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August 4, 2008

How-to Monday: Credit scores

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You probably know your SAT score, assuming you took the test in high school. But what about your credit score?

Once you're past the college-application stage of life, the second score is a lot more important. Or, rather, scores, since a variety of companies are watching and grading you. Mortgage lenders look at your scores to help determine how big a risk you are, and therefore what interest rate you should pay. Many others will take a peek, too, from credit card companies to insurers to apartment complexes.

Do they know more about you than you do?

"The U.S. consumer is grossly undereducated with respect to credit," says John Ulzheimer, president of consumer education for Credit.com, a financial services and consumer education firm.

Credit scores are such a big topic that I couldn't possibly cover everything in one How-to, so I won't. Next week: tips on improving your credit. Today: how credit scores work.

Many companies look at your FICO score if they're deciding whether to extend you credit. Fair Isaac Corp. developed the FICO formula, but the scores themselves are produced elsewhere -- by the three national credit-reporting agencies, Equifax, Experian and TransUnion. They use the FICO model and plug in information from lenders, public records, collections agencies and the like.

Your score can vary between the agencies in part because they might not all have the same details about your credit history, said Barry Paperno, consumer operations manager with Fair Isaac. But five overall factors influence your FICO score:

Payment history. Whether you pay on time accounts for 35 percent of your score -- the most important piece, but not as important as many assume.

Amounts owed. This is 30 percent of your score and primarily refers to credit cards. The lower your balance compared with your limit, the better.

Length of credit history. How old is your oldest account? How old are the rest? The longer, the better, and these answers add up to 15 percent of your score.

New credit. Ten percent of your score is based on this factor. Opening a lot of new accounts lately? That can ding your score, as can multiple applications to credit-card companies, which show up as inquiries on your credit report. (Multiple inquiries as part of the shopping-around process for auto loans, mortgages or apartments aren't supposed to count against you, Ulzheimer says.)

Types of credit used. This accounts for the final 10 percent of your score, and what the scorers are looking for is variety. You'll do better here if you have credit that's revolving (for instance, a credit card) and installment (i.e. an auto loan or a mortgage).

Got that?

In these days of rising mortgage defaults, you might be wondering what's worse from a credit-score perspective, a foreclosure or a bankruptcy. Answer: It depends. Filing for bankruptcy is a hit equal to foreclosure, Paperno says. If the result of that bankruptcy is multiple debts discharged, that hurts more, he says.

FICO scores range from 300 to 850. Like the SAT, higher is better. Fair Isaac's consumer site, myFICO, says a monthly payment on a 30-year fixed-rate mortgage can range from about $1,850 for someone with a credit score of 760-plus to $2,700 for someone in the low- to mid-500s. (That's for a $300,000 loan calculated with the going rates in late July.)

The newest information Fair Isaac has on the breakdown of FICO scores is from the 1990s -- yes, really -- but here's how it looked then: 

Of Americans with FICO scores, 13 percent were 800 and above. Forty-five percent were in the 700s. Twenty-seven percent were in the 600s. Thirteen percent were in the 500s. The rest -- 2 percent -- were below that.

(EDIT on 8/6: Fair Isaac says it was wrong, and these figures are actually much more recent, probably from late 2006. Glad to hear it.)

High income doesn't guarantee a great credit score, by the way, just as low income doesn't necessarily doom you to the bottom of the barrel. "Wealth is a measure of capacity, not creditworthiness," Ulzheimer says. A credit score "is the measurement of how you manage debt."

Next week: How to manage that score.

Posted by Jamie Smith Hopkins at 4:00 AM | | Comments (8)
Categories: How-to Mondays
        

Comments

I recently paid Experian to tell me my credit score. They didn't seem willing to tell me a FICO score; they have some other number. They called it a "vantage" score, or some such name. It had a different range, from about 500 to 900-something. Can anyone tell me in what relation that number compares to a FICO score?

You can get details about the VantageScore here: www.vantagescore.com. Bankrate.com has also written about this scoring system here: http://www.bankrate.com/brm/news/debt/debtmanageguide/vantage-scores1.asp

I've also heard that there is a completely different score used by the mortgage companies.

Hi, Jelena -- Consumer Reports has a piece that's on-topic here: http://www.consumerreports.org/cro/money/credit-loan/credit-scores/overview/credit-scores-ov.htm

How is Length of credit history calculated? How long does the time open have to be before it is not considered New credit?

I don't know, Denis -- sorry.

Everyone,

First, the VantageScore is often referred to as a "Fako" score, as in fake, as in nobody from a mortgage lender to a BMX bike financer uses them. As part of FACTA mortgage lenders are required to give you your score when you apply for a loan. As a practical matter you're better off paying down revolving accounts, bringing everything current, and reviewing one of the free reports you can get for inaccurate information, and not worrying about the score until you apply. In other words, worry about the things that affect your score, but save your money from buying a "Fako" score.

Length of credit history: There are two measures:

1. Total time you have had a credit reoprt (called your "in file" date)
2. Age of your accounts, the older the better. Never, ever, ever, never, ever close any of your older accounts.

The second a new account is opened it affects your score, but not always for the better. This is factor that really depends on a number of factors including overall payment history, overall debt load, time since last new account was opened, amount of new account, and type of new account. Generally speaking, opening more than one new account within 6 months is cause for concern and will hurt your credit. Opening new accounts on top of an already heavy debt load or spotty payment history will hurt your credit. On the other hand if you haven't opened anything new in at least 6 months, have a light debt load, and a clean payment history, it can actually help your credit by "thickening" your credit profile.

If your question is how long to I have to have a new account opened before it can be counted towards a minimum # of credit accounts requirement (basically if you're trying to overcome a turn down due to thin or limited credit) the answer is 12 months from the time it starts reporting.

That's very helpful, Josh -- thanks for sharing.

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About Jamie Smith Hopkins
Jamie Smith Hopkins, a Baltimore Sun reporter since 1999, writes about the regional economy. Her reporting on the housing market has won national and local awards. Hopkins is a Columbia native and has lived in Maryland all her life, save for 10 months spent covering schools in Ames, Iowa.
She trained to become a wonk by spending large chunks of time as a geek and an insufferable know-it-all.
Baltimore Sun articles by Jamie
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