The Scoop on Credit Scores

Credit scores are one of the most important financial numbers.  Credit scores not only affect the interest rate you pay when you borrow, but also your ability to borrow and other important financial transactions. It has been a long time since I’ve borrowed money, so I talked to Cody Jensen, a consumer loan officer at Missoula Federal Credit Union, to get the most current information.  In his role as a loan officer, Cody spends a lot of time educating young borrowers, so he was a terrific resource.  Here is a summary of the interview (with a few tidbits I found on line to expand on a few of his points).

What are Credit Scores?

Most lenders and vendors use the national score calculated by Fair Isaac Company.  It is a number between 300 and 850 that measures your creditworthiness and is sometimes called FICO score.

How are They Used?

Your credit score affects whether you can get a loan (see this post for more about loans) and, if so, the interest rate you will pay.  The lower your credit score, the higher the interest rate you will be charged.

Your credit score also impacts other financial transactions, such as:

• Landlords use it to evaluate whether to rent to you.
• The amount that you will pay if you lease a car (see this here for more on leases).
• Most companies issuing you a contract, such as cell phone providers and cable companies, use it to decide whether you have to pre-pay for your services. That is, if you don’t have a high enough credit score, you will need to pay in advance for your services or make a significant deposit.
• In many jurisdictions, car and homeowners/renters insurers use it as a rating variable. The lower your credit score, the higher the insurance premium you will have to pay, all other things being equal.

What is a Good Credit Score?

The thresholds vary between categories depending on the user of the information. The chart below shows the approximate distinctions considered by many vendors.

What Determines My Credit Score?

According to Investopedia, there are five factors that determine your credit score:

• Payment history – Do you pay your bills on time. Timely payment for a long period of time will improve your credit score.
• Credit utilization – The ratio of the amount you owe to your credit limit on credit cards.While you want a score that is more than 0% (i.e., using your credit cards is good), as the ratio increases above 30% your credit rating will decrease.
• Length of credit history – The length of time you have used credit, either through mortgages, student loans, other loans or credit cards. The longer you have used credit, the higher your score will be.
• New credit – The amount of recent increases to your credit (e.g., new credit cards or loans). Once you have established credit, taking on additional loans or credit cards will lower your score.
• Credit mix – The types of credit you use. Using different types of credit, such as loans and credit cards, improves your score.

The chart below shows the weights given to each of these factors.

What Can I Do to Improve my Credit Score?

Whether you are just getting started with credit or have an established credit history, here are some things you can do to improve or maintain your credit score:

• Pay your bills on time. As indicated above, paying at least the minimum payment on your credit cards and making your full installments on any loans by their due date combine to be the biggest contributor to your credit score.
• Wait until you have a couple of years of experience on your record. By taking the time to establish your credit experience before taking out a loan, you can reduce your interest rate or increase your ability to get a loan.
• Get a secured credit card. If you are just getting started or need to re-build your credit, you can use this type of credit card.
  • When you open the account, you need to put down a security deposit that is higher than the limit on the credit card, often 110% of the credit limit. For example, if you get a card with a $1,000 credit limit, you’ll need to give the issuer a security deposit of $1,100.  This deposit will be returned when you close the account.
  • Ask someone else to co-sign on the credit card. In this case, the card becomes a shared secured credit card.
  • To improve your credit score, you’ll want to pay off all your charges every month.
  • You will establish a strong payment history, which improves your credit score, by using the secured credit card regularly for a period of time.
  • A secured credit card doesn’t count as a loan so it doesn’t hurt the credit utilization part of your credit score.
• Make sure there is a balance on your credit card on the last day of the calendar month.
  • That’s when FICO checks your balance, so it is the date on which credit utilization is calculated.
  • You can then pay it off when your bill is due to improve your payment history and avoid interest payments.
  • You score will improve if your balance is between 3% and 30% of your limit on the last day of the month.
• Check your credit information as maintained by the credit bureaus (Equifax, Experian and TransUnion). This information includes all of your loans and credit cards, your outstanding balance at the end of each month and your payment history.  You are allowed to request your credit report (but not your credit score) for free from each bureau once a year.  If you want it more often than that, you need to pay a fee. You can either enter the information on Annual Credit Report.com’s web site or print a form and submit it by snail mail.  I know a few people who have found mistakes (usually due to identity theft or confusion with a person with a similar name) that have hurt their credit scores. There is a process by which your credit report can be corrected, though it isn’t always easy.

What Are the Causes of Low Credit Scores?

Obviously, not paying your credit card bills or re-paying loans will lower your credit score.  Other factors that can lead to a lower credit score are:

• Late payments. Again, whether you make your payments on time is the biggest factor in determining your credit score.
• Too much debt (including credit cards and student loans). If you take on too much debt, you are less likely to be able to re-pay it.  When you have so much debt you can’t keep up with your payments, credit utilization will be too high and payment history could become poor.  These two factors alone drive 65% of your credit score.
• While a divorce itself does not lower your credit score, some aspects of unwinding the finances can put downward pressure on credit scores.  In many marriages, the couple acquires debt based on their combined income.  For example, many couples rely on both incomes to secure a mortgage for a home.  If the couple gets divorced, they now need two households and neither one has sufficient income to pay off their joint mortgage or other debts.

How Do I Find Out My Credit Score?

Many banks and credit card companies will provide you with your credit score for free.  When I log into my bank’s web site, I can see my FICO score.  You can also pay one of the major credit bureaus (Equifax, Experian and TransUnion) for your credit score.