Credit Scoring 101

This morning I made a presentation at a professional business networking meeting. I thought this topic would be practical because it would apply to everyone in the room - we all have credit scores. I also chose this topic because I thought it had a realtively low chance of putting everyone into a coma (it was 7:30 AM and we had just eaten breakfast).

Factors that determine your credit score

35% Payment History – There are really three main components to the payment history factor - number of late payments, recency, and severity. The number of late payments is pretty self explanatory; how many late payments have you made? Recency will of course refer to how long has it has been since your last late payment. Severity deals with how late you were with your payment (30, 60 or 90+ days). The good news is that time heals all wounds in this category. The key time frames (after the last late payment) is six months, 12 months, and 24 months. A late payment loses some of its negative effect after six months, and most of its effect after 12 months. If you are able maintain a 24 month history without any more late payments, you can consider them ancient history (as far as affecting your score).

30% Outstanding Balances - This is the one area that catches most people off guard. The second biggest factor essentially boils down to: Are your credit cards maxed out? The higher the balance on your credit cards in comparison to the credit limit, the worse your score will be. A person should at least be below 50% utilization (i.e. no more than $1,000 balance on a $2,000 card) and ideally below 30%. The reasoning is that the three major credit bureaus (TransUnion, Equifax, and Experian) that compute your credit score rely on the information provided by the creditors. They don't factor in any other information (income, assets, etc). The credit bureaus assume that the credit card companies have done their homework. Thus, if you have a Capital One card and they extended to you a $5,000 credit limit, the bureaus will assume that is what you are qualified for. If you have a balance of $4,900 on the card, the bureaus will view you as being essentially tapped out and on the verge of insolvency (whether that is the case or not), and your credit score will be negatively affected.

15% Length of Credit History - This is primarily weighted towards revolving (credit card debt) but mortgage and installment loans count as well. The longer the accounts are open the better.

10% Types of Credit - Mortgage debt is considered to be the best debt, followed by installment loans (car, student), with revolving debt (credit cards) considered to be the worst. In a perfect world a person will have a good mixture of all three types of debt. As far as credit cards, typically three to five is considered to be the appropriate number to have.

10% Credit Inquiries - People are now no longer punished for rate shopping when it comes to mortgage financing and auto loans. Generally, you are allowed an ulimited number inquiries for these two reasons within a 14 day window and it will only count as one inquiry against your score (roughly a five point hit). Some of the bureaus have actually gone to a 45 day window, but we can assume all are 14 days to be conservative. Each credit card inquiry will impact your score separately and can have a very wide range - anywhere from two to 50 points.

There is a tremendous amount of misinformation and partial truths floating around and I wanted to make sure I set the record straight. This is how the credit scoring models work in a nutshell. The credit bureaus are continally tweaking the algorithm they use so this info is subject to change at any time. If you or anyone you know need assistance improving your credit, please contact me (tim@timothyabbott.com). I have standard dispute letters I would be happy to share as well as years of advice to pass along. I don't charge a penny, all I ask is that you consider me when you are in need of mortgage services.

In closing I thought I would share a few tips I've passed on to many folks. This is by no means exhaustive - I could spend all night blogging about credit if I tried to list everything.

• If your credit balance is close to the limit on a credit card (ex $1,400 balance/$1,500 limit) and it is not possible to pay the balance down, ask the creditor if its possible to increase the credit limit. A $1,400 balance on a $3,000 card is much better.
• Sometimes creditors will grant an extension based on payment history. Tell them you do not want a 'hard inquiry' in order to receive the increase.
• If an old collection account needs to be paid off, wait until closing!! Recent activity (even paying off an old collection account) likely will lower the scores. It is an update to a negative account that should be avoided until closing.
• There are several ways to leverage paying off a collection account. Many times the agencies will accept a fraction of the amount due. Sometimes it is possible to receive a 'letter of deletion' from the collection agency. Payment in full is typically required, but sometimes deleting the record permanetly is better than saving money on a settlement.
• While your credit score may not be penalized for having seven, eight, nine, or even 10 credit cards open, it's a bad idea!! If you are ever the victim of identity theft, the theif has that many more accounts to steal. Keep several good cards open that you use on a regular basis. Close out all of the rest. If you really, really need to save an extra 15% off at Old Navy, open the account, pay it off, and close it out. You can always open another account during the next sale.
• Credit cards typically become unrated after three months of no use (use being defined as making a charge and a payment). If the card is unrated it is no longer helping your credit score. If you have one card you use for all of your purchases, it is a good idea to use the others a couple of times a year to keep them active and helping your credit score.

Comments

[mitigateddisaster]

hi can I ask you a question about this? I pulled my credit reports the other day, and my consolidated student loan is not showing up as a student loan, it just looks like an installment loan. Does the loan type not showing it is a student loan affect my credit score at all? Or do all installment loans affect credit scores in the same way? thanks!

[Tim Abbott]

It shouldn't affect your score as all installment loans are essentially treated the same. The credit bureaus don't make a distinction for the type of loan - you should have nothing to worry about!

[mitigateddisaster]

ok thanks! I guess my only worry then is how little of them I've paid off (my interest rate is only 3.5% so I just pay the minimum). Oh well, they will get there!

[Tim Abbott]

MD - I don't know your age or particulars so please take this for what it's worth. I am assuming you are relatively young and out of school for a couple of years.

Generally speaking your student loan interest will be tax deductible. It starts to phase out when your income is close to six figures. With your student loan costing you 3.5%, paying extra towards it should be one of the last things you do. Assuming you have no other debt (mainly credit cards) typically the first thing you want to do is to max out your 401K to the degree that your company matches (if it does). I would then fully fund a Roth IRA. If you don't own your own place, I would then start to save up a down payment.

Please remember I am a mortgage planner, not a financial planner or CPA. Your best bet is to contact them for more particulars. I wanted to give you a general idea of a good course of action. Please feel free to email directly if you have more specific question. Thanks!