Benjamin Franklin once said "credit is
money". Although he was referring to actually
having credit with a store to purchase things, his
quote still rings true today. Whether renting a new
apartment, applying for a credit card, a mortgage
or even homeowners insurance (yes, homeowner's
insurance), your credit score will determine the
particular interest rate or premium you are
quoted. In essence it has become the filter many
industries use to decide if they want to do
business with you and at what price. This article
explains what a credit score is, what it is based
on, and how it should be maintained.
The most common credit score is the FICO
score, created by the Fair Isaac Corporation. It is
the standard for the mortgage industry as well as
many others, and it can range from a low of 350
to a high of 850. The higher the score, the lower
the interest rate you will be offered, potentially
saving you hundreds if not thousands of dollars a
year. You want to remain above 720. About half of
the country maintains a score above this magic
number. As you begin to move below this number,
interest rates may begin to rise. Fall below 500
and you may not be able to take out a mortgage
even if you currently have one. How the score is
determined is one of the most common questions
we get from clients trying to improve their credit
score? While we do not know the exact formulas
used by the three biggest credit agencies using
FICO's standard of scoring, here is what we do
know.
There are five key elements that make
up your score
Your payment history, or how you pay your
bills, makes up 35% of your score. How much you
owe is 30% and how long you have had credit is
another 15%. The type of credit you have and any
new credit issued make up 10% each. Factors that
are NOT considered in this formula are your
income, savings, age, race, geographic location or
marital status. Basically the score indicates your
track record of making payments to companies
you owe money to including your utility bills.
Although it seems it should be an exact formula it
is more of an art form in knowing what affects
each component.
The largest factor is "do you pay your bills on
time". While it is best to always pay your bills on
or before the date that they are due, paying a bill
a few days late and incurring a late charge will not
necessarily go on your credit report. Having a
"late" on your credit report means that the bill is
30 days or more past its due date. The more
"lates" you have, the lower your score will go. If
you have a bill that is 60, 90 or even 120 days
late your score will rapidly decrease. But even if
you already have a "late" on your report, the
more time you gain between that date and the
current date the more your score will improve.
The mortgage industry has two major thresholds
when looking at any late payments on your
report: Are they older than 12 months and older
than 24 months. Each milestone will provide you
with better financing solutions as your late
payments fade with time. In addition, a mortgage
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"late" is much more serious than a credit card
"late". So if it comes down to a choice "which bill
should I pay?" always choose your mortgage
payment and never miss paying this one. The
consequences are far too great.
How much you owe combined with what types
of credit you have available, make up the "art"
side of the calculation. You might think that if you
owe less you will have a better score.
Unfortunately that is not always true. This portion
of your score is determined by a delicate 3-way
dance between the types (mortgage, car loans
and credit cards), how much you owe, and how
much you have available to you. Having too many
credit cards can be a negative and so can having
only one. Having a credit card with a large limit
can be a good thing, as long as you are not near
that limit. Same with a second mortgage or a
home equity line of credit. When you have lots of
credit available you want to make sure you "use"
that credit but do not maintain a high balance.
The closer your balance is to the maximum credit
available to you, the lower your score will go.
The last two components of your score are the
length of your history and new accounts. Of
course the longer you have a credit history the
longer your track record will be, but another
important factor is how long you have had a
particular account. The longer an account is open
and active the better your score will be. Opening
up a bunch of new accounts and playing the credit
card-switching balances game does not look good.
So now you know what a FICO score is and how it
is calculated. The big question is now: how do you
maintain it?
As the saying goes, most people don't plan to
fail, they simply fail to plan. It happens all too
often in our business, but if clients regularly
monitored their credit scores we would be able to
save them thousands of dollars on their
mortgages. What this means is, if you are
planning to buy a home, don't just go look at
houses, make an offer and then get a mortgage.
You may not like what you are offered as a result
of your FICO score. Our suggestion is to plan for
this event. The same holds true if you are thinking
about refinancing.
Improving your credit score is kind of
like getting ready to run a marathon
You can't just sign up today and expect to run
tomorrow. If you have a poor credit history or if
there is inaccurate information on your report it
can take months to repair and correct. We have a
saying that we have been using years, Make Life
Happen! Don't sit back and let it happen to you.
Being proactive with your credit scores (like many
other areas of your life) will improve the results
and your experiences. Some of you reading this
will be thinking you don't have to worry about this
because you have never missed a payment and
have excellent credit. Well, so thought a client
when we were in the process of obtaining a loan
for him.
This client, we will call Mark, was referred to us
by an attorney and was only 30 days away from
his purchase closing date. Mark advised us that
his credit was perfect. However, when we ran it as
part of his application, it turned out that it was
not. One of the student loans that Mark co-signed
on behalf of his daughter indicated several missed
payments despite the fact she was still in school
and the first payment was not due for another 2
years. We still got the mortgage approved at a
rate and payment Mark could live with but had
Mark proactively monitored his credit scores he
would have had a better interest rate. Mark did
contact the student loan provider and they agreed
that it was a mistake but the damage was done. It
took three months to reflect the corrected
information on his report, too late to affect that
mortgage.
In that example "life happened to Mark" and
had he been proactive about his credit score he
would have been better off. This is not a hard
thing to do – it is just like going to the gym, you
have to do it regularly. While we are not
suggesting that you monitor your scores daily or
even weekly, we are suggesting that you institute
a bi-annual credit review to ensure your credit is
the best it can be so you are not caught off guard
like Mark.
If you would like to read more in-depth
information about what you need to know to take
control of your finances simply go to
www.MyFICO.com and download a FREE 20-page
booklet entitled "Understanding Your FICO Score".
They also have a paid service to alert you anytime
there is a change to your score and/or credit
history. In today's world of stolen identity this
could prove to be a prudent investment. Not only
will you save money by ensuring you have good
credit but you may be able to prevent any
fraudulent charges against your name as well as
the accruing interest and legal fees should you be
an unfortunate victim. You can also obtain free
credit report by visiting
www.annualcreditreport.com. At the very least,
monitor your credit twice a year and you will be
happy you did. Make Life Happen!
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