Consider your credit report a “report card” on your personal finances. Your credit report is used by lenders to determine if they will approve your loan application. Further, it helps them set the interest rate on your mortgage or other consumer loan. Landlords and utility companies will look at your credit rating before they agree to do business with you. It will be used to determine the type of deposit required from you. Insurance companies review your credit score to help set the rate you will be charged for your automobile, homeowner or renters insurance policy.
It may well be that the most important usage of your credit report is by your current or potential employer. An employer may use the information from your credit report to help them decide whether they make you a job offer, give you a promotion, or retain your services. The Fair Credit Reporting Act and amendments require that businesses in the United States obtain your written permission before utilizing your credit report for these purposes.
Now that we see the importance of establishing and maintaining a good credit report, let’s look at what determines the composition of your individual credit report and score. The dominant scoring model for credit reports is FICO, which was developed and is licensed by the Fair Isaac Corporation. A newer credit model called VantageScore was created jointly by TransUnion, Equifax and Experian, the three national Credit Reporting Agencies (CRAs). The newer VantageScore model is not radically different than FICO, but does give more weight to payment history. Currently, VantageScore is being offered as a competing product to FICO, but it is believed to be used by a limited number of businesses. The three CRAs continue to gather and sell the FICO model scores. Therefore, we will focus on the FICO model.
The FICO score is derived by a weighting of reported credit activity in five categories. These categories and weightings were revised by FICO in 2009. Ways to improve your score are as follows:
Payment History: 35%
Pay your bills on time, every time. This is the most straightforward and the most heavily weighted portion of your score.
Debt-to-Credit Ratio: 30%
Keep the amount of open debt owed on each credit card or credit line relatively low, preferably no more than 25% to 50% of the credit limit. This is a heavily weighted factor in your credit report, and probably the least understood component of your credit score. For example, it is better to owe $1,000 on three separate credit cards with each card’s limit being $4,000, versus owing $3,000 on one credit card with a credit limit of $4,000. Spreading the debt over three cards results in a favorable “debt-to-credit” ratio of only 25%. Whereas, owing $3,000 on one card with a $4,000 credit limit would unfavorably use up 75% of that particular credit line. The way this category is scored is the primary reason credit experts usually discourage the outright closure of existing credit lines.
Length of Credit History: 15%
A longer credit history will count in your favor. Since it counts as a portion of your score, it is somewhat biased against younger adults. It is comforting for some to recognize that this is one thing in life that definitely treats us better as we age.
New Credit Applications: 10%
Do not apply for and open multiple credit lines and/or cards in a relatively short period of time. The credit scoring models will deduct points, if it appears you might go on a borrowing binge. Additionally, multiple new credit openings will lower your Length of Credit History, as mentioned previously.
Types of Credit Used: 10%
Responsible use of multiple forms of credit adds points to your credit score. Credit cards and home equity lines of credit are the two major types of revolving credit. Revolving credit is weighted more than fixed loans, such as, mortgages or auto loans. However, multiple credit accounts of all varieties will add points to your score. Therefore, when trying to attain the highest possible credit score, it is favorable to have more than one credit card, an open home equity line of credit and a mortgage.
For more information on this topic, please contact Henssler Financial at 770-429-9166 or [email protected].