Credit Score – What is it and how it’s used?

3-23-2014: The Federal Trade Commission (FTC) recently reported that about 25% of every person’s credit report has an error and that error may affect your credit score. WSJ, 3-15 & 16, 2014.

You may have a good idea that a good credit score means:   you can obtain credit easier or at a better mortgage or credit card interest rate. But have you ever considered how it’s calculated or what it’s based on?

The closely guarded formula (algorithm) that “predicts your financial debt behavior” (i.e., credit risk) is compiled from all sorts of financial information about you.  All the FICO (Fair Isaac Company) score is trying to do is to give creditors your “predictive” behavior of handling money and debt.  Generally, the more fluctuation in debt or erratic your financial behavior, the lower the score. It an also be used by employers as part of their analysis of your total profile. Sometimes, employers considering people in positions of high responsibility will look at your amount of debt to determine the likelihood of you selling information to competitors to pay your debts.

Note:  It also helps that things get reported correctly and that credit reporting agencies have “a code for that” – some short sales were being reported as foreclosures since some agencies didn’t have a code for short sales.

5 major factors comprise the credit score and what % of the score:

  • Payment history (37%) – Basically, Do you pay on time? If you’ve ever been late (especially within the past 12 months), your score gets reduced.
  • What you normally owe, how much of the available credit balance you have, and how many accounts you have. (29%) For example, if you open a bunch of retail accounts, and use a large % of the balance, this could score negatively.
  • Length of time you have carried a credit history. (7%) In other words, have you used credit wisely. Also, if you open a number of accounts, or purchase major items on credit shortly before you apply for a mortgage, this could also negatively impact your score.

Are you increasing the amount of debt? (12%)  Opening new credit lines within a short time (whether special similar retail offers from Kohl’s, Macy’s, etc or different types for car, student loan, furniture, clothing, etc,).

Note:  I understand that you can apply/research any number of mortgage rates within a 14 to 45 day period and it will not seriously degrade your credit score.  However, since the Fair Isaac website mentioned it’s up to the lender to use anything between 14 to 45 days, ask the lender what formula they use.

  • Types (credit cards; installment – car/furniture; retail (clothing) accounts; and finance companies-student loans) of credit you are using. (15%)  A good mix of types and consistent payment helps raise score.
  • New debt (10%) – Are you opening alot of new accounts from retailers offering incentives or applications for several other types credit?

Notes:

Judgments, liens, and paid collection items stay on your report for 7 years.

For more information about credit scores, check this website from FICO.

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