Understanding Your Credit Score

Understanding Your Credit Score

What you need to know about how your FICO credit scores impact your borrowing and how FICO scores are calculated.

One of the most important numbers in your adult life is most probably your FICO score. As you go out in the world to purchase your first car, buy insurance, purchase your first home and apply for credit cards is your mostly misunderstood FICO score.  Good credit and your FICO is crucial to getting the best interest rates and the highest leverage to grow your wealth.  If you have bad credit this will lead to a repetitive cycle of higher credit card interest rates, mortgage costs and insurance rates than are possible with good credit.  

This article was written to give you an overview of what makes up your credit and what you know to achieve and maintain the highest credit score possible. We will also discuss some techniques that can help you with your credit as well as provide live one on one help for potential homeowners looking to get their credit into shape to purchase or refinance a home. If you are looking to purchase or refinance your home and would like to immediately speak to an expert you can visit our Ask the Expert section, call 800-826-5077 or email info@Cambridgehomeloan.com to  setup a FREE appointment with a credit expert.

What is a credit FICO score?

A FICO credit score is a three-digit number taken from each credit bureau and then averaged that tells a lender the likelihood of you repaying your debt obligation or to put it another way, how likely you are to default on your loan. The score itself is a determination of your creditworthiness. If you have a low credit score,  this would indicate that you have had issues with your credit in the past and may have difficulty in repaying your loan.  

If you have a high credit score or A credit than you are a lower risk and credit providers will run to lend to you. It is the old maxim of the less you need it, the more you can have. Each lender or type of credit has different requirements and can use different calculations to determine your credit risk.  Most consumers only have access to their consumer credit score which is different than their risk credit or risk based FICO.

A history of credit scoring

In the past a consumer would go into a local bank and sit one on one with a loan officer that they would have to convince of their ability to repay a loan.  The loan officer had complete discretion to provide the loan or to turn down a consumer for their loan. 

In1956, two statisticians William Fair and Earl Issac founded their company, Fair Isaac and Company. They explored through statistics how past consumer behaviors correlated with the likelihood that a consumer would repay a new debt. From their research, they created the first credit scoring model – the FICO credit score.

FICO scores didn’t become widely used until 1989 when FICO began calculating scores based on credit reporting information from the three bureaus. However, the three bureaus weren’t exactly keen on FICO. So, they all created their own private scoring models in the hopes they could compete against FICO. But most lenders and creditors still relied on FICO instead of the other scoring models. In fact, FICO scores are still used in 90% of lending decisions. Talk about getting it right the first time.

In 2006, the three credit bureaus decided to stop competing against each other and focus on competing against FICO. They created the VantageScore together. They’ve updated the model several times, and the newest version – VantageScore 4.0 is a scoring model that uses the same range as FICO (300-850). The 850 being a perfect credit risk. This score is very difficult to achieve. Will get more into that later.

Today, the VantageScore is widely used by many credit monitoring services when you want to track your credit score. More commonly called consumer credit today. However, FICO is still used in 90% of lending risk decisions.

The most current version of FICO® is known as FICO® Score 9. This version made some pretty significant changes to the FICO® Score. Some of those changes are that paid-off collections no longer have a negative impact, medical collections are treated more favorably than other types, and rental history can be used a factor in the score calculation if it’s reported.

However, the most commonly-used version in practice is FICO® Score 8. Lenders have historically been slow to upgrade to the latest FICO® Score versions, and as FICO® Score 9 has been in existence for several years now, that’s definitely still the case.

So, in addition to the three credit bureaus, there are two rather different versions of the FICO® Score that could potentially be used when assessing your credit risk.

For this reason almost every consumer has multiple FICO scores. Each of the bureaus can make additional modifications for the type of credit that you are borrowing and other factors.  A FICO when you go to purchase a vehicle is different than your mortgage FICO. 

What are the biggest 5 factors that affect your credit score?

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Lets Review the top 5 main factors the affect your credit. There are about five main factors that are used to calculate the most popular credit scores. Each of the following factors carries a different percentage amount  towards your entire score.  Understanding all of the scoring factors is a big factor to maximizing your credit score.  Having the best score will allow you to qualify for better interest rates and terms on credit cards and car loans.

 #1 – YOUR CREDIT HISTORY
The largest factor that contributes to your credit score is your credit history. biggest scoring factor looks at payment history. Best described as the presence or lack of bad or derogatory information. First and most important are on time payments and secondly any Bankruptcy, liens, judgments, charge offs, settlements, repossessions, foreclosures, and late payments can cause a FICO score to drop.

 
Decreases to your FICO score are caused by missed payments  and collection accounts.  Newer credit models discount accounts that have been paid off and medical collections. Still it is best for your credit to pay all bills on time.

Creditors report payments to the credit bureaus every 30 days.  So payments missed by a few days should not affect your credit. Payments that are missed by 30 days or more will certainly adversely affect credit. According to equifax, just one payment missed by 30 days can drop your score by 90+ points.  Making your payments on time is critical in maintaining a good credit score. 

Payment history =35%

#2 – TOTAL CURRENT CREDIT UTILIZATION PERCENTAGE This is a ratio of total credit vs how much of a total credit line that you have.  Anything over 30% is detrimental to your score. This includes number of accounts with balances, the amount owed across different types of accounts, and the amount paid down on installment loans. Be careful, paying off installment loans can close those accounts which could negatively impact your score.

For example if you have a car payment of 300 for a $20,000 car loan and you payoff and close that account you have $20,000 less credit, so your score may drop.  Paying off credit cards is a good thing and can only help.
Debt burden = 30%

#3 – CREDIT AGE This factor looks at how long you’ve used credit. It considers how many accounts you’ve maintained in good standing, and for how long. The longer you have maintained good credit the better. Knowing this try to keep your oldest credit accounts open. The longer the bureaus see that you have maintained credit the higher your score will remain. 

Some credit card companies will close your account if you have not used it for a while so you may want to try and find a way to keep those accounts active. 

Length of credit history = 15%

#4 – RECENT SEARCHES This evaluates the number of new credit applications you’ve had in the past 6 months by looking at the number of hard credit inquiries listed on your credit report.

Recent searches for credit (10%): 

#5 – TYPES OF CREDIT BEING UTILIZED
This factor assesses the diversity of your credit portfolio by looking at the types of credit you hold, and whether you have good debts, such as a mortgage. installment, revolving, consumer credit, etc.

There are many myths when it comes to credit pulls. Pulling credit or hard inquiries for a mortgage “rate shopping” will not affect your rate.

Hard credit inquiries or “hard pulls”, which occur when consumers apply for a credit card or loan (revolving or otherwise), can hurt scores, especially if done in great numbers.

 
Bureaus count hard credit pulls done in the past 14 days as 1 pull. You may still want to be cautious allowing car companies from pulling credit from multiple banks. 

Remember, Using anything above 30% of your credit line is bad for your score. If you go over your credit limit on just one account and it is reported to the credit bureau, it can hurt your score by as much as 45 points.

FICO scoring model considers all of those types of hard inquiries that occur within 14 or 45 days of each other as only one. Further, mortgage, auto, and student loan inquiries do not count at all in a FICO score if they are less than 30 days old. 

Types of Credit =10%

Getting a higher credit limit can help a credit score substantially. The higher your credit limit on a credit card, the lower the utilization average. The utilization ratio is the amount owed divided by the amount extended by the creditor and the lower it is the better a FICO rating.

So if a person has one credit card with a balance of $500 and a limit of $1,000 as well as another with a used balance of $700 and $2,000 limit, the average ratio is 40 percent ($1,200 total used divided by $3,000 total limits). If the first credit card company raises the limit to $2,000, the ratio lowers to 30 percent, which could boost the FICO rating.

There are other factors that can weigh on the FICO score.

  • Any money that you owe because of a court judgment, tax lien, etc., can carry an additional negative penalty, especially when recent.
  • Having one or more newly opened consumer finance credit accounts may also be a negative.

CREDIT DIVERSITY

A diverse credit portfolio means that you are experienced in paying off different types of loans, , credit lines and credit cards. If you only have one type of credit it may be a red flag to creditors. 

A good mix of debt both for you and your future are mortgages, that help build long term wealth and student loans that can increase your earning potential for the rest of your life. Almost all other debts may in some way help with your credit score but are not good long term. In other words they do nothing to help you increase your net worth. 

BEST PLACE TO CHECK YOUR CREDIT SCORE

Consumer credit is easy to check and i would highly recommend on of the FREE credit services like Credit Karma or Credit Sesame. These can help you monitor your credit as well as have simulators that help show you how to improve your credit score. 

The best place to get what i feel is the closest thing to bank or risk based credit is annualcreditreport.com. Their score is the most similar to bank credit if you are applying for a mortgage. `

FICO SCORE UPDATES

The next FICO rollout has some interesting updates. Be careful though, like we said it can take a long time for these updates to be implemented by the credit bureaus. 1. Medical payments will no longer have such a disasterous affect on your credit, even if in collection. 2. Tax liens will no longer affect your credit score at all.

 

EXPERT MORTGAGE AND FINANCING INFORMATION
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