What I Have Learned About Credit Scores

I have been educated over the last several weeks about how credit (FICO) scores are calculated and what you can do to improve your score, sometimes by a drastic amount. During this educational process, I found bits and pieces of critical information scattered all around the net, and by talking to mortgage brokers, banks and others. I am not a lawyer, and this is certainly not legal advice, but here is the (relatively) short version of what I have learned.

Your Fair Isaac FICO score is a 3-digit number that can be used to quickly evaluate your past credit performance, and can be used to predict your likely future credit worthiness. The valid range of numbers is 350-830, with the US Average somewhere in the 680 range. Scores above 620 are considered fair to good, 650 and higher good, and over 700 is basically the same as those over 800. Anything under 600 is poor to very poor. In today's mortgage market, you won't get anyone to talk to you with less than a 620, and they really want to see a 650, especially if you are looking to do a 0-3% down payment. Many mortgage companies are even going back to the old style of underwriting, requiring more documentation, proof of employment and salary, etc. in addition to determining your FICO score.

Fair Isaac scores are based on your payment history, at least primarily, that is the largest component of your score, some say as much as 35% of your score is based on this. The best way to improve your credit score over time is to ALWAYS pay your bills on time. Some mortgage companies will not offer a mortgage to you even if you have a high FICO score if you also have more than 5 late payments to your creditors in the last 2 years.

Another major player in determining your FICO score is how you use credit. This is the part that I feel is totally un-American and contrary to excellent money management skills. You must have credit cards, even if you don't use them. In fact, you need at least 3 credit cards, and you need to use them, but just a little. Most experts will tell you to never let your balances go above 10% of your available credit, other say 30%, but never more than 30%. So if you have 3 credit cards with a total credit limit of $6000, you should never have more than $600-$1800 on them. The best practice is to use credit cards for day to day purchases, such as gas and food, and then pay off the credit card balance before any interest has been charged. The credit card companies will report this to one or more credit bureaus. They will report not only that you pay your bills on time, they will report the percentage of available credit you have. Good credit card skills, keeping balances below 10-30%, paying the bills on time, etc. go a long way towards your FICO score. Some believe this is worth up to 30% by itself.

Pay off your credit cards, now! Carrying high balances, or specifically high percentage of used credit to available credit, will bring down your score. Credit cards are a necessary evil, at least with regards to your FICO score, you have to override common sense with what is required to "fit" into the FICO system.

Don't make the mistake I made. When you do pay off your credit cards, DO NOT close the account. The length of time your account has been open also plays into your credit score. Closing the credit card accounts is a bad thing, pay them off, use them just a little to keep the account active and keep the credit card company reporting to the credit bureaus. If for some reason your credit card company does not report inactivity to the credit bureuas, you can request that they do.

Do no accept credit cards with a very low credit limit. Having a card with a $300 limit will likely lower your score. It shows creditors that the company "just barely" trusts you. Plus, if you stick to the 10% utilization rule, you will only have $30 worth of credit to use. You cannot even fill your car with gas these days for $30, so don't bother. Of course if you are rebuilding your credit and can only get a card or two with these very low limits, do it. Within just a few months of low usage and paying the balance off before the interest can be charged will probably be enough for the card issuer to increase your limit, though you may need to call them to request this. If they refuse after several months, take your business elsewhere. Often the threat of doing this will be enough for them to increase your limit. Some say it costs credit card companies up to $200 to attract a single new customer. Take advantage of this. When they do increase your credit limit, stick to the 10% rule. Your score will go up.

In addition to credit cards, always pay all of your bills on time, especially car and other loans. These are scored somewhat differently than revolving accounts, but paying on time is critical. If you must let something slide for a month due to financial hardship, let it be the telephone, power or other utility. In my 21 year credit history, none of these companies has ever reported to the credit bureaus, good or bad, so if something must be deferred, let it be one that nobody will ever see. DO NOT not pay them, just pay them late. If you skip out on them, they will turn it over to a collection agency, which certainly will report it.

Limit "hard" inquiries into your credit. Credit bureaus classify inquiries into 2 groups, hard and soft. A soft inquiry is when you check your own credit, or when credit card companies or others are "pre-screening" potential credit customers. These DO NOT reduce your credit score. Hard inquires are done when you request credit, via a loan or credit card application, for example. Having many hard inquiries in a short period of time can reduce your score, and these inquiries stay in your report for 2 years. Having many in a short period of time can indicate you may be overextending yourself. There is an exception to this rule, however. When you are shopping for a home mortgage, multiple mortgage companies can make hard inquires into your credit in a 2-week time frame and basically count as a single inquiry. I guess the logic here is that a smart mortgage shopper will shop multiple companies before picking one, and you are not likely to be trying to secure multiple mortgages in a short period of time. Use this exception to your advantage when shopping for a home mortgage.

Pay off ALL collections and charge-offs that are reported. These account for up to 30% of your score and collection companies will always report negative data. After some period of non-payment, your credit report will show "KD" for each month. This stands for "Key Derogatory", and no, I don't know exactly what that means, but it ain't good! Basically after you go past 150 days late, they flag it as KD, which is worse than worse. These must be paid! KD's have to go. Even accounts that are marked as "charge off" or "account closed" can and should be paid off. Contact the creditor or collection agency. Chances are very high they will accept a settlement offer from you, taking less money than is actually owed. This is good for both parties, they get most of the money you owe instead of none, and you get them to remove the negative data from your credit report.

Subscribe to credit monitoring, or at least check your credit report and score every 3 months. The scam here is that there are 3 major credit reporting bureaus, all with different information about you. Some creditors report to all 3 (which is a good thing as long as you pay your bills on time), some report only to 1. There seems to be no pattern as to which companies report to which bureaus, but I suppose you can ask before you open accounts. The big 3 are Experian, EquiFax and TransUnion, and to get a valid picture of your credit, you must get reports from all 3. You are entitled to reports from each of these companies once a year for free by going to annualcreditreport.com. They will give you the report online, but not a score, you will have to pay for this. An alternative is to use one of the many companies that pull these reports for you, such as freecreditreport.com, which is run by Experian, and despite its name, is far from free. This can get expensive, especially if you are monitoring all 3 companies. But this is the price you have to pay to keep on top of what is in your credit report. Yes, I think this is a scam too. If you have deep enough pockets, you can even monitor your credit with all the bureaus using Fair Isaac Corporations (the FICO people) MyFICO service. It's expensive, but accurate.

The Fair Credit Reporting Act provides consumers with good protection from misinformation contained in your credit reports. Without hiring lawyers or "credit fix-up" companies, you can request that inaccurate information be removed from your credit report. This can be done online with each of the credit bureaus, or by mailing form letters to each disputing the information. When you file a dispute, if the credit bureau cannot verify the information in the report, by law, it must be removed. They have 30 days to investigate disputed information, and up to 60 days to remove inaccurate information.

If they fail to repond to your request for changes to inaccurate information, you can report them to the Federal Trade Commission. You can also hire a good law firm to force their hand. One of the most respected is Lexington Law, who's only business is helping consumers legally clean up their credit reports. Their fee's are reasonable considering the level of service they provide.

This brings up another point. There is no "quick fix" to cleaning up bad credit. It takes initiative, time, and money on your part. Companies that claim otherwise are trying to sell you snake oil, don't believe it. At best, you will be out some more money, at worst you will be breaking the law. The ONLY WAY to clean up your credit is to take responsibility for the negative marks on your credit by working with the creditors, having inaccurate information removed from your record, and time. A history of late payments will only go away over time, up to 2 years. You may be able to talk some of the creditors into removing late payment history, but this is entirely up to them. If you do decide you need help clearing up inaccurate information, use a respectable law firm that deals with this, one that knows the law and does not break it.

As for mortgages, everyone knows that right now they are hard to get with less than stellar credit. Most mortgage companies that I have talked to will pull your credit report from all 3 bureaus, then toss out the low and high score, using the middle score as the base for determining if they will extend a mortgage to you. This is why if you are shopping for a mortgage, you must monitor and correct information with all 3 bureaus. The difference in interest rates between a 620 and 720 score can be staggering, literally up to $1000/month difference in your home payment for a modest midwestern home.

It is said, even by Fair Isaac, that 90% of banks use FICO scores for determining who they will extend a mortgage to, and what interest rates will be offered. Who is the other 10%? I have not found a single mortgage lender that does not use FICO as the basis for mortgage decision.

As bad as this whole system is, Fair Isaac is far from fair, having 3 different companies with different sets of inaccurate information about you that you must to pay to see should be illegal, this is the way it is, and will not change for a long time to come. This is the world we live in, knowledge is power, and I hope this blog entry summarizes accurately the research I have been doing over the last several weeks and months. I'm not done yet, and as I learn more or remember things I forgot, I will update this page.