By Lita Epstein, credit and debt expert, WalletPop.com
With debt a big part of modern life, many people know they have a credit score and it determines whether they can obtain a loan at a decent interest rate. But after that, confusion reigns. In this series, I explain how the number is calculated and debunk eight myths people have about their score.
The most important thing people need to understand about credit scores is what goes into the calculation. Payment history accounts for 35% of your score. The amount that you owe accounts for 30%. Next in line is credit history, which makes up 15% of your final score. Applications for new credit and types of credit in your record each account for 10% of your score.
Credit scores range from about 300 (lowest) to 850 (highest). Generally the best interest rates go to people with a score above 750. In today's tight credit environment you will have difficulty getting credit with scores under 650 and will likely be forced to pay much higher interest rates.
There isn't just one type of credit score. In fact, there are at least six primary ones that are given to consumers and many more assigned to businesses. The primary driving force behind most of them is the Fair Isaac Corporation, known by most as FICO.
Each of the three credit reporting agencies has a slightly different formula for calculating scores, but all are developed by FICO. Equifax's is called BEACON, TransUnion's is called FICO Risk Score and Experian's is called FICO II. You'll find your credit score is not exactly the same at each agency, but scores should be within 20 points of each other.
In addition to these, Fair Isaac has come up with some new alternatives that the agencies may offer. Plus, there is scoring done for insurance companies and other businesses that use a different set of parameters. In many states, your insurance premiums can be higher if you have a low credit score.
You Should Close Cards to Improve Your Credit Score
Sometimes when you apply for a loan for a major purchase, such as a mortgage, you're told you can improve your credit score if you close some of your credit cards. Don't believe it. In fact, sometimes when you close an older card you can actually cause your credit score to go down.
That happens for two reasons. First, the best scores go to people who use credit moderately over a long period of time, so the older the cards, the better. If you need to close some accounts, close the newest ones first so you retain the cards with the longest history of prompt payment. If you don't have a credit history you'll find it very hard to get a major loan when you need one.
Second, credit scoring agencies put a lot of emphasis on what is called your 'utilization ratio.' It is essentially your total debt as a percentage of all your available credit. If you lower your available credit by closing cards, your utilization rate can actually look higher, hurting your credit score.
In most cases, lowering your credit limits will likely hurt your credit score. That's because credit scoring companies emphasize the debt utilization ratio (total debt as a percentage of all your available credit). Suppose you have $20,000 total credit available to you on four cards of $5,000 each. You carry a total of $6,000 in debt on those cards. The debt utilization ratio would be 30% ($6,000/$20,000).
Now suppose you close one of those cards and your total credit available is $15,000, but you still have $6,000 in debt. Now your debt utilization ratio would go up to 40%. That move could actually lower your score by 50 to 100 points because it looks like you're getting yourself into deeper credit trouble.
If you want to improve your credit score, don't reduce your available credit. But do pay down your debt as quickly as possible. People with a debt utilization score of 10% to 20% get the best credit scores as long as they are paying their cards on time.
You Must Pay Off Your Cards in Full Each Month to Get a Good Score
You may think you have to pay down all your credit cards to zero to get a good credit score. That's not true. In fact, to show you know how to use credit wisely, it doesn't hurt to occasionally pay a card over time. Showing you know how to use credit wisely can actually help you get a better credit score.
If you don't buy on credit and pay everything with cash, you'll likely have a lower credit score because you have no credit history for the credit scoring agencies to use. This not only hurts your credit score, but it can also impact your insurance costs because insurance companies do use your credit score when determining rates. They believe people with a higher credit score file less claims and therefore are lower risk, so they get the best insurance rates as well as the best interest rate offers.
The ideal way to use credit is to use 10% to 20% of your available credit and pay all bills on time. That seems to get people the best credit scores. It shows the credit rating companies that you know how to use credit wisely and you know how to pay your bills on time.
Shopping for the Best Credit Rates Can Hurt Your Score
If a loan officer tells you that you shouldn't shop for the best interest rates because it will hurt your credit score, don't believe them. They're just giving you a line to keep you from comparison shopping.
Whenever you shop for rates within a short period of time, the credit scoring agencies lump these requests into one inquiry. For example, if you apply to four different mortgage lenders within a two-week period, it would count as just one "hard" inquiry against your score. Don't drag out your search too long or the credit scoring company may end up counting the inquiries separately.
Also, don't apply for a new car loan or a new credit card just before you apply for a new mortgage. You will lower your score and you will likely end up with a higher interest rate on your mortgage.
Contrary to popular belief, you can not hurt your credit score when you ask to see a copy of it -- as long as you do it yourself and don't ask a friend at a financial institution to do it for you. When a bank requests a credit report, it is usually tracked as a "hard" inquiry, which prompts the credit reporting agency to presume you've made an application for a new credit card or another kind of loan. That's when it hurts your credit score.
When you request a copy yourself, it's considered a "soft" inquiry and does not impact your score at all. If you want a free copy of your credit report, you are entitled to one free copy a year from each of the three top credit reporting agencies.
You definitely should check your credit report from each of the credit reporting agencies yearly to be sure no one is using your good credit name and to be sure all your credit accounts are being reported accurately.
Paying Your Cards in Full Will Give You the Best Score
Even if you are someone who pays their cards in full each month, you might not have the highest credit score. Most people pay their credit card bills after they receive them in the mail. But, if you do that, the credit reporting agency ranks your credit based on that outstanding debt even if you're going to pay in full in 10 days.
For example, if you have a $2,000 credit limit and used $1,000 of that credit, the credit utilization on that card would look like 50 percent. If you want to improve your credit score quickly, pay your outstanding debt before the credit card company reports. Since reports are usually sent monthly right after the end of a billing cycle, pay most of the bill in full a few days before the billing cycle ends. Leave 10 or 20 percent of the amount due on the card for reporting purposes. If you do this for a few months before applying for a mortgage you should see a nice improvement in your credit score because your debt utilization ratio will look much lower."
Putting a Statement in Your Credit File Can Help Your Score
Some people think they can fix a credit score problem by putting a statement in their credit file. It's probably a waste of time. While the law does require that credit reporting agencies allow you to submit a statement of explanation when you dispute a negative mark on your credit report, these letters don't go into calculating your credit score. Many lenders make credit decisions based purely on scores.
What can you do if you are in a dispute over payment? While credit scoring companies must investigate any credit information you challenge, they will only take a negative mark off your report temporarily while investigating and they tend to agree with the vendor in ongoing disputes.
If you've been battling it out with a creditor and don't want to pay the bill, you could end up severely damaging your credit score. You may be better off paying the bill and taking the vendor to small claims court for a refund. If you want to fight, be sure you tell a potential creditor to expect the negative report and explain why you won't pay the bill.