What's Your Score?
by Gary Foreman
Dear Dollar Stretcher,
A recent article on credit cards got me thinking about something my husband and I argue about constantly. We are recovering from bankruptcy and have paid off almost all of our debts except our mortgage and cars. My husband wants to pay off and close our remaining bank credit card account and have no open accounts. I have heard that you should have one account available for emergency use and also to continue building a good credit rating. Who's right?
Good question! And one that's frequently asked. So let's see if we can't learn something about the main tool that lenders use to decide whether to loan you money.
We'll begin our study with something called "credit scoring." It's a mathematical score of your credit worthiness. The idea has been around since the 1950s. The company that started the concept (Fair, Isaac Co.) describes the credit score as "the quickest, most accurate and consistent way of determining the likelihood that credit users will pay their bills."
The score is also commonly referred to as a FICO score (named after Fair, Isaac Co.). Your FICO score will be between 375 and 900 points. A higher score indicates a better candidate for credit. Typically 650 and above will put you in a good position to obtain new credit.
The score is calculated based on a mathematical model using up to 33 different factors about your history. The formula is proprietary and and Fair, Isaac will not release it. In fact, there's more than one formula. Different credit reporting agencies and lenders have customized variations. So you don't really have just one score. You have many scores.
Ok, so what goes into the score? The different factors fall into five groups. The first is your payment history: how good you've been about keeping up with your payments. Julie's bankruptcy would be considered here. Any late payments or charge-offs are also considered. Remember that this isn't a all-or-nothing deal. So one missed payment doesn't doom you to a low score. But a pattern of late charges will certainly hurt.
Next the model will consider your outstanding debt. How many accounts are open and how much debt you have? This is the other category that Julie asked about. And the answer to her question is, yes, you can have too few accounts. The model seems to give you the highest score if you have some credit, but not too much. Having one or two open accounts that are fully paid off each month will actually help your score.
The model also considers your credit history. You get more points if you've had an account for a longer period of time. The theory is that if you've been consistent over a number of years, you're more likely to continue responsible behavior.
The pursuit of new credit can be a potential minefield to your score. The model considers how many new accounts you've opened. But, more than that, it also looks at how many times you've asked for credit.
Now this is where it can get interesting. The model doesn't always know why new requests for credit are coming in under your name. Suppose you're out shopping for a new car and visit a number of dealers. Let's further suppose that you ask them to find the best rate for a car loan. Depending on how they get the information, it's possible that they can generate a number of new queries on your credit. All those queries can actually lower your score by making it look like you're out there trying to get a bunch of new credit.
Finally, the formula includes the types of credit in use. You'll receive a higher score for home and auto loans than for bank and store credit cards. And installment loans will likely count against you.
Now that we know a little about what goes into the formula, let's look at some of the things that can cause a low score. In no particular order they are: delinquency on accounts, total owed on accounts too high, and too many or too few bank revolving accounts. Other negatives are having too many accounts with balances and consumer finance accounts. These are only a few possibilities. Remember, the calculation includes up to 33 factors.
The next question is an obvious one. How do I find out my score? And you're not going to like the answer. It's very difficult to get your FICO score. None of the companies who calculate or use the score are under a legal obligation to tell you what it is. If you're denied credit because of the score, the lender must tell you which questions reduced your score, but it isn't required to tell you the score. The lender might choose to do so, but you can't force it to.
So how can you improve your score? There are five ways tomake sure you have the best FICO score possible. First, pay your bills consistently and on time. That demonstrates that you know how to use credit wisely. Check your credit report for errors and have them removed. There are three main credit-reporting agencies. By law they may charge you up to $8 for your report unless you have been denied credit due to their report within the last 60 days.
- Equifax: 800-685-1111
- Experian (formerly TRW): 800-682-7654
- Trans Union: 800-888-4213
Next, keep your debt to reasonable levels. The models want you to have balances of less than 75% of your available credit limits. Please remember that we're not encouraging you to increase your balance to that level. The formula considers a balance above 75% as a warning sign of impending trouble. Carrying a zero monthly balance is the wisest use of your money.
You'll also improve your score by having a reasonable amount of unused credit. So lowering the amount you owe on credit cards is a good idea. Closing unused accounts won't help your score and could hurt it by reducing the average age of your accounts.
Finally, avoid too many inquiries for new credit. Sometimes these computer models have a hard time telling the difference between someone shopping for a new car and a borrower who's desperately trying to find money to avoid bankruptcy.
Thanks to Julie for a good question. Let's hope that her credit score continues to rise in the future.
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.