The Wong Ohana

Do You Know How Your Credit Score is Calculated?  If not, you should!

There are many things that the Credit Card companies don’t want you to know, and one of them is how your FICO credit score is calculated.  The less you know, the less you can alter or correct and the more interest they will ultimately be able to charge you.  So get in there and be informed!

So what parameters do the 3 Major Credit Bureaus use to determine if you have Good, Poor, or Excellent credit.  Now, you may wonder, what difference does it make HOW its calculated, perhaps you’re just a “Bottom Line” kind of person, and you’ve always just wanted the facts - such as “Do I, or don’t I qualify for that loan?”.  This is a very dangerous stance to take because knowing the formula used gives you the power to not only avoid areas that will negatively affect your rating, but also to make changes in specific areas that could positively improve your final score.

Now, these figures are public information - and although its been printed in books, can be found on the internet, and if you write or call the credit reporting agencies, you might even find someone who will share the formula with you, I’ve found that its something that the average person is typically unaware of, and yet you should be.

PLEASE NOTE, however, that the descriptions below each heading are my own opinions and interpretations, after doing much research, over years, on the subject.  Please be aware that I’m not a professional financial adviser, and while I may be giving my opinion on things that I’ve done, that have positively impacted my own credit rating, you should consult with your own financial adviser before implementing anything posted here. 

So here’s how it goes.  There is a simple mathematical percentage applied to 5 different areas that will either positively or negatively impact your credit rating depending on how your credit activity and history has been reported over a period of time.

Here is the breakdown:

• 35% - Payment History

This is a simple to understand one.  Pay on time = good, late or delinquent payments = bad.  But its really more than just that.  The credit card companies update to the reporting agencies every month.  a 30 day delinquency will affect you less than a 90 day delinquency will.   Anything that goes to collections will obviously hit you harder than just a one time “oops, I forgot to mail that check”.  Total number of infractions also add up to more negative value.  If you have only one bad mark of 30 days past due, that is completely different than 4 accounts all showing 30 days past due.  So the bottom line here is to pay your bills, and pay them on time.

This is fully 35% of your total credit score and one of the easiest to keep under your control.  If you have an electronic bill pay service, use it.  Set it up to pay your bills at least a week prior to the due date so that any holiday, weekend, or whatever won’t cause that payment to go late.  And if you do make that ultimate error and skip a payment, call the company as soon as possible, and explain your circumstances and ask if they can forgive this small indiscretion and promise that it won’t happen again.  If you know in advance that you’re going to be late, or have trouble meeting an obligation, it is also recommended that you call the company as soon as you can to let them know IN ADVANCE that the payment is coming, but will probably be a bit late.  They LOVE it when you communicate with them, and this may keep you from getting reported.  You can even make a request that they write in your file so that it won’t be recorded against you as a late payment.

The bottom line here, I guess, is that if you can’t afford it, don’t buy it.  Don’t commit to making payments you won’t be able to afford, and don’t stretch your budget so thin that any small emergency will cause you to fall in arrears.  Don’t buy something because you are “expecting to come into some money soon”.  Wait till the money arrives, then buy it, and charge as little as possible.  There is something to be said for trying to maintain a cash lifestyle.  The less you owe, the less interest you will be paying and the more money in your pocket!

So if you have to use credit, please pay your bills, and pay them on time.  This will help you on your way to a good credit score.

• 30% - Amount You Owe

This one also seems simple, we’ve all heard the phrase “debt to income ratio”.  The Readers Digest condensed version is to calculate everything you owe on credit and compare that number with how much money you make.  Hopefully you make more than you owe!  You’d think that was the end of it, but its not.

What Your Credit Score is actually used to determine is “What are the odds that you will be able to repay a debt”.   That’s it in a nutshell.  That is what they are trying to find out.  Yes, they know you want it, and there you are waiting in line to buy it, but what are the odds that you will pay this debt if credit is given to you?

The amount you owe is just part of that equation.  Something a lot of people don’t know is that its not just how much you owe that they are looking at.  Its how much you owe COMPARED TO what your overall credit line is.  In other words, what they want to see is that your total debt on any one individual card falls within 30%-50% of your Available Credit.  For example, lets say you have a $1,000 card and you’ve charged $900 worth of merchandise on it.  The average person would feel that they are well within their rights to do so - and yes you are, but what the credit agency looks at is that you’ve used up 90% of your Available Credit and this is a bad thing.  It would be better to have 3 credit cards all with $1,000 limit and charge $300 on each card.  Now, you still owe the same $900, but what the credit agency looks at is that each card only has 30% of available credit charged to it.  This is what they want to see, and it will result in a higher score.

Now there are a couple of ways to use this information to your advantage.  Either pay down your cards so that your resultant debt falls within the 30%-50% range (obviously this would be the preferred solution if at all possible), transfer some funds from a higher balance to another card with a low or zero balance so they’ll both fall closer to that range, or call the credit card company and ask them to raise the limit on your card.  This will result in your total debt being a smaller percentage of your new higher credit line, and thus increase your credit score.  Just remember DO NOT use that higher limit as an excuse to increase your spending!!

• 15% - Length of Your Credit History

Now this is an interesting subject.  It used to be the common thought that when a credit card was paid off it was a good thing to close the account.  Now we know that is not the case.  The old tried and true credit card that you have had since you were in school buying books will earn you a higher credit score than a new card you just applied for.  The credit reporting agencies want to see that you not only pay your bills on time, but that you have a HISTORY of paying your bills on time.  So the longer you have a credit line, combined with the amount of time since that last activity (as long as you have shown good history on that account), the better your score will be.

Now lets say that you have been transferring funds in order to take advantage of promotional offers, but you use the cards only for paying down the debt and never make a new charge on it.  First I congratulate you on reducing your debt, and your restraint in not using the cards to increase your spending habits, but there comes a time when the card will go “inactive” in the eyes of the credit reporting agency even though you’ve been faithfully making payments.  After 2 years time, if no spending has been reported, that card will cease to be used in calculating your credit score - sucks doesn’t it??  I have a few that fall into this category.  Now if you’ve been faithfully making payments for those 2 years, believe me, you WANT this card to count if possible, so you might go to your local store and buy a couple of bags of chips and put it on that card.  Once you use the card, even once, the old history will suddenly be be brought forward, the card moved to active status, and you can increase your credit score.  If you look at your credit report, there should be somewhere on it next to each card that will let you know if that card is considered “active” not.

Now something to be aware of is that if you have a promotional offer on this card of 5%, and now you make a purchase, your new charge will be calculated on the standard rate that your card holds, which may be quite a bit higher than that 5% promo offer.  Now your credit card company will also pay off the lowest interest rate first, so it will continue to pay down that 5% until the offer expires, and all the while the new purchase, at let’s say 14% standard rate, will continue to increase every month.  So definitely think twice before doing this.  You’ll want to compare what your current score it, how much you think you can positively affect it, and what the monthly cost will be to do so by making a purchase on that card.  These are not things to be taken lightly, and are not suitable for everyone, nor for every situation, so you should always get the advice of a financial expert before attempting this.

• 10% - Types of Credit Used

This one is a little trickier - but basically it means that the credit reporting agencies want to see a well rounded mix in your credit history.  If all you have are a couple of department store cards, or gas cards your score probably won’t be as high as someone with a car payment, a mortgage and a couple of major credit cards.

• 10% - New Credit

Now this is not as straight forward as it looks at first glance.  Yes New Accounts, does mean exactly that.  Number of recently opened up accounts - but it also includes “inquiries” in that total.  That means that if you go “shopping” for a new car, and stop to test drive 3-4 different cars on 3-4 different lots, and each one runs your credit to see if you qualify, each one of those inquiries will count against you.  So, look all you want, and test drive all you want, but don’t let them run your credit until you’re sure that’s the one you want to buy.  Its seems an easy request, “well, just let me check your credit and I’ll show you what you can afford”.  Don’t fall into that trap.  Wait till you’re ready to open up your check book before you let them contact the credit agencies.  Even if you walk away and don’t buy, if they have run your credit, the agencies already know, and they’ll ding you each time it happens.

The bottom line here, is that only 65% of your score is directly due to your actual paying history.  That other 35% also counts.  So the recommendation I will give you is to be aware what is on your Credit Report.  It is legal in the US to get your credit report once a year at no cost.  All you have to do is to call and ask for it, or go online and download it.  Check each and every item.  Make sure that its you, make sure that its correct.  If you find any discrepancies, contact the reporting agency and let them know.  There are millions of people out there, and yes probably even a few with your same name, and who knows if they are as good at paying bills as you are, so make sure your credit report is accurate.  Everything counts in one way or another!  Its either good or its bad, but it does count towards your total credit score, so make sure you stay on top of it and have the most accurate report you can have.

Filed under: FIX / REPAIR Your Credit, Personal Finances on January 18th, 2008