Breaking Down and Improving

As you may know, based on some recent articles, I have started my home buying process. I have looked at many factors like the economy, monies available for down payment and job security when weighing the decision to buy a place. However, I have found that the one financial factor that seems to be the most important in being able to afford the home I want is my credit score. This determines what kind of interest rate I can get on my mortgage, how much down payment and subsequently my maximum loan amount. In fact as I researched what is in a credit score, I have come to realize that it is probably one of the most important numbers in your financial life. Simply put and all other things being equal, the better your FICO credit score, the cheaper your cost of borrowing. So here is a breakdown of your credit score, how to get it (cheaply) and ways you can improve it:
Your FICO credit score breakdown
The term credit score usually refers to your FICO score, a number based on a formula developed by the Fair Isaac Corporation, which looks at a summary of all your credit accounts and payment history. Your FICO (credit) score determines your access to and cost of credit. Most lenders use it as the main basis for loan or credit approvals, so the higher the better and the lower the more problems. FICO score ranges from 300-850, and Fair Isaac calculates them for each of the three big credit-reporting agencies: Equifax, Experian and TransUnion.

Here’s how your score is determined:

• 35%is determined by your payment history. Do you regularly pay your bills or fines on time to any creditor that submits your information to the credit bureau? Overdue medical bills, parking tickets and other fines may appear here.
• 30% based on the amounts you owe each of your creditors, and how that compares with the total credit available to you or the total loan amount you took out (debt to equity ratio). If you’re maxing out your credit cards, your score may suffer.
  
• 15% is based on the length of your credit history, both how long you’ve had each account and how long it’s been since you had any activity on those accounts. The fewer and older the accounts, the better (assuming you’ve made timely payments).
• 10% is based on how many accounts you’ve recently opened compared with the total number of your accounts, as well as the number of recent inquiries on your report made by lenders to whom you’ve applied for credit. Your score can drop if it looks as if you’re seeking several new sources of credit — a sign that you may be in financial trouble. (If a lender initiates an inquiry about your credit report without your knowledge, though, it should not affect your score.) Shopping around for an auto loan or mortgage shouldn’t hurt, if you keep your search to six weeks or less. But every inquiry you trigger when you apply for a credit card can affect your score. So be selective.
• The final 10% is determined by the types of credit used. Having installment debt — like a mortgage, in which you pay a fixed amount each month — demonstrates that you can manage a large loan. But how you handle revolving debt, like credit cards, tends to carry more weight since it’s seen as more predictive of future behavior. (You can pay off the balance each month or just the minimum, for example, charge to the limit of your cards or rarely use them)

What’s not in your FICO credit score: Contrary to popular belief, your age, employment history and where you live are not used in determining your credit score. This is not to say this information won’t be considered by lenders when evaluating you for a loan, its just that it will not factor into your FICO score calculation.

How do I get my FICO score cheaply and is it any good?

Now that you know what your credit score is made up of, you want to see how your’s stacks up. If you have a social security number and have conducted any type of financial transaction, chances are you already have a FICO score. One important point to note is that your Credit Report (available free from annualcreditreport.com – the only authorized online site under federal law) is not going to give you your FICO credit score. It is a good place to start and identify errors, because it shows all your credit history, but it will not give you your actual score.

For that, you’ll generally have to pay. You can go through the three major agencies Equifax, Experian or TransUnion directly, which have 3 for 1 packages or sometimes their own scoring methodology, which can be different than the FICO scores lenders generally use when they evaluate your loan applications (so read the fine print). I have found that myFICO.com (Fair Isaac corporation’s own website) offers the best and most reasonably priced options on its site. The $15.95 FICO Standard package (as of March 2009) lets you get your credit scores from your choice of Equifax or TransUnion. With this comes a full explanation of the credit score and how lenders view you. Best of all, it also includes actions you can take to get your FICO score into the higher ranges. You can all also get myFICO’s Score Watch which monitors important changes to your score and alerts you (weekly) when there are any changes. Another nice feature: It also notifies you when you qualify for a better interest rate. It costs $8.95 p/month, you can try it for free via this promotion.

How does your credit score rate? For the best rates on a loan or credit card, you want a score that’s above 750. The median US credit score is 720 (half the population has more than this, while the other half is lower). The next section looks at how to achieve a good score, but here how the various FICO score ranges compare:

Top Shelf Score: A score above 780 means you have excellent credit with an excellent history of paying back and managing debt. Even in this economy, banks will happily lend to folks with 780+ credit scores, meaning they will get the best rates and easiest access to credit.

Middle of the Pack: FICO score from 700 to 780 is very good and above average (the FICO score is not a linear range). You may not get the best rates, but if you have a stable job and little debt then you should get a very competitive rate. However focus on getting to the 780 level, using the simple tips that follow
Work to do: FICO credit score between 600 to 700. You won’t be denied loans on this score but the terms aren’t going to be too generous. You need to work hard to get your score into the higher ranges or face the prospect of years of rising debt payments, while your higher credit neighbors live the cheaper debt life.

In the Dog House: Credit score below 600. Once upon time banks used to love sub-600 borrowers because they could charge them the highest rates and reap the biggest profits. This group were called the “sub-prime” borrowers. Then we had a crisis with the same name, and the rest is history. Now banks and brokers won’t give you the time of day. You really need to focus on repairing your credit (it can be done!) or learn to live without it. Cash is your best friend and stay away from the loan sharks.

You are likely to see improvement in your scores within 30 days if you pay down significant chunks of your credit card debt. But otherwise, credit repair takes time, and how much time depends on the many details of your credit reports. If you have serious black marks, such as bankruptcies or foreclosures, you can see significant improvement in your scores as time passes but you may have to wait until those negatives drop off your credit reports before you can join the 700-Plus Club.
Improving or Repairing your FICO Credit Score

The good news is that no matter what your score you can always do things to improve it. Some may seem counter-intuitive, but they are all looked upon favorably by the rating agencies:

• Check the credit reports that you get with your FICO score for errors, omissions and potential identity theft. Omissions matter because you want to show that you have paid off loans. If you notice information that’s inaccurate, you can submit a request for removal by mail or online with the major rating agencies. Be sure to specify what information you think is inaccurate and why, and include any documents that support your argument. Ask in writing that the information be corrected or removed from your report. By law, the bureaus must investigate your complaint, usually within 30 days, and give you a response in writing (or via e-mail, if your request was made online) and a free copy of your report, if the information is changed as a result. Your score should reflect that change shortly after.
  
• Paying your bills on time is crucial. Since 35% of your score is based on your payment history, delinquent payments and collections can have a severe impact on your score. If you can’t pay off your credit card debt every month, pay it down to less than half the maximum available balance.
• A quick and effective way to improve your credit score in this area is by paying down your revolving credit. In fact, owing the same amount but having fewer open accounts may lower your score. So don’t cancel the credit card once you’ve paid it off because the score considers longevity and available (revolving) credit.
• A common mistake for many frugal and debt averse individuals is never using a credit card. Advisers recommend that they use it even just once a year and pay it off immediately.
• A score can be hurt if multiple lenders request a person’s credit report because they’re shopping for a mortgage or auto loan. To avoid this, get “good faith” estimates from banks without giving your Social Security number.
  
• Re-establish your credit history if you have had problems. Opening new accounts responsibly and paying them off on time will raise your credit score in the long term.

Monitoring your Credit score

With the rise in identity theft over the last few years, there has been much debate about how often you should monitor your credit score. Companies like Lifelock have been advertising heavily about protecting your identity and hence your credit. Whether you need to monitor your credit that often is debatable. For most, a close look at the free annual reports from each bureau is probably enough. But if you plan to apply for a loan or credit card, check your score and report at least a couple of months beforehand. Not only will you be aware of how creditworthy you are, you’ll also have time to remove any errors you spot and make sure your score reflects the changes before you fill out any applications.

So there you have it – a pretty detailed look at how your credit score is calculated, measured and can be improved. Feel free to leave a comment if you have any questions or stories on how you improved your credit score.