Understanding Credit Scores (6/29/2009)

I work for a trust company in St. Louis and we publish a quarterly newsletter that highlights a specific topic our clients will hopefully find timely and relevant. In May, I was asked to write an article on credit scores. Of course, the finished newsletter was much prettier, but you get the benefit of the substance below.
_______________________________
In today’s market conditions, obtaining credit has become more difficult for consumers. The mortgage crisis has put a crunch on capital in the financial services industry and as the supply of capital remains low, lenders have been forced to tighten credit standards.

Tighter credit standards have meant a much greater emphasis on your credit score when obtaining financing than in the past. Not only can your credit score determine your credit worthiness to a lender, but it can also determine how much you’ll pay when you borrow money. Many lenders practice credit-based pricing on many financing options, meaning those consumers with higher credit scores can obtain better borrowing terms, including a lower interest rate.

Lenders aren’t the only people checking your credit score. Insurance companies routinely use your credit score to determine premium rates. Landlords often check the credit scores of prospective tenants prior to renting an apartment. According to the Society of Human Resource Management, 35% of employers check the credit of prospective employees to help determine their degree of responsibility. Even cell phone carriers will routinely check your credit score.

To understand your credit score, you need to know where it comes from. There are three major credit reporting agencies in the U.S. – Experian, Equifax, and Trans Union. All three of these agencies use slight variations of computer software developed by the Fair Isaac Corporation. This is why your credit score is commonly referred to as your FICO score. All three of these entities collect data from creditors independently, therefore your score will vary because the data collected is not consistent among each agency and neither are the formulations used to compute your score. When applying for credit, some lenders will obtain all three credit scores and some will use one credit reporting agency exclusively.

Scores can range from 300-800. The median credit score according to the Fair Isaac Corporation is 723. It’s tough to determine exactly what a “good” score is because every lender has different cut off points where they will lend at the best rates or lend at all. Here are general ranges:

800+ Excellent
750-799 Very Good
700-749 Good
650-699 Average
600-649 Below Average
550-599 Poor
<550 Very Poor

Below are the five characteristics that go into determining your score and how they are weighted according to the Fair Isaac Corporation:
35% = Payment history
30% = Amounts owed
15% = Length of credit history
10% = New credit obtained
10% = Types of credit used

There are several things you can do to improve your credit score. 1.) Always pay your bills on time. This is the highest weighted characteristic that makes up your credit score. 2.) Keep your credit card balances low relative to your credit limit. It’s important to have a high credit limit relative to your outstanding balances, but having too much credit availability will make you a high risk borrower to a prospective lender. Therefore, you should never have open credit you don’t need. 3.) Since credit history is a significant portion of your overall credit score, it’s important to begin obtaining credit at an early age. 4.) Pay down your debt rather than moving it around between different credit facilities. Transferring balances to new credit cards could lower your FICO score. Because so many variables go into determining your score, it is not considered an exact science. The bottom line: Obtain credit, pay your bills on time, and minimize outstanding debt. If you follow these rules, it will reflect in a positive credit score.

VantageScore
While each credit bureau has traditionally used their own version of the FICO formula to compute your credit score, they have recently introduced their own version called VantageScore. VantageScore is a new formula created by the three credit bureaus to improve the consistency of your credit score. Even though the VantageScore formula used by each credit bureau is the same, the score will still differ slightly because the data used by each credit bureau is still not consistent. In addition, VantageScore has a different scale, similar to an educational grading scale. The scores range from 501-990 as follows:

A = 901-990
B = 801-900
C = 701-800
D = 601-700
F = 501-600

VantageScore also weighs credit characteristics slightly different from that of the FICO model. Here’s the VantageScore breakdown:

32% = Payment history
23% = Credit utilization (debt to credit ratio)
15% = Amounts owed
13% = Length of credit history
10% = New credit obtained
7% = Available credit

You can obtain your VantageScore from each one of the three credit bureaus. Because VantageScore is not yet widely accepted by financial institutions, it’s unclear how your VantageScore compares to your FICO score. However, if your FICO score is high, it should also reflect in a high VantageScore. Even though VantageScore was created three years ago, FICO continues to be used by the vast majority of financial institutions.

How to obtain your credit report
The Fair Credit Reporting Act of 2003 allows each U.S. resident to obtain a free copy of their credit report annually. The only government-sanctioned website available to obtain your credit report is http://www.annualcreditreport.com/ or you can call 1-877-322-8228. This website requires you to choose which credit reporting agency to use when obtaining your credit report. While the credit report is free, it will not contain your specific credit score. You have the option of paying a fee to get your score.

Under normal circumstances, most experts will recommend getting a copy of your credit report annually. If you plan to finance a large purchase in the near future, you should prevent any surprises by obtaining a copy of your credit report for review prior to applying for a loan. If you have any reason to suspect any errors in your credit history, you should obtain a copy to be sure. Staying on top of your credit is even more important during these uncertain economic times.

What to do about errors on your credit report
If you find what you believe to be an error on your credit report, you should write to both the credit bureau and the specific creditor, immediately. Mistakes or inaccuracies will affect your credit score and even your ability to obtain future credit. Your letter should include your name and address, a description of the specific item(s) you’re disputing, and why you’re disputing it. If you’re not sure what information to include, you can find sample letters on the Federal Trade Commission’s website, www.ftc.gov/credit. Be sure to send copies (not originals) of any supporting documentation of your claim. As an additional measure, you should send your letter via certified mail and request a return receipt. The address for the creditor and the credit bureau furnishing the report will be on your credit report.

Both parties will take typically 30 days to research the claim. Although don’t be surprised for the process to take several months, especially if you’re dealing with multiple inaccuracies. Be sure to include as much information as possible to help expedite the correction. In most states, you’re eligible to receive an updated copy of your credit report to ensure the error was rectified.