Understanding How Credit Scores Work
Let’s face it.
We live in a credit driven economy. Without credit, the US Economy would not be anywhere the size and benefit that it is now. As a result, there are very few Americans that can live their lives without needing some sort of credit in the form of a loan.
What is a Credit Score
Fair Isaac Corp originated the concept of credit score – what it calls a FIco score in the 1950’s. Financial institutions needed financial information based on various personal data to determine the creditworthiness of an individual.
With that, there had to be some sort of measuring device that lenders could use to determine whether or not you are a good credit risk, marginal credit risk or just a bad or too risky of credit risk. This is where our credit scores and credit reports come into the equation.
It was not until the 1950’s that the Fair Isaac Corporation worked on selling credit scores to individual businesses. The major credit bureaus who were collecting this information followed this model. In 1987 this credit rating system became publicly available to lenders. Because it was started by the Fair Isaac Corporation it became known as the FICO score. It became the standard in 1989.
If you were born 20 years earlier, this has been with you for your entire working life. For those that were born before 1969, it has not been the standard on your creditworthiness. This will be an important point later on in this article.
How Credit Scores Work
Although the Fair Isaac Corporation is not really specific in exposing how they calculate your score, rest assured it is based on a curve. It is a comparison of all the other borrowers out there with similar criteria.
Here is what we know. It has various ratings that are weighted against all other borrowers. This can be compared to the grading curve in high school or college. The score reflects these approximations.
- 35% payment history
- 30% amount owed
- 15% length of history
- 10% new credit
- 10% types of credit
The interest rates you get when you borrow money depends on the type of loan (collateralized or not) and where your bracket falls into.
Credit Score Ranges from 300 to 850.
The higher the score the better rates you will get. According to Experian, it basically breaks down as follows
- 800-850 is exceptional and is about 20% of people
- 740-799 is considered very good and is about 18% of people
- 670-739 is considered good and is 22% of people
- 580-669 is considered fair and is 20% of people
- 300-579 is considered very poor and is 17% of people
So basically that is what you need to know about your credit score.
Who Uses Your Credit Score?
The FICO score was intended to only be used by lenders. However, over the years it has been used by insurance firms, employers, landlords and just about any other entity that wants to know how responsible you are.
How do they find your credit score and credit report? Why they use your social security number?
Of course, your social security number was initially meant to track your social security as you paid into it. Now it is used as another form of identification and is tied directly to your credit report and your tax returns.
Welcome to our credit driven economy!
Your Credit Report
There are basically three main credit reporting bureaus that track your credit accounts and they are Experian, TransUnion, and Equifax. You are by law entitled to a free report from each of the three bureaus on an annual basis, so it is in your best interest to obtain them.
The reports will be different because the information on the reports about you is given to them voluntarily by your creditors and the court system.
What is on one report may not be on another report and all of the reports could have incorrect or inaccurate information. There are four sections of the report which are as follows:
- Identifying information
- Credit history
- Public records
Identifying information is all about you, your birthdate, where you have lived, drivers license number employers, spouses’ names and so forth.
Credit history has a list of all the creditors and the information of that creditor pertinent to your loan or obligation. These include:
- The kind of credit
- Whose name is the credit issued to
- The total amount of the credit, including high and lows
- How much you still owe
- Monthly payments
- Status of the account
- How good were you at paying the account
They can show whether it was charged off, paid off or paying as agreed to.
If there are any public records, that will be shown on the report as you were issued a lawsuit against the debt. This is not good and affects your score. It is only financial transactions that appear on the report, no other type of civil or criminal cases.
Inquiries are just a list of those entities who have asked to see your report. There are two types.
- Hard inquiries are when you fill out a credit application and can affect your score. Understand that they are initiated by you.
- Soft inquiries are basically insurance companies, employers, and landlords and do not appear to affect the credit score. Basically, a soft inquiry has nothing to do initially with borrowing money.
Fixing Your Report
It would probably be in your best interest to get your report at least once a quarter. You need to get them from all three reporting agencies. Once you have them, take some time to go over them with detailed inspections.
They by law will have to contact the creditors which will have a 30 to 45-day window to respond to your dispute. Basically, you tell them to “verify or remove” from your credit report. This will, in fact, help you clean up any misinformation on your report.
If you feel that your complaint was not verified or handled properly, you can then contact the Consumer Financial Protection Bureau. It is their job to help you with the dispute process.
You should try to pay off the more recent debts on your report first, with the exception of maybe your vehicle loan or your mortgages. This is because if you start to pay off a debt older than 5 years or longer that you have neglected to pay on, it will be treated as a recent debt and negatively affect your score. So pay off the more recent ones first.
Your Own Attitude Towards Your Credit Score
- Go ahead and dispute every item on your credit report that you can as mentioned above. It is possible that even with the ones you know are yours, their still might be a balance issue that needs to be resolved. Compare what is on your credit report with your actual statements.
- Decide to eliminate all credit cards down to about two major card companies and maybe one retail card, unless used for business. I am talking about individual cards. The more cards you have, the higher the possibility it is to get into a huge debt spiral.
How to Raise Your Credit Scores!
The issue of having a good credit score and protecting that score is paramount in our credit driven economy. For many of life’s expenditures, it will require the necessity to borrow money.
The credit score is simply an indication of how you have paid your debt known as credit extended to you.
Although it is used as an indication of how you will repay your debt in the future, it should be noted that it is no guarantee, either way. In other words, past debt repaying performance is no guarantee of future debt repaying performance.
In spite of what everyone else may tell you, the best way to raise your credit score is to simply pay off your legitimate debts systematically. The best way is to set it up so that you pay off the smaller ones first then add the amount you were paying on the one you just paid off to the next one. Then when the next one is paid off, you take that total amount to the next one and so forth.
So if you want to raise your Credit Score, do not try to figure out how the algorithm works, or some fancy way of trying to fake out the system. There are basically three things you can do to raise your credit score.
- Review your Credit Report quarterly to make sure that the information is correct and accurate
- Request from the three reporting agencies to verify or remove any information that is not yours or any debt you have no intention of paying back for one reason or another
- Pay back your debts as you agree to when you borrowed the money in the first place
This last one is the one we will focus on. I will give you a systematic method to not only pay your debts back but do it in an accelerated fashion. The key to this system is that you stop the cycle of getting more and more into debt every month. That habit needs to be corrected first.
So here is the systematic method of paying back all of your debts that you intend on paying back quickly. The first thing is to put all your debts on a spreadsheet in the following manner by referring to the chart below as an example.
You will arrange your debts by using factoring numbers from the smallest to the largest.
The smaller factoring numbers will be paid off first. The factoring number is the current balance at the time you set up this spreadsheet divided by the minimum payment.
The sum total of your monthly payment is all the minimum payments plus a small additional amount. You can see that as you arrange this, the interest rate order is not considered. It is just there to remind you of the rate you are being charged. So just start making these payments every month.
Once the first debt is paid off, you will take the monthly amount you were paying on that debt and add it to the next minimum payment of the next debt in line. You simply keep doing this month in and month out until your debts are paid off.
As you can see, this chart does not care about the time frame. It simply gives you a process and system to use while you are not adding additional debt to the problem. This system will accelerate your debt payoff quickly.
Because we know life happens, if you do incur new debt, simply place it in the spreadsheet in the proper factoring number position. You will have to add to your total monthly debt service that minimum payment amount.
You now have a systematic way of paying off your debts and raising your credit score.
Every quarter review your credit score and reassess your debt balances. You do not have to buy a course on raising your credit score or paying off your debts. You should not even have to consolidate your debts into a debt shifting scheme like refinancing your house.
Just use this payoff method and take care of your debts in a responsible manner. You will be amazed and should reward yourself with a nice dinner out with your significant other and pay cash for the evening.
Lastly, you should work as a goal in your life that you do not need to use credit significantly in your life. We understand that this could take a while, even most of your working life. However, just maybe it is time for Americans to rethink their use of credit, why do they need it and why not save and invest for that which you feel you need in life.
If you have not purposely designed your life by prudent thought and reflection and know exactly where you desire to be and have in your life in the future, this may be exactly why you are in a downward debt spiral.
Just remember, that at the end of the day, no one cares more about your credit score than you and you are the only one who can make sure it does not define your life.