From the interest rate and features you are offered on a credit card to your ability to qualify for a mortgage, your credit score plays a large part in the bank's decision making process. A good score can have banks competing for your business when you apply for a loan. A bad score may mean that you won't qualify for your auto, mortgage or credit card – or if you do, you may only be offered high rates which will cost you extra money each month.
How is your credit score determined? Not too many years ago the way it was calculated and the actual score was a big secret. When I worked at a bank in Indiana we would link up with the credit bureaus to obtain credit scores and reports on people applying for a loan. We were told very explicitly to never give a person their credit score – that it was proprietary information that the loan applicant could not be given.
Things have changed quite a bit since then. You can now find out your credit score (for a fee, of course) through a number of different websites or when you apply for a loan your lender will usually tell you what your score is (if you ask). Fair Isaac and Company, the company that determines your FICO score (which is the score most often used by lenders), has also released the general parts of what is called the Credit Pie.
The Credit Pie
Here is how the credit pie looks:
Let’s examine each of those pieces of the pie briefly.
Payment History (35%): This piece of the pie is determined by how well you have paid your debts. Your lenders send information on your payment history every month to the credit bureaus. If you are late it is reported on your report, and in turn takes your score down. Negative items such as bankruptcy, judgments and liens are also factored in here. Because this is the biggest piece of the pie you should focus on getting your loan payments in on time, every month.
Amounts Owed (30%): As the second biggest piece of the pie it is important to pay close attention to this piece as well. While there are several factors that go in to this, the biggest one is the percentage of credit you are using. If you have a credit card with a $1000 limit and you consistently carry a balance of $700 you are using 70% of your available credit. You want to keep that below 25% for the best score. On installment loans they will look at how much you owe in proportion to the original balance.
Length of History (15%): Two factors play in here – how long you have had credit and how long since there has been activity on the account. Someone who has been using credit for 25 years is going to have a higher score than someone who has been using it for 2 years (everything else being equal).
New Credit (10%): This piece of the pie is determined by the number of recently opened accounts and the number of inquiries on the report. What is an inquiry? Recently I was picking some things up at JCPenney and they asked if I wanted to apply for a JCPenney credit card – just for applying I would get 10% off my total purchase. I declined the offer, but if I had accepted they would have pulled my credit report and checked my score. That is an inquiry. If you have a number of inquiries that starts to pull your score down. Don’t let that stop you from shopping for a loan, though – inquires within a short period of time are just counted as one inquiry.
Types of Credit Used (10%): Lenders like to see that you can handle several different types of loans, such as installment loans (auto loan), revolving credit (credit cards), student loans, a mortgage, etc.
In my experience, people tend to worry about the little things; such as how many inquiries are on their report. While it is important to watch all of this, remember that 65% of your score is determined by your payment history and amounts owed. Focus on making your payments on time and paying your balances down. Over time these two actions will have the greatest impact on your score.
How much of a difference will having a good credit score make? Based on national averages, here is how much you will pay for a 36-month auto loan:
Credit Score Interest Rate Payment
500 18.957% $916
620 12.213% $833
720 5.141% $751
Between the high and the low score you have a difference of $165, or $1280 for the year! $1200 will go a long way for most families.
For more information visit http://www.myfico.com/crediteducation/.
Ryan H. Law, M.S., AFC
Department of Personal Financial Planning
Office for Financial Success Director
University of Missouri Center on Economic Education Director
239E Stanley Hall
University of Missouri
Columbia, MO 65211