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Understanding Credit Scores

February 6, 2012

 

Most savvy consumers know about the FICO score — the three-digit number that companies use to figure interest rates. Even though FICO has published the main factors that affect FICO credit scores, many still wonder why when they apply for an auto loan they are told one set of scores, and another for a mortgage loan

There are three different types of credit reports: consumer, mortgage, and auto. The mortgage and auto reports are weighed more to the mortgage and auto criteria. Your scores would be different on all three types, even from the same credit bureau.

You also have three different credit bureaus. Not all creditors report to all three credit bureaus.
So you actually have 6 different credit reports

Your credit history is your strongest argument for assuring lenders that you’re a good credit risk. So it’s wise to take these 6 steps to build the best credit record you can… before you need to ask someone for a loan.

Step #1: Pay on Time, Every Time
More than one-third of your credit score (35%), is determined by your payment history. Do you always pay your bills? If you do pay them, are they on time, or do you consistently incur late fees?

Paying your bills on time will avoid costly late fees and will eventually help increase your credit score.

Step #2: Pay Down ALL of Your Balances
Approximately one-third of your credit score (30%), is determined by the ratio of money you owe (your balances) to the credit that is available to you (your credit limit). In other words, if you are carrying high balances on many cards, it has a very negative impact.

Paying down debt so that you are carrying credit balances that are at or less than 25% – 30% of your account limits is ideal. For example, a $250 balance on a card with a $1,000 limit will have a fast and positive impact on your score.

Step #3: If You Don’t Have Credit…Get it NOW
Contrary to what you may think, it is not a good idea to have zero credit since 15% of your credit score is determined by the length of your credit history.

The past is considered a great predictor of the future, so a consumer who has borrowed and repaid loans and debts consistently over a 12-month period is a better risk than someone who has no credit record whatsoever.

Step #4: Don’t Go Credit Card Crazy
It seems like every time you go to pay for a purchase these days, someone is offering you a credit card. Remember that 10% of your credit score is based on of the number of times you have applied for credit. It doesn’t matter if you have never used the cards or even been approved!

The more cards and loans you have, or have applied for, the more credit report inquiries will show up on your credit report. Why do inquiries matter? A higher number of credit report inquiries are a ‘red flag’ to creditors that you’re struggling financially or may have a lot of debt. All inquiries stay for a minimum of 1 year from the date the inquiry was made, and most inquiries will stay on your credit history for 2 years. Therefore, the more times your credit is “run” the more negative the impact on your credit score.

Step #5: Diversify Your Credit
10% of your credit score is determined by the variety of different types of credit accounts you have. Your score is based upon whether you have:

A variety of loans and credit arrangements demonstrates that you are able and committed to pay all different types of accounts.
Step #6: Monitor Your Account Like a Hawk
We don’t live in a perfect world, and credit scoring is a far from perfect process. Fortunately, under the Fair Credit Reporting Act, you’re entitled to one free credit report each year so your fact-finding mission doesn’t have to cost you (meaning that the inquiries you make do not show up on your credit report nor will they affect your credit scores).

It is important to monitor all three credit bureaus because the information contained in one company’s records may not coincide with information contained in the others’. If you discover an inaccuracy has occurred, you have the right to dispute these errors and have them corrected or removed all together.

You’ll need documentation to make your case, so be sure to keep copies of all paperwork related to any loans, mortgages, or credit cards you may have.

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