Credit Scores Explained

It seems that everyone is talking about credit scores these days, and with good reason:  Having a lower credit score can mean paying higher interest rates which translates to more dollars out of your pocket.

Credit scores (also sometimes referred to as FICO scores) range from 400 to 900, and the higher the better.  Each of the three credit repositories in the US (Experian, Equifax and TransUnion) keep tabs on each individual and issues a score based on a complex mathematical formula.  For mortgage lending purposes, lenders typically discard the highest and lowest scores, and use the middle score.  In the case of joint borrowers, the lower of the two middle scores from each borrower is used.

The middle score is not necessarily an average of the three scores; rather each repository determines their own scores based on the information that has been reported to them by creditors.  Since most creditors report to all three companies, scores will generally be close to one another.

What can you do to raise your score?  There are a number of things that impact your rating and some simple things you can do on your own to improve your standing.

Besides avoiding the obvious credit score-killers like bankruptcies, foreclosures and judgements, the best thing one can do to maintain a favorable rating is also the most common sense - pay your bills on time.  If a company is considering extending credit to you, they’ll want a reasonable assurance that you’ll pay back the debt in a timely fashion.  How you’ve handled your finances in the past is the best predictor of what creditors can expect in the future.

Next is to not overextend your use of credit.  In other words, don’t max out your credit cards.  This is important because the proportion of balances to limits accounts for 25-30% of your score.   I tell my clients to never let their credit card balances exceed more than 30% of the maximum credit limit.  For example, a card with a $5000 limit should never have a balance exceeding $1500.  Otherwise, the computer model that determines your score “thinks” than you’re using too much credit, and maybe using it to live day to day.  A better approach would be to spread balances out over more accounts, or, in some cases, to request an increase to the credit limit on a particular card.  Just don’t be tempted to use that extra credit!

Don’t ignore collection notices from past due accounts, even for seemingly  small things like parking tickets, library fines, etc.  More and more government agencies are turning to collection agencies to collect the money they’re owed.  A collection showing on your credit report can reduce your score by nearly 100 points - a huge price to pay for ignoring a $25 ticket.

I’m often asked if it helps one’s score to close accounts.  The answer is both yes and no, depending on the accounts.  Older accounts should be saved; the length of your credit history counts as much as 15% of your total score.  So if you’re looking to close out accounts, choose those that are relatively new.

On that subject, don’t make a practice of opening new accounts simply to save the 10% that the merchant is offering, unless you’re quite certain your score can stand the “hit”.  Each time you apply for credit, it’s registered as a new inquiry; too many inquiries also can lower your score.  If you’re shopping for a mortgage or a car, however, multiple pulls on your credit from similar lenders in a 30 day period only count as one inquiry.

Paying off your credit card in full each month can also be good and bad.  You’d think that would be considered a good thing - and most of my clients who do so have impeccable credit.  But for some borrowers it can be a mistake:   Once again, creditors are often concerned with a borrower’s payment discipline; can and will they make regular payments each month, and on time?

Especially in this more credit-conservative environment, it’s important to maintain a clean record.  While it may be tempting to ”forget” a payment for a month or to ignore a collection notice, you’ll end up paying for it in the end, and then some.

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