February 5th, 2009 4:44 PM by Dan Marchiando
Last month I covered why credit scores have become important. In this issue I'll discuss what goes into a person's credit scores. But first I'll mention what doesn't go into credit reports and the credit scores that result from those reports. The credit reporting agencies do keep limited information about our past employment and job titles, but they have absolutely no information about how much income we make. So income is not a component of credit scores. The credit agencies also do not collect any information about our checking, saving, investment or retirement account balances. And they don't keep records of our other assets like homes and other property. So the amounts of assets we have accumulated in our life are also not a component of credit scores, however our assets and income are usually part of the lending approval process.
All the information that has been collected by the Big Three credit reporting agencies (Experian, Equifax & TransUnion) has been provided by some company or agency that we have done "business" with. That could include the banks that gave us our last few mortgages, car loans, and credit cards. And it could include government taxing agencies and courts. And it could also include the local hospital where we rang up a whopping bill for our last emergency room visit. Most information is from the last seven years, but there are some exceptions that remain on our reports for ten years.
The creators of credit scores do keep their computer programs secret; however they have provided some general hints about how scores are arrived at.
Listed in order of Importance:
1. Payment Habit – 35%
The largest component of our credit scores (35%) is based on payment habits. It is relatively simple concept. If I pay my bills exactly as promised, I will theoretically have the best possible credit scores (all other factors being equally positive). If I pay my bills a little late, or not at all, then, depending on the severity of my lapse, I can expect to have less-than-perfect scores. Credit blemishes pull down scores based on four factors: Recency, Size, Severity, and Number. Recent blemishes weigh-down scores more than old blemishes. Large-size payment lapses affect scores more than small. Severe blemishes like a 90-day late-payment, bankruptcy, foreclosure, collection, or lien take a bigger bite out of scores than say a 30-day late-payment. Having a number of any types of credit blemishes can hurt scores as well.
2. Balances Owed – 30%
Large balances owed, and high utilization of credit can affect 30% of our credit scores' makeup. If the combined balance of all accounts is high—especially on credit cards—then scores will be lower. If individual credit card balances exceed approximately 40% of the account's credit limit (this is called utilization), then scores will be lower. Likewise, if there are an especially large number of accounts with balances, scores will be lower.
3. Length of Credit History – 15%
Fifteen percent of our credit scores are based on how long we have used credit wisely, how old our oldest active accounts are, and the average age of all our active accounts. Most (young) people, who are just starting to use credit, will find that their scores are somewhat modest at first. Depending on how they manage their finances, their scores will slowly rise over time, as they acquire more positive experiences using credit. Conversely, if users new to credit are not careful, their scores can quickly plummet.
4. Types of Credit Used – 10%
This category accounts for only 10% of our scores' makeup. The scoring system rewards borrowers who have a history of using a mix of different types of credit. A person with superior credit will typically have experience with mortgages, installment loans (like car and student loans), and revolving debt (like credit cards and equity lines). Oddly, doing business with "consumer finance" companies, like Household Finance, American General, and the like, are viewed negatively. These companies frequently provide small installment loans through furniture, appliance and electronic stores.
5. New Credit – 10%
This category also only accounts for 10% of our scores. Recency and Number come into play here too. Having recent new accounts or a number of new accounts can diminish theoretical perfect scores. Likewise, recently applying for other credit—which is indicated by lender credit inquiries on a credit report—can diminish scores, as will having a large number of these inquires.
Next month I'll discuss some strategies to consider—to make your credit score the best it can be. If you can't wait for next month's newsletter, please don't hesitate to call me sooner.
Thanks for your interest, Dan