Anatomy of a Credit Score

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Why is pulling a credit report the first thing lenders do when an application is filed?

The credit score is one method used to measure a consumer’s creditworthiness. Credit scores range from 300 to 850. Credit reporting agencies don’t pull these numbers out of thin air. There are several financial factors that, once analyzed, are used to generate the credit score number. 

A credit score can be compared to report card grades in school. Grade point average (GPA) is calculated from grades that the student earned in a variety of classes over a period of time. Likewise, consumers are assigned a number based upon their history of credit usage. Depending on financial habits, credit scores can be raised or lowered over time. 

Credit Score

Topics:

  • Credit Reports and Credit Scores
  • Credit Activity Affects the Credit Score
  • Types of Credit Accounts
  • How to Raise a Low Credit Score

Credit Reports and Credit Scores

A credit report includes a credit score, which is basically an analysis of statistical characteristics of the consumer’s behavior patterns when it comes to managing credit. Fair Isaac Corporation (FICO) is a major credit score model used by reporting agencies. According to FICO, a credit score is the assessment of these 5 areas of credit activity:

  • The borrower’s payment history (35%)
  • How much debt is owed (30%)
  • Credit history age (15%)
  • The number of new credit lines (10%)
  • Credit mix (10%)

When a borrower makes (or doesn’t make) payments on credit accounts, the lender reports it to one or more credit bureaus. The three major bureaus are Experian, Equifax, and Transunion. The credit data they keep on file is what potential lenders see when they pull a report.

The reports also contain personal identifiable information (social security number, past and current name, addresses, and employers). They include a list of all open and closed credit accounts. Any public financial records, such as bankruptcy or judgments, and recent credit inquiries are also listed in the report. It does not display income, marital status, level of education, and bank account information.

Credit Activity Affects Credit Score

The borrower’s payment history makes up the largest percentage of a credit score (35%), and for good reason. Lenders take a monetary risk when they approve credit; nonpayment results in a loss to their bottom line. The primary reason that they review credit reports is to see if the applicant honors their credit commitments. 

The ratio between credit balances (debt) and credit limits is known as credit utilization. Lenders view credit utilization over 30% as an indication that the borrower is likely to overextend credit and default on repayment because of too much debt. Credit history age does impact credit scores to a lesser degree (the older, the better). Opening too many new accounts in a short time has a negative effect on credit scores.

Types of Credit Accounts

The fifth credit activity is the credit mix, which means the different types of credit accounts the borrower has open at the time the report is viewed. The credit mix includes credit like mortgages, auto loans and credit cards. The credit report breaks down the types of credit into three categories: revolving, open, and installment credit accounts as follows:

Revolving credit is the most common credit account. It is a line of credit that can be borrowed against as needed, up to the credit limit. The credit can be reused as the balance is paid down. Credit cards are one example of revolving credit accounts, which require a monthly payment plus interest on any balance left at the end of the billing cycle.

Installment loans are approved for a set amount. Payments are the same each month on a regular schedule until the loan is paid in full. Examples of installment loans are mortgages, personal loans, and auto loans.

Open credit is the rarest type of account. The borrower has access to a credit limit that has to be paid in full every month. Charge cards (not credit cards, which are revolving credit) are considered open credit.

Most lenders do see borrowers with a variety of healthy credit account types as more reliable to some degree. Although a variety of credit types with good payment history is helpful, it is not the most important element of the credit score. Opening new accounts solely to boost credit mix is not a prudent financial strategy.

How to Raise a Low Credit Score

No one enjoys living with the consequences of having bad credit. Being denied for a car loan or any credit account is disappointing to say the least. The extra interest charged to people with low credit scores costs hundreds of thousands of dollars over the years. For these and other reasons, people are deciding to improve their credit scores for the benefit of their financial health. 

Some helpful suggestions to achieve better credit:

1. Borrowers should exercise patience during the process. It takes time to turn credit around but with persistence it will most likely happen sooner than expected.

2. Consistently paying bills on time is the first step toward improving credit. As noted, payment history carries the most weight on a credit report. Every single bill should be paid when it is due, even if it means making only the minimum payment or sacrificing a luxury or two.

3. Try to work with creditors by making arrangements to bring past due accounts current. Avoid getting a judgment and payroll garnishment by keeping the lines of communication open with lenders and sticking to any payment agreements.

4. Lower credit utilization ratio to less than 30% by paying off as much debt as possible. To calculate the ratio, add the amount owed (not including mortgages) and then add the total credit limits on the accounts. Divide the total of the credit limits by all balances to get the credit utilization. For instance, $10,000 total of all credit limits divided by $1000 credit usage equals 10% utilization.

5. Restrict credit card use to help reduce debt. Leave unused credit card accounts open, which can improve utilization ratio due to the unused card limit.

6. Borrowers trying to raise their score should not apply for new credit that will place hard inquiries on the credit report. A high number of inquiries will lower the credit score.

7. Make every effort to avoid filing bankruptcy since it stays on the credit report for up to ten years, far longer than it will take to repair credit.

8. Set goals to pay off small credit balances in order to lower debt. The accomplishment also serves as an incentive to keep going.

9. Check your credit report regularly to make sure there are no errors and to track progress. Consumers are entitled to one free report each year. Most banks and credit card companies offer free credit scores and reports to their customers.

10. Borrowers should not hesitate to correct any type of errors or missing information on their credit report. The correction can add valuable points to their credit score almost immediately.

Finally, borrowers should remember that a credit score is a statistic generated from financial data. It is not a personal reflection of the person overall. Life happens; any number of unforeseen circumstances can cause credit problems. A total turnaround is possible for anyone with bad credit. All it takes is reliable information, finding and accepting help, and a firm commitment.

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Sheila Kay

Sheila Kay is an author, ghostwriter and editor residing in the Atlanta, GA area. Among her favorite writing genres are creative nonfiction, self-improvement, and finances. Her first published book, PTSD and the Undefeated Me, is a memoir which has been a stepping stone to her involvement with mental health advocacy for military and civilian men and women. She is currently working on the first fiction novel to be published under her name. For more information or to purchase her books, visit Sheila’s Author Page on Amazon.com.

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