How-to Monday: Credit scores
Image courtesy of Stock.XCHNG
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).
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.