Joseph Hanson JD EA
Demystifying Credit Scores
Let us talk about credit scores. I know people think credit scores are important. I personally think there is too much focus placed on credit scores. As we make the right financial choices in life credit scores tend to take care of themselves. Credit scores matter the most to those that are young and to those that are poor; aka those who need credit. As we get older and have accumulated more wealth and savings, a credit score does not matter as much.
Why is that? Let us talk about what makes up your credit score and some tips and tricks to help your score.
First, there are three credit bureaus: Experian, Equifax, and TransUnion. Not all your accounts report to every credit bureau because each creditor must have a contract with each credit bureau. So many of your creditors may only have a contract with one bureau because it is cost prohibitive to pay to report to all three. The credit bureaus do not give you a credit score. They compile credit reports about your loan history, collections, legal judgement, payment history, length of credit, etc...
Your credit score is created by the Fair Isaac Corporation (FICO). FICO pulls information from the credit bureaus and other sources and compiles it through their algorithm and creates a score. Did you know that car insurance rates are even influenced by your FICO score?
Here are the factors that affect your credit score, and how you can help your score.
1.) Credit usage: This is a measure of current credit usage divided by total credit limits. Keep this ratio less than 30%. The lower the better.
2.) Shrinking or expanding credit card debt: This is a measure of the direction of your credit card debt, an expanding amount of credit card debt is going to negatively impact your credit score and as you pay down credit card debt your score will positively reflect that progress.
3.) Payment history: This is self-explanatory. Making payments on time is going to help your credit score. While missing payments or defaulting is going to have a negative impact on your score.
4.) Collections: If you have accounts in collections, this can negatively impact your credit score. If you disagree with a collections account that is reporting to the credit bureaus you can dispute the account with the credit bureau and they give the creditor 30 days to respond and prove the validity of the disputed account. If they fail to do so or they cannot then the negative report is removed.
5.) Credit History length: The longer your credit history the better. If you are thinking about cancelling credit cards you do not use anymore, you may want to think again. Keep your oldest accounts open even if you do not use them anymore. It is okay to close newer accounts, and in some cases, it can be beneficial to close newer accounts because part of this calculation is avg. age of accounts.
6.) Debt-to-income ratio: FICO has become smarter over time and is constantly farming information on you from your buying habits, to where you live, where you work, and even what you search for online. Through the gathering of that information they guess what your income is and create a debt-to-income ratio for you. Obviously the lower your debt to income ratio the better credit risk you are.
I hope this helps demystify the credit score process for you.