Your credit score is a tool that lenders, future employers, leasing agents and insurance companies use to predict an individual’s capacity to manage risk. That risk includes making payments and exhibiting responsible behavior.
Credit scores (sometimes called FICO scores) are based on a formula developed by the Fair Isaac Corporation. Scores range from 300 to 850, with the vast majority of individuals having scores in the 600s and 700s. A score above 650 is generally considered a good score, while anything below 620 tends to indicate credit problems.
Individuals with higher scores frequently receive lower interest rates, more favorable employment opportunities and lower insurance premiums. Lower scores may have the opposite result, leading to higher monthly payments. Oftentimes, people with low credit scores will need a co-signer to make a transaction or even be prevented from getting credit, jobs, insurance and housing.
You should keep track of your credit score even if you aren’t looking for a loan or a job; your credit score is not static and it always matters. Many lenders and employers to check credit scores on a regular basis to determine potential increases in rates, reductions in credit limits or changes in employment status. Dropping credit scores indicate a potential problem making future payments and may raise suspicions about work-related issues such as distractions, loss of productivity or even embezzlement.
Credit scores are based on five primary factors: payment history, total debt, length of credit history, new credit and types of credit. Each factor is weighted, as shown in the chart. Following is a brief description of each:
• Payment history: Delinquent or missed payments in the past indicate a problem with money management and personal responsibility. Credit bureaus consider the number of late payments, the frequency of missed payments and the number of days late when calculating credit scores. One missed or skipped payment can drop your score as much as 100 points! The best way to improve a credit score is to make payments on time. Persons who have problems tracking monthly payments should consider setting up an automatic bill pay plan or setting up a calendar noting due dates to help reduce the late fees as well as the negative impact on their credit scores.
• Total debt: Lenders are particularly concerned about your debt load, which is based on an estimate of the ratio of monthly payments to monthly income. Higher debt levels reduce credit scores, and a debt ratio greater than or equal to 40 percent raises concerns about a person’s credit risk. A debt ratio over 50 percent significantly reduces a person’s credit score. Total debt accounts for 30 percent of the credit score; therefore, reducing personal debt is an important step in raising that score.
• Length of credit history: The FICO formula assumes that people with a longer credit history have a lower credit risk. The longer the credit history, the more accurate predictor it is for future behavior because it shows a longer pattern of payment history. The length of credit history is 15 percent of the credit score.
• New credit: Multiple credit applications are an indication of an increase in potential debt. Fortunately, FICO distinguishes between applying for a single loan and attempting to open several new accounts. When seeking a mortgage or car loan, it is best to shop around in a short period of time—about 30 to 45 days—to reduce the impact of applying for new credit. Even though new credit only represents 10 percent of a credit score, it is enough to put a dent in anyone’s credit rating.
• Types of credit: Not all credit is the same. For example, secured credit cards indicate a higher level of risk than unsecured cards or home mortgages. Most people have a mix of installment and revolving credit accounts. (With installment loans, a person borrows money once and makes fixed payments until it is repaid; revolving credit does not have fixed payments or fixed amounts of debt.) The credit mix accounts for the remaining 10 percent of the credit score.
Credit scores do not include age, salary, occupation, titles or employment history; however, many lenders will consider these factors when making decisions about a person’s creditworthiness. By law, credit scores and credit decisions cannot include race, color, religion, national origin, gender or marital status.
While consumers may request free credit reports yearly from each of the credit bureaus, credit scores are only available for a fee. Legislation in Congress is currently pending that would allow consumers free access to their credit scores.
Access to credit is not only a right, it also is a responsibility. Families can protect their rights and maintain their creditworthiness by exercising personal responsibility when establishing their credit history.
Sue Lynn Sasser, PhD, is a professor of economics at the University of Central Oklahoma.