Getting behind the numbers
Three numbers in a row, from 300 to 850: How harmful can they be? Plenty. You probably already know that those numbers, your credit score, often called a FICO score, after the popular model developed by Fair Isaac, the largest provider of consumer; credit scoring models can determine your entire financial life: the interest rate on your home loan and credit card, the premium on your auto insurance, even your worthiness as a tenant. But did you also know that if you take out a home-equity loan, the interest rate on your credit card could double? Or that if you miss a student-loan payment, your auto insurer may refuse to renew your policy? Sound scary? Get used to it, says Chris Larsen, CEO of online lender E-Loan: “Credit scores are the trend of the future.” It’s a trend that’s had privacy-rights advocates up in arms for years. Even Congress has joined the fray: The Senate is debating an amendment to the Fair Credit Reporting Act that will hold lenders to higher standards of credit reporting accuracy and allow consumers to get a free copy of their credit reports and scores each year. Bear in mind, not all credit scores are FICO’s. FICO simply refers to the formula that Fair Isaac developed. (All credit scores are built around the same ingredients the data found in your credit report; the recipes are just slightly, different.) For instance, each of the major credit bureaus (Equifax, Experian and TransUnion) creates its own proprietary score, as well as its own FICO score. But because most lenders use the FICO score, you hear about it more. Moreover, the credit agencies customize the recipes for just about every industry out there. “It’s a zoo full of scores out there,” says Fair Isaac spokesman Craig Watts. To guide you through it, we’ll tell you what kind of score creditors look for in four industries: mortgages, auto loans, credit cards, and home and auto insurance and what factors have the most influence on the scores. Plus, we’ll tell you where to get a copy of your score and how you can boost your numbers.
MORTGAGES AND HOME-EQUITY LOANS
With home loans, the FICO score is the “800-pound gorilla,” says Watts. When you apply for a mortgage, nearly every lender will pull your FICO score from each of the three credit bureaus and use the median score, not the average, to determine the interest rate you’ll pay. Most lenders say a score above 620 is considered creditworthy, and 670 or higher is excellent. But 50 more points can make a huge difference. For a 30-year fixed $200,000 mortgage in Iowa at the end of September, for instance, a score of 675 would have gotten you a 6.4% interest rate. A score of 720? A rate of 5.7% -a difference of $10,320 in loan payments over 10 years. (Above 720, says Larsen, you won’t see much difference in the rates you’re offered.) Here are the factors that make up your score:
A History of On-Time Payments
This is the biggest ingredient-35% of the total-which should come as no surprise since home-loan FICO scores were developed primarily to determine the likelihood of your defaulting on your mortgage in the next 90 days. Lenders want to see that you’ve paid all of your bills on time -mortgage, utilities, credit cards, loans and so on-over the past seven years. The more recent the gaffe, the more it hurts your score.
How Much Credit You Use Each Month
This makes up 30% of the score. Insiders call it your credit-utilization ratio. For installment loans, like an auto loan, FICO takes the ratio of the original loan amount to your outstanding balance on the loan. (That’s why a new loan can drag your score down for the first ear or so.) For revolving credit, like credit cards, it’s the credit limit vs. your current monthly balance. Revolving credit counts more toward your utilization ratio than does installment debt. But the numbers that go into the ratio aren’t straightforward. Instead of your credit limit, some card companies’ will report the highest balance you’ve ever racked up. This can hurt your utilization score. Say you have a $5,000 limit on your card, but the most you’ve ever charged is $1,800. Some companies will report $1,800 as your limit. Sounds fine-but if you currently have a $1,000 balance on your card, your utilization ratio will look high. There’s a timing issue too: Card companies report to credit bureaus on the statement date that appears on your bill, but every month you may have a different balance. This makes your ratio fluctuate every month. Even if you pay the card off in full each month, says Watts, your credit report “will almost always show a balance.” Do home-equity lines of credit affect your credit- utilization ratio? Yes, but just how much depends on the amount you withdraw. A sizable withdrawal more than, say, $18,000 on a $20,000 credit line is counted as an installment loan. But a small withdrawal of $2,000 on the same HELOC is considered revolving credit and therefore has a bigger impact on your utilization ratio.
Length of Credit History
The longer your relationship with a creditor, the better. This accounts for 15% of your FICO score. To score well here, don’t close your old accounts even if you rarely use them. “Unused credit doesn’t hurt you,” says Watts.
Recent Credit Inquires
The number of credit inquiries from lenders in recent months is 10% of your score, and too many will drag it down (creditors take it as a hint that you’re shopping for more debt, which can be a negative). The exception: If you’re shopping for a mortgage or auto loan, you’ll get a 30-day grace period during which inquiries won’t hurt you.
Managing Different Kinds of Debt
Your lender wants to know that you’ve had experience in making timely payments on different kinds of debt, a school loan, a credit card and a mortgage. This counts as the last 10% of your score. What if you’ve never bought a house or a car, or taken out a school loan? If you have a clean track record of making timely payments on two credit cards and have kept balances below your credit limit, that’s just as good as someone who has juggled a school loan, two car loans end a mortgage, says Fair Isaac’s Watts.
Auto-loan scores are much like those (or mortgages, both in the way they’re calculated and in the way lenders use them. Last year, lenders raised their standards. A recent Consumer Banker association study found that the average credit score required for a new loan rose 48 points last year, from 668 to 716 (a 7% hike). But even a few points can make a big difference. For a 48-month auto loan in Iowa in September, for instance, a credit score of 730 would lave earned you a 4.96% interest rate, a credit score of 719 gets you 5.64%.
Nearly all credit-card companies use FICO scores the same score your mortgage lender sees-to determine the interest rate you’ll pay, but there are no general guidelines for what the credit-card industry considers an ideal rate; each issuer sets its own standards. More- over, those standards fluctuate from quarter to quarter. Issuers will modify their target FICO score at any time, based on their current default rates and need for income,” says Watts. It can happen overnight: Most contracts you sign with credit-card companies allow them to peek at your credit report periodically and reset the interest rate you pay based on what they find.
If you’ve recently taken out a new home-equity loan, for example, the issuer may decide that you present
a greater risk of defaulting on your debts and hike your interest rate. So check your statement for the rate each month. If it jumps suddenly, call the company to find out why. Also check your credit report once
HOMEOWNERS AND AUTO INSURANCE
Recent studies confirm what insurers have known for years: The better your credit history, the less likely you are to file a claim against your insurance policy. And vice-versa the worse your credit history, the more likely you are to file frequent, and sizable, claims. “Bad credit doesn’t make you a bad driver,” says P.J. Crowley of the Insurance Information Institute. “It puts you in a group that is more likely to have an auto accident than other groups.” Your insurance score, better known as an “insurance risk score” is a different beast from your FICO score, says Jeffrey Skelton of Choice-Point, a credit verification company that, with Fair Isaac, develops insurance scores. Because the insurance score treasures your likelihood of filing a claim, insurers “are looking for a track record of stability,” says Fair Isaac’s Watts. A history of on-time bill payment is a good indicator of stability; the amount of debt you carry matters less. Even a single payment lapse on a loan several years ago won’t hurt you much, as long as you’ve amassed a sterling track record of on-time payments ever since. For $12.95 you can order a copy of your home or auto insurance score from ChoicePoint (choicetrust.com) or the credit bureau Equifax (equifax.com). A score of 700 or higher is considered good. Most large underwriters, like Allstate and State Farm, develop proprietary scores, so you may not see the score your insurer uses. But credit scores aren’t everything. Some states have banned the use of credit scoring to underwrite insurance policies; others have prohibited insurers from relying solely on credit scores to determine pricing. And depending on the insurer, your driving record and the number of claims you’ve made against your home insurer are just as important as your credit score in determining the premium you’ll pay, since these factors also correlate closely to the likelihood of your filing a claim. You can get a copy of your home’s claim history-a.k.a. the CLUE report-from Choice- Point for $9.
A Dos-and-Don’ts Guide to Straighten Up Your Credit History
It’s a fact: An extra 45 points in your home-loan FICO score can save you almost $40,000 over the life of a 30- year mortgage. A 20-point spread in your auto-loan score could make the deference between a rate of 4.96% on a 48-month loan or 5.64%. Read on for more on what moves will goose your score-and what moves will lower it.
Do keep your credit-card balance under 50% of the credit limit on any card. Do payoff your it-card balance at least a week before the monthly statement date rolls around-it typically falls two to three weeks before the actual payment is due. That’s when most card companies report to the bureaus. Do pay your biggest bills first, if you’re juggling them. The larger the missed payment, the more it hurts your FICO score. Don’t cancel some credit cards in an effort to help your score. It won’t. In fact, even long-dormant accounts will figure positively toward your history and the extra available credit won’t hurt your score either. Don’t sign up for extra credit cards or request unnecessary rate quotes from lenders. Too many inquiries will drag down your score.
Do build up a track record of paying ordinary bills on time. Insurers like to see a history of responsibility. A stream of late payments will hurt your insurance credit score more than it would your FICO. Have any unpaid bills older than five years? Don’t try to clean up your record by paying them if all you’re worried about is your insurance score. Older bills have a minimal impact on it; paying them will only draw attention.
The same do’s and don’ts for a home-loan score apply here. The auto score is most influenced by auto-loan activity, so if you’ve never had a car, loan, you’ll score lower.