How your Credit can hurt you!

Credit scores are very important as they dictate how much your life costs you. Your good credit score will enable you to borrow money at the least expensive rates. Bad credit will cause you to pay much more than “market” rates as the best case, worst case, bad credit can cost you that new car or home you have been dreaming of! Many people have no real understanding of how credit scoring works. Here is some important information to demystify credit scoring and hopefully help you make the best decisions for your credit score now, and in the future.

First of all, not all scores are created equal. There are three national credit bureaus, Experian, Equifax and Transunion. Almost all of the creditors you utilize are reporting your trade line information back to one or more of these national bureaus. Even if the data collected by the credit bureaus is identical, you will likely see different scores for each bureau. This is because each bureau uses their own scoring model which is slightly different that the “FICO” model we all hear so much about. You also have many vendors these days offering to provide consumers a “credit score” which is not a FICO score at all. The credit monitoring service you subscribe to for example is more like an “educational” score and not a FICO score at all. When you have credit pulled to buy a home, that inquiry is coded as a mortgage inquiry. The mortgage inquiry is set up to return the lender a standardized mortgage score so no matter which lender pulls the credit, the scores are all the same. There can be a wide variance between your consumer score and a true mortgage score because of these nuances.

How does the credit score work? Since there are all kinds of companies selling credit scores and they all use their own scoring method, let’s just look at the FICO score for simplicity. As a general rule, FICO scores are based on five categories:

1. The payment history makes up 35% of your score. By simply paying your bills on time, you will have good credit. Keep in mind that your monthly rent and utilities are not reported to the bureaus at all (unless they become judgements or collections). Only revolving debt (credit cards), installment loans (most commonly auto or student loans), and mortgages are reliably reported to the big three bureaus.
2. Balance owed makes up another 30% of your score. Each revolving debt trade line (credit card) is carefully evaluated to make sure you are using, but not overusing your credit. For example, if you have a credit card with a $1,000 limit and you charge $500 on that card, you will have a 50% balance to limit ratio. The trade line with the balance at a 50% balance to limit ratio begins to report negatively for your score. It gets worse as the balance climbs higher and if you go over the limit due to fees or interest, the trade line is severely affecting your credit score in a negative way. The trade line generates the best score for you at a 30% balance to limit ratio (yes, even better than a zero balance).
3. Length of credit history is 15% of your FICO score. The longer a trade line has been open, the better your score will be. This is why I advise clients to leave trade lines open whenever it makes sense to do so. If the card carries an annual fee or some other adverse term, you may still choose to close it, think this through carefully.
4. New credit and inquiries to your credit count for 10% of your score. It is important to guard your credit closely and not let it be pulled without careful consideration. Each credit inquiry can affect your score negatively and this is especially true if your score is low to begin with.
5. Types of credit used makes up the last 10% of the score model. The perfect credit profile utilizes all types of credit, revolving debts (credit cards), installment debt (auto and student loans) and mortgage debt.

The importance of the five scoring categories can vary from person to person as people will have different credit profiles. For example, a younger person will not have had time to establish the same credit history that a retiree would have. If you keep the above information in mind regarding how your score is computed, it should help you make the best credit decisions for your personal situation.

Source:  Stephanie Ham, Mortgage Consultant, Caliber Home Loans, www.StephanieHam.com