The Real Truth About Credit Scoring

The Basics:

Most people understand that you need to have a good credit score to buy things in America, but not too many of us know who calculates that credit score or how they calculate it. It’s almost like taking a test without knowing what the questions are and who will be grading it. When you look at it that way it seems really unfair, however this is the credit system that all of us deal with every day. This article and many of the others in the Money section of the Survival Guide will attempt to shine some light on the mysteries of credit scoring and credit management.

Before we dive too far in we need to clear up the first and biggest misconception put out there by corporate America – each person has a credit score. No person has a single credit score. When people talk about your credit score they are actually talking about 3 primary scores that come from 3 separate credit rating agencies (Equifax, Experian and TransUnion).

Each of these credit rating agencies use a slightly different scoring method to calculate your credit score, but each of the 3 scoring methods are created by 1 company – The Fair Isaac Corporation (FICO). Why each of these rating agencies use a slightly different algorithm is beyond me, but based on that your score is almost guaranteed to be different for each agency. In addition, not everything is reported to each of the 3 agencies. A collection showing up on Equifax may not even be listed on TransUnion or Experian. For these (and other) reasons your score can vary greatly between the agencies.

Even though each agency scores a little differently, all 3 follow the same percentage breakdown to calculate your score between 350 (mama wouldn’t loan you money) and 850 (you qualify for any card you want).

35% – Payment History. This is the most important and covers how many late payments you have (hopefully none) and/or charge-offs (where you stopped paying your card and it went into default). Generally if you can keep this to 1 late payment per year you will get all these points.

30% – Outstanding Debt. This covers the amount of credit card you have as a percentage of the total credit available. For example, if you have a credit card with a $1,000 limit and you have a balance used of $300 your debt ratio is 30% (which is good). If you can keep this ratio under 30% you will get most (if not all) of these points

15% – Length of Credit History. How long you have had credit is important and longer is better. Don’t cancel your old credit cards (even if you don’t use them anymore) because it will actually hurt your score.

10% – Mix of Credit. The combination of car loans, mortgage payments and credit cards is used as a factor in calculating your score.
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A healthy mix of these is considered best, and anyone with a mortgage (paid on time each month) will generally score higher

10% – Inquiries. Whenever a company checks your credit to see if they should give you their credit card or sell you their car they are creating an inquiry. too many inquiries in a short period of time will hurt your score as the credit agencies perceive that you may be in trouble and need credit.

What You May Not Know:

– There is not 1 credit score that each of us has. Our credit is evaluated based on scores from 3 separate agencies (Equifax, Experian and TransUnion)
– Your credit score does not come from FICO, it comes from one of the 3 rating agencies
– Your credit score does not come from the government. The Fair Isaac Corporation is a private company
– The lowest credit score you can get is a 350. The highest is 850

Everything related to credit (purchases, loans, defaults, etc.) is not reported equally to each agency. Every business has the right to report your transactions to 1 all or none of the credit bureaus. Many do not report to all 3.

What You Need To Know:

When someone offers you a credit card (store card, visa, etc.) and your application is reviewed, you are creating an inquiry. More than 2 inquiries in 6 months will hurt your credit score. Only apply for what you need.
Having 5 credit cards with small balances on each is better for your credit score than having 4 credit cards with 0 balance and 1 card with a high balance.
If you want to know your true credit picture you have to get scores from all 3 rating agencies. Your score can vary wildly from 1 agency to the next.
If you payoff a credit card and don’t want to use it don’t cancel it. This will shorten your length of credit history and hurt your credit score.

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