period of time, your credit score will show it.
Your score in this area also takes into account how long it has been since you used certain accounts. So just having an idle card for 10 years won't necessarily raise your score. Because the credit scoring formula is a secret, we don't know how often you should use accounts, but suffice to say, don't let them go stale.
How much new credit (10% of your credit score)
"Would you like to save 10% by opening a Target credit card?" Your answer should be: "No way, no how, no-thank-you-m'am!" Saying "yes" to such a tempting offer will hurt your credit score in three different ways. First, an inquiry will be placed on your credit by Target, which drops your credit score. Second, if you are approved for the line of credit, it counts as "new credit," which also hurts your score. Lastly, you have just opened a "department store" credit card which isn't viewed as favorably as a major credit card such as VISA, MasterCard, Discover or American Express. The end result is that saving yourself $20 bucks at Target could put your credit score at risk. Opening several new credit accounts could put your credit score in the toilet. If you plan on applying for any type of loan, do NOT open new lines of credit, particularly the sort that isn't a major credit card.
Also be careful about inquiries as they too affect your credit score whether or not you wind up opening the credit account or not. Let's say that you and your fiancé are looking at engagement rings. You apply for a credit line at a jewelry store after spending hours picking out just the right ring. At the last minute your future wife to be tells you that she wants to "sleep on it." The next day she decides that she doesn't want that ring after all. As a matter of fact, she doesn't want any ring from that particular jewelry store. She wants something totally different. Keep in mind that you applied for credit at that jewelry store even though you didn't wind up buying anything. That inquiry will stay on your credit report for two years, even though it will only be factored into your credit score for 12 months. It gets worse. One month passes and your fiancé finally finds just the right ring at yet another jewelry store. You apply for credit, buy the ring, and the rest is history. Now you have two inquiries on your credit report, both of which negatively affect your credit score. You also have a "department store" credit line on your credit report, which is viewed less favorably than a major credit card.
The best thing to do in this scenario is to use an existing major credit card to make your purchase, thereby avoiding two unnecessary inquiries. If your credit limit isn't high enough to accommodate the purchase, ask your credit card company to raise your limit. You can also ask the jewelry store to place the purchase on two different credit cards. Keep in mind that you need to keep the balance on each individual credit card below 50% and the total debt ratio on your credit cards below 30%. Don't be embarrassed to put the ring purchase on three different credit cards. Your credit score will thank you.
Type of credit (10% of your credit score)
You need to shoot for a "healthy mix" of credit. No one quite knows what that "healthy mix" actually is, but we can use some common sense. For example, having one VISA card and one American Express card is better than having five department store credit cards and no major credit cards. Mortgage loans and car loans also help your credit if they are paid on time. In my opinion, a "healthy mix" would likely be something like: one mortgage loan, one or two car loans, one to three major credit cards, and maybe one or two additional credit accounts like a gas card or a department store card. Again, it's just my opinion. Because the exact way that FICO scores are calculated is kept secret, we are left to speculate.
Why are credit inquiries so important?
An inquiry is a record of someone checking your credit information. There are two types of credit inquiries: "hard inquiries" that occur when a business checks your credit and "soft inquiries" that occur for other reasons. The important thing here is that "hard" credit inquiries negatively affect your credit score. "Hard" inquiries are made by lenders. "Soft" inquiries are routinely made by your existing credit card companies for the purposes of "account reviews." The credit bureaus themselves make "soft inquiries" on your account. Another type of "soft inquiry" is a credit pull for employment screening. Inquiries resulting from "pre-approved" offers also have no impact on credit score. Checking your own credit is also harmless. The long and short of it is that soft inquiries don't affect your credit score, whereas hard inquires affect your credit score negatively.
The good news is that credit scoring models have now been adjusted to count multiple auto and mortgage inquiries within a 14-day period as a single request. This means that, if you do all of your car shopping within a 14-day timeframe, you can let Honda, Toyota and Subaru pull your credit, and the three inquiries will be counted as one.
Inquiries are important because they indicate potential risk. Opening several credit accounts in a short period of time could indicate that a person plans to "live it up" or that the person is scrambling to get themselves out of a financial jam. Of course, we all have inquiries on our credit reports. Landlords sometimes pull credit as does any lender be it for a credit card account or a home loan. Inquiries are unavoidable. As such, they don't affect your credit score as much as other factors. Still, it is important to keep "hard" inquiries to a minimum.
Quick tip: inquiries are also helpful to consumers because they can notify you of a potential identity thief applying for accounts in your name.
How many points does a credit inquiry drop a credit score?
It is estimated that a single "hard" inquiry will drop your credit score 5 points, but that's just for the inquiry itself. If the inquiry results in approval for a new line of credit, that drops your credit score even more because it is considered "new credit." Multiple inquiries can have an even greater negative impact on your credit score because it looks like you are either planning to go financially hog wild or that you are trying to rob Peter to pay Paul. Multiple inquiries + multiple new lines of credit = very bad idea if you are planning to apply for a mortgage.
It's also important to understand that a single "hard" inquiry may not affect your score at all. Whether it does or does not affect your score is part of the complicated scoring mechanism that is kept top secret by the designers of the credit scoring system. What we do know is that if your overall credit profile is sufficiently healthy, a single inquiry may not affect your score at all.
In contrast, multiple inquiries always hurt your credit score. The reason is simple: people with six or more inquiries are eight times more likely to declare bankruptcy than people with no inquiries. That means that lots of inquiries can be devastating to your credit score.
It is also important to understand that inquiries can have a greater effect on your credit score if you have a relatively short credit history or if you have few total accounts.
Will checking my credit lower my credit score?
No. Checking your own credit is considered a "soft" inquiry and will not hurt your credit score. Only "hard" inquires made by potential lenders negatively impact credit score. It's harmless to check your own credit, so go for it!
Which factors are NOT considered in credit scoring?
There are a lot of factors that are NOT considered in your credit score calculation, including race, age, religion, sex, marital status, income, salary, occupation, employment history, "soft" credit inquiries, place of residence and a host of other items. Remember that your credit score is a predictive mechanism. Its goal is to predict how likely you are to repay a loan—nothing more, nothing less. Click here to learn about common credit score myths.
Here is a partial list of reasons for why a particular score isn't higher:
- Amount owed on accounts is too high.
- Delinquency on accounts.
- Too few bank revolving accounts.
- Too many bank or national revolving accounts.
- Too many accounts with balances.
- Consumer finance accounts.
- Account payment history too new to rate.
- Too many recent inquiries in the last 12 months.
- Too many accounts opened in the last 12 months.
- Proportion of balances to credit limits is too high on revolving accounts.
- Amount owed on revolving accounts is too high.
- Length of revolving credit history is too short.
- Time since delinquency is too recent or unknown.
- Length of credit history is too short.
- Lack of recent bank revolving information.
- Lack of recent revolving account information.
- No recent non-mortgage balance information.
- Number of accounts with delinquency.
- Too few accounts currently paid as agreed.
- Time since derogatory public record or collection.
- Amount past due on accounts.
- Serious delinquency, derogatory public record, or collection.
- Too many bank or national revolving accounts with balances.
- No recent revolving balances.
- Proportion of loan balances to loan amounts is too high.
- Lack of recent installment loan information.
- Date of last inquiry too recent.
- Time since most recent account opening too short.
- Number of revolving accounts.
- Number of bank revolving or other revolving accounts.
- Number of established accounts.
- No recent bankcard balances.
- Too few accounts with recent payment information.
Recent negative activity hurts your credit score even if the amount of the delinquency is seemingly insignificant. A mere $40 that is 60 days late can have a greater impact on your credit score than a $2,000 account sent to collection three years ago.
If you have a bankruptcy and a home foreclosure on your credit report, the good news is that you can easily get a home loan if your recent payment history is spotless and the delinquencies are in the distant past (at least 2 years ago and the more distant, the better). A person in this situation would have a better chance of being approved for a home loan than a person with two credit card accounts that are 90 days late and one car payment that is 60 days late. The great thing about the credit scoring system is that it is forgiving. It allows a person to put their past in their past and focus on their present and future credit profile.
Also realize that the credit scoring system doesn't understand that you didn't pay a bill based on "principle." Your non-payment will be flagged whether it was for good reason or not. It also doesn't matter how small the amount. Even a $20 non-payment that shows up on your credit report will adversely affect your credit score.
Which credit score do lenders use?
They could use all of them or none of them or one of them. Some lenders don't use credit scores at all. They have their own scoring mechanism. It's confusing, I know. Some lenders use the middle of the three scores. A lot of lenders maintain their own proprietary credit scoring technology which amounts to a lender-FICO hybrid. The bottom line is that you can't zero in on one particular score if you are looking for a home loan. The best thing to do is to read everything that you can on this site in the Credit Score and Credit Tips sections, and apply what you have read to increase or maintain your score. If you are interested in buying your credit score, read why I recommend buying the Equifax version.
Will I pay through the nose if my credit isn't perfect?
No. Lenders are willing to offer favorable terms even for borrowers with less than stellar credit. In some cases a borrower will wind up paying an interest rate that is 3% more than they would have paid if their credit had been perfect, but many times the rate won't be any more than .5% to 1% over what a perfect credit score would have earned.
Why would my data be different at the three credit bureaus?
Different creditors—such a gasoline cards, store credit cards, landlords, finance companies, utility companies, etc.—report to different credit bureaus. Some report to only one credit bureau, some to all three. It is also possible that one or more of the credit bureaus contains inaccurate information about your credit history in their file. Check your report for free at www.annualcreditreport.com.
How long do negative items stay on my report?
Most negative items are deleted after 7 years—except for bankruptcy, which can stay on your report up to 10 years. Inquiries remain on your report up to 2 years. Unpaid tax liens stay on your report forever; once paid, they must come off in 7 years. These are the requirements of the Fair Credit Reporting Act (FCRA). Remember that the creditor or the credit bureau can choose to delete items whenever they please.