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Credit Scoring Basics

What is a Credit Score?

Most consumers know the basics, like how failing to make a payment will cause your score to go down. However, there are a number of complexities that will almost always trip up the average consumer. If you pay your debts on time, don’t carry too much debt on any one card, don’t close older accounts unless absolutely necessary, and only apply for new credit when you have to, generally speaking you will be in good shape with regard to your credit score. However, it is important to keep yourself informed so you can maintain a credit score that accurately reflects your true consumer credit standing.

Lenders use your credit report in order to asses risk as to your reliability as a loan candidate. Your credit report maps out a number of things including your current debt load and your historical ability to handle debt responsibly. When a bank is considering loaning you money, your credit report is the main component used to decide if you are a desirable loan customer who poses little to no risk to them should they finance you. A high credit score can help you lock in low APR rates or secure special financing deals on a variety of loan programs. Conversely, having bad credit may prevent you from securing loans and will limit your ability to buy a car, open a credit card or rent and/or purchase a home. A history of inability to manage your credit successfully will make lenders uncomfortable about trusting you with additional funds in the future.

You are entitled to a free copy of your credit report once a year which is an offer you should take full advantage of. When you do receive your credit report, check to ensure the figures and ratings are accurate and act quickly to correct any mistakes. This may include any clerical errors, identity theft issues, or incorrect information that may be reporting on your credit profile. If you find that the information reporting is correct - yet your credit scores are lower that what you expected them to be, considering entering into a credit repair or financial rehabilitation program may be the most effective way to get you back on track.

What Makes Up a Credit Score?

Currently, there are three major credit agencies that dominate all areas of credit reporting. Equifax, Experian and TransUnion are the three who specialize in collecting and reporting financial histories a.k.a. your consumer credit report. Although the big three provide the credit report and the data contained within the report, your credit score (which was likely simultaneously generated when your report was ordered) came from a different entity all together. Your credit score is determined by an algorithm developed by the Fair Isaac Corporation, hence its name FICO. While the exact formula used to calculate your credit score is a tightly guarded industry secret, these companies provide general guidelines about financial behavior that can affect your credit score.

1- Payment History

Thirty-five percent of your credit score is made up by your payment history - more specifically a delinquent payment history. This includes late payments, collections, bankruptcies, tax liens and anything else considered derogatory in nature. Each type of account will stay on your credit report a specified period of time based on federal laws established per the Fair Credit Reporting Act. Conversely, each derogatory account will adversely affect your score independently and will have a range in the value and length of its effect respectively. RE Credit Repair, LLC works to remove accounts that are not 100% accurate, 100% verifiable or accounts that are obsolete. On average, our negative account deletion ratio (as of September 2010) is 68.20% of the total negative information reporting on a consumer credit report with a 51 point average increase.

2- Debt Ratio

Your debt ratio is the amount of revolving credit (i.e. credit cards) you owe in relation to the amount of credit you have available. For instance, if your credit limit is $10,000 and your current balance is $2,000, your debt ratio would be 20%. Ideally, your debt ratio should be maintained at 0%. However, financially speaking most consumers have to carry some type of credit card debt on a month to month basis. Rule of thumb that we recommend when trying to maximize your credit score, is 30% or lower with 0% being the end goal.

3- Length of Credit History

Your length of credit history dates from the oldest reporting tradeline reporting on your credit report. At face value, this seems like something you don't really have control over as you do not have the power to change the hands of time. To the contrary, there are ways you can both help and hurt yourself in this category. If you close out your older cards -even if they have higher interest rates- it will hurt your scores. Credit scoring models are all real time snapshots, thus they have no memory that take into account purged or closed histories (unless derogatory). Therefore, if your oldest tradeline is a 10 year old credit card and your current credit score is based on having a 10 year established credit history, should you close that account the average age of your credit file will revert to the second oldest account. The longer the history the higher the score - so in this scenario your decline from a 10 year history to let's say a 2 year history would cause your credit score drop.

4- Types of Credit

Types of credit include revolving, installment and mortgage loans. By having diversity in your credit portfolio, you demonstrate to the creditors that you are responsible and able to handle various types of financing and debt management.

5- Inquiries

There are two types of inquires that you will see on your credit report. The first type is called a hard inquiry. Hard inquiries do affect your credit score and are acquired & recorded on your credit report each and every time you apply for new credit (i.e. when you apply for a home, auto or credit card loan). The second type of inquiry is known as a soft inquiry. Soft inquiries are defined as inquires into your credit file but not as a direct result from you applying for credit. Examples of soft inquiries include when you pull your free annual credit report, unsolicited offers made by lenders and credit card companies, insurance companies and employers, and your current creditors pulling your report for performance and/or account review purposes. Soft inquires do not count against your score but do show on your credit report. All inquiries, regardless of whether they are soft or hard inquiries will report on your credit report for two years. However, the hard inquiries (which do have an adverse impact on your credit score) only count against you for a twelve month period. Mortgage inquiries and auto industry inquiries have separate standards as the scoring system anticipates that a consumer will be either rate or product shopping when purchasing a home or vehicle. Therefore, the scoring system counts all auto or mortgage specific inquiries pulled during a 30 day period as a single inquiry as opposed to hitting your credit file multiple times.