Tuesday, January 29, 2013

How is your Credit Score Calculated?

Until recently, people mostly were able to spend money only if they have them. With ability to borrow money through credit cards, mortgages, student and personal loans, people got the clear opportunity to spend money they do not have – borrowed money, paying certain percent for this use.

Why you Need Good Credit History?

When you lend money yourself, you will not give it anyone who will ask for that. The organizations, which will provide you with loan, will be even more sensitive, choosing the reliable people and getting the adequate conditions. For those who look more reliable, the financing conditions will be essentially better, than for those who may become a burden over time, not able to pay back.

So, a good credit history will benefit you in almost any major purchase that requires financing - buying a home, getting an auto loan, or setting up a business. When lenders review your credit history information, your credit score plays a big role in setting your interest rates and repayment terms. If your track record of building credit history is excellent, your efforts will save you money on interest charges. The same rule applies to insurance coverage; a high credit score means lower monthly premiums.

Landlords will use your credit history to gauge how likely you are to pay your rent on time. Phone companies and cable service providers examine your credit history to determine if you'll be a responsible customer.

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Who Defines your Credit Score?

There are many credit reporting bureaus in the US, of which the three main ones are Experian, Equifax and TransUnion. These bureaus maintain a credit file of every person who has ever borrowed any kind of credit. All your credit information, bank account information, loans, payments, etc. is contained in the credit file.  On the basis of this information, a credit score is calculated as simple numerical prediction of our creditworthiness.

Although there are many different types of credit scores, the most important is the FICO credit score.  This is the credit score that is used by the 3 leading credit bureaus in the country and it is also the credit score which the majority of the lenders look at to determine your credit worthiness.

The Fair Isaac Corporation (FICO) first developed the formula to calculate a person’s credit score based on their credit information. Since then, the FICO credit score has been accepted as the most official credit score in the US. Although there are other credit scores, none come close to the FICO score in terms of authenticity, correctness and nationwide acceptance.

A FICO credit score is a three digit number which can be anything between 300 and 850. A score in excess of 760 is considered to be an excellent credit score. Scores ranging from 700 to 759 are good, those ranging from 650 to 700 are average, and below 650 are low credit scores. Don’t feel bad if you are on the low end of excellent. Scores of 800 or higher are extremely rare. Even so, the median score is around 720, meaning half of all people have scores higher than 720.

Note that the same information, received by three competing credit bureaus, can produce different results, since the credit score calculation algorithm is slightly different. Each lender or credit issuer can choose whom it asks for your credit history. If several of your applications result in credit pulls from Equifax, your credit report and score may look different than one from TransUnion. Each bureau also manages your details separately from the others, so if there is a blemish on your credit report that needs to be fixed, you need to follow up with each bureau to make sure it has accurate information.

What are the Factors Affecting Credit Score?

While Fair Isaac and all credit bureaus keep the score calculation algorithms as top trade secrets and never reveal the exact formula, there is the following indication disclosed of what factors influence the score and what the weight of each of these factors is:
·         35% - Payment History. Not surprisingly, the biggest chunk of the score is your record of timely payments. If you pay your bills on time, you’re likely to continue paying your bills on time in the future as well. In brief, any late payments of 30-days late or worse can show up here, although a 60-day late or a 90-day late delay will have even bigger negative impact. If you just barely miss a due date and pay it off within 30 days, it shouldn’t show up here.
·         30% - Credit Utilization. This refers to the trend of how much of your available credit you are using, the value also known as utilization ratio. From the creditability perspectives, the lower the better. Being maxed out on all your cards is obviously not a good sign. Utilization ratio is tracked both on an overall level and on a per card level. For example, having five different cards with a $1,000 balance each and $10,000 credit limit each (10% ratio x 5 cards) is better than having 4 cards with no balance and one card with the $5,000 balance (50% ratio on 1 card). On the long run, having more credit cards would be a good thing as it should mean more available credit and a lower utilization ratio.
·         15% - Length of Credit History. The longer your credit history is, the better. Both the age of your oldest account and the average age of all your accounts are tracked. Continuously opening new credit lines may thus hurt your credit score. At the same time, having a lot of old cards can “anchor” your average account age as well. If I already have 20 cards averaging 8 years old, adding another new credit card won’t make that average budge hardly at all. The closed account will stay on your credit report for 10 years.
·         10% - Types of Credit Used. This factor refers to the mix of different credit accounts out there – revolving credit like credit cards, retail accounts (store cards), installment loans like auto loans, and home mortgages. Having a greater mix is better. However, due to the lesser weight of this factor, you should not deliberately open store cards, take auto loans, and buy new houses with mortgage, unless you really need this kind of the financial activities.
·         10% - Past Credit Applications. This low weight factor comes into play when you are working on some important financial operation, for example, shopping for refinancing, or purchasing a new real estate, or shopping for extra credit cards. This factor is taken in consideration because multiple inquiries and applications in a short period of time may represent an indication of existing or expected financial troubles. Therefore, you should be very careful with what are called “hard” credit inquiries. Hard credit inquiries (“pulls”) are usually from loan applications (asking for more credit). Soft credit inquiries occur when you are just checking your own credit score, or when other financial companies check your credit history as identity verification or for pre-approval offers. Hard pulls affect your credit score negatively for a temporary period of time. For mortgage and auto loans, there are special accommodations by FICO for “rate-shopping”; all hard inquiries within a 14 day period for mortgages or auto loans will only count as one inquiry. In regards to apply for new credit cards, it’s difficult to know the effect of a hard inquiry by itself, as a new credit card account will also affect the other factors above (average age of accounts, credit limits, and utilization ratio). For someone with a longer credit history, a new credit card application will have little effect. For someone with zero credit cards, it will have a larger effect. The general consensus is that each hard pull knocks about 3-5 points off your credit score, and the effect decreases as time passes – after 6 months the effect is reduced, and after a year it is gone. The recording of inquiries does stay on your report for 2 years.

What is Better: No Credit or Bad Credit?

The common sense says that people with bad credit should have a lot more hard times getting loans with bad credit. Bad credit tells bankers, loaners, etc. that your credit worthiness is not good enough for them. People with no credit should have a better chance because they have no negative reports against them.

However, the financial specialists often claim that the common sense does not work here. They think, a bad credit is better than no credit. Bad credit means that you were extended and trusted at least at one point in your life. Bad credit score could also mean that you're paid off, but the bad history of the past is still weighing your score down. Depending on your current credit situation, you'll probably get extended another loan or card...your rates will stink, but you'll get one. Also, bad credit shows that the application you filled out is probably not filled with any fraudulent information and they will have some way of being able to get a hold of you.

NO credit may be riskier for creditors because they have absolutely NO track record to what the person's character is. With no credit or anything on your report, how do they know that none of the info on the application is good or bad? Someone with no credit is going to have the higher interest rate from the beginning.

How to Fix Bad Credit?

·         Pay all bills on time or ahead! To help simplify the process, once you get paid, pay all the bills that are due between then and your next paycheck. Allow time for the mail and processing. 

·         Learn to live on your take-home income. This means if you do not have the money, don't buy it. In other words, do not add to your existing credit balances.

·         Pay all charged-off accounts that appear on your credit report. A paid charge-off is much better than just a charge-off. 

·         Create a realistic plan to allocate a portion of your income to pay off large credit card balances. A high debt-to-income ratio could be causing you to lose points on your FICO score.

·         Give it some time. Most creditors look at your most recent credit history (last two or three years).

How to Fix No Credit?

·         FICO developed the Expansion score to help new-to-credit borrowers. It looks at information not included on a regular credit report, including utility and rental payments, payday loans and use of a checking account. Ask your lender if they use the Expansion score.

·         Apply for a secured credit card. A savings account secures the card in case of default. 

·         Once you have used your secured card for several months, apply for an unsecured credit card. You may have the best luck with a retailer or with the same bank from which you received the secured card. 

·         Your credit history measures all types of credit accounts, so you may want to establish a longer-term installment loan for a car or some other large purchase loan, such as furniture, with pay-back terms of longer than one year. 

·         To avoid problems, never borrow without knowing how and when you will be able to pay off the balance. Also, you should establish an emergency savings cushion for those times when life throws you an unexpected curve.

Sources and Additional Information:

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