Credit Score 101

I would be surprised if there are more than six adults in the U.S. (and certainly none of my readers) that don’t know what a credit score is. We’ve all been drilled over and over again about the importance of this mythical number, but not many of us know exactly where it comes from. That’s what this week’s post is all about. Hopefully by the time you’re done reading, you’ll have a solid understanding of where your credit score comes from, how it is used (and by whom), and how you can manage it. Make no mistake, your credit score could possibly be the most important number in your life.

What is a Credit Score?

Your credit score is a number between 300 and 850 that potential creditors use to determine the level of risk associated with you. Some say the range ends at 800, some say 900. For any practical purpose, though, it doesn’t matter. If your credit score is above 800, no creditor will turn you down as long as your income fits the bill.

First, let’s sort out what exactly what a creditor is. A creditor (in some cases, a “lender”) is any entity that provides you with a service or property in advance of actual payment. The list of creditors in the average person’s life is extensive, and includes banks, credit card companies, utility companies, phone companies, and a slew of others. You get the idea…if you’re using something that you haven’t completely paid for, there’s a creditor in there somewhere.

Naturally a potential creditor is going to want to know a few things before entering into a contract with you. The first of which is how capable you are of repaying the debt. For this they might ask for information such as your monthly income, expenses, as well as other current debts. The second thing they want to know is how likely you are to pay them back in a timely fashion. For this, they seek your credit score. The higher your score, the more likely that a creditor will accept your business.

Since your access to everything from housing to vehicles to electricity and phone service is all tied to this number, it’s clear that you should be paying attention! J

Where Do Creditors Get My Credit Score?

Potential creditors get your credit score from one of the three major credit bureaus; Equifax, Experian, and Trans Union. Each of these companies is separate entity, and as such they have different policies regarding when their information is updated, how thorough it is, and what they charge creditors to use it. As a result, not all creditors use all three bureaus to get your score. In fact, most only use one or two, and there really is no telling which ones they’ll use.

The three credit bureaus are private, unregulated companies. There is no government agency that regulates their practices, or oversees the accuracy of their claims. Of course, inaccurate credit scores can lead to lost business opportunities for both creditors and the credit bureaus, so there is some incentive to keep information accurate and up to date. Never the less, mistakes do happen.

So, how do these credit bureaus come up with your credit score? There is a company called FICO (Fair Isaac & Co.) that creates the algorithms used to determine your score. This is why you might sometimes hear your credit score referred to as a “FICO score”. You may notice that your credit score varies from bureau to bureau, and this is why. Each one of them purchases a slightly different algorithm from FICO, which results in a slightly different score. You may also notice that you may have negative factors (such as public records or collections accounts) that appear on one bureau’s report, but not the other two. This also has an impact on your score with that bureau, but is a result of reporting practices by creditors and not the algorithms used.

What Goes Into a Credit Score?

So now we know what your credit score is, and where it comes from, but what is it really made of? What are the factors that increase of decrease your score, and how much weight does an infraction carry? The answer is relatively simple! There are five main categories of information that get scrambled up in these algorithms and spit out as your credit score. Next to each category there is a percentage that represents the impact that each has on your score. Before we go on, understand that these are general guidelines, and may vary slightly from one bureau to another. Read on.

Payment History (35%): The largest contributor to your credit score is your payment history. This makes sense, since the creditor wants to know if you’re going to pay, and if you’re going to do so on time. Typically, most creditors will not report a late payment until it is overdue by 30 days or more. This isn’t an absolute, though, so it’s just best to make payments on time. Payment history also includes nasty things like bankruptcies, public records, and collections accounts. While the affect these things have on your credit score is reduced over time, they never go away.

Outstanding Debt (30%): The second largest contributor to your credit score is your current, outstanding debt. If you have taken out a number of loans, and/or have a number of credit cards that are at their limit, this will reflect negatively on your credit score. Conversely, if your debt is relatively small, your credit score will improve.

Length of Credit History (15%): Creditors want to know how long you’ve been in the game. Is this going to be your first credit card, or your 5^th? Have you had your other credit cards for many years, or do you cycle through them at the same rate that you max them out? Think of this as the “Past Experience” section of your resume…the longer your history, the more skilled at debt management you appear.

Credit Inquiries (10%): The credit bureaus assume that if there are many people that are viewing your credit report, it must mean that you are applying for many loans, which in turn must mean you are overextended, which in turn must mean that you pose a higher risk. I think I speak for most of the population when I say that this is an asinine theory, but they don’t much care what we think. The effect is relatively small, but be aware of it when entering situations that may result in a credit check. More than three in a 12 month period could spell trouble.

Depth of Credit History (10%): Not only are creditors interested in the length of your credit history, they want to know the depth. Are you only capable of managing one account at a time, or can you manage six at a time without overextending? Do you just have credit cards, or do you have a mortgage, a car loan, and a personal loan as well? A narrow credit history reflects poorly on your score, and a broad credit history reflects positively on your score.

Credit Management 101

If you’re one of those people whose credit score is 700 or more, then you probably don’t need my help. If you’re not one of those people, don’t worry, all is not lost! You can improve your credit score, but it will take some time and a fair amount of discipline.

With the exception of the big downers (collections, public records, bankruptcies, etc.), most negative factors on your credit report can be rendered negligible within two years. For the really bad stuff it can take five to seven years. For much of what goes into your score, though, you can make improvements as fast or as slow as you like within what you can afford.

The quick fix version is as follows:

1) Make payments to all creditors on time!

2) Keep credit card balances at 30% of the limit or less. This is very important! One card maxed out at $1000 and four cards with a zero balance looks WORSE than five cards with $300 balances.

3) Start building a good credit history when you are young, and keep a long term relationship with your creditors.

4) Keep credit inquiries to a minimum. Often times, if you can provide a print out of your credit report from an accredited source (such as myFICO.com), creditors will accept the number without making a formal inquiry.

5) Check your credit report for inaccuracies! The law requires that each credit bureau allow you to access your credit report for free once per year. Take advantage of this by visiting http://www.annualcreditreport.com. If you find a mistake, report it immediately. They will verify your claim very quickly, and correct the mistake.

Author’s Tips

As some of you know, I am NOT one of the people that fall in the 700+ range. In fact I have worked hard to bring my credit score out from the abyss, and I still have a long way to go. Here are a few tips that I know to be effective.

Calendar – There are a number of sites online where you can get a free desktop calendar that allows you to add notes. If you use Outlook, that will work as well. When a bill comes in the mail, I look at the due date, and mark the Monday prior to it on my calendar. I do my finances on Monday’s, but if another day works better for you then just as well. When I come to my computer on Monday, there is a list of payments to be made, which I do online through my bank. Nice and easy, and everything gets paid on time. If your not tech savvy, just use a regular calendar. Or, if you have a good positive cash flow, pay the bills as soon as they arrive.

Credit Report Monitoring – It is essential that you check your report annually, if for no other reason than to ensure there are no mistakes. I have made a bit of a project out of my credit score, and so I opted for a program from myFICO.com called ScoreWatch. It’s a service that charges $84/year, and works in conjunction with FICO, and all three credit bureaus. The service keeps track of my credit score in graph format, and notifies me by text message of any changes. I find the service to be worth the cost to me personally, but it isn’t necessary.

Once a Compulsive Spender, Always a Compulsive Spender – If you find that you’re having trouble controlling your credit card debt, get rid of your cards. Give them to someone you trust for safekeeping, and request one if you want to make a purchase. If you don’t have anyone you trust, cut them up. The card company will send you a new one once you’ve gotten things back under control.

On the Flip Side – Credit cards can be a good thing! As I discussed in my previous post, credit card companies are evil. However, if you use them responsibly, they can be an excellent way to build a lot of positive factors into your credit history. Remember, though, that with each application you incur a credit inquiry, so pace yourself.

Until next week, happy finacing!

How to Piss Off a Credit Card Company

Make no mistake about it, credit card companies ARE out to get you. No if's, and's, or butt's about it. They are out to rape you completely, and they are legally allowed to do it. Horray for lobbyists.

Consider Miss Jane Doe, a not-so-young woman collecting Social Security disability. She cut up her Discover card and (obviously) stopped using it when she hit her $1,900 limit. Over the next six years she made $3,492 in payments, and still had a balance of $5,564.

In 2003, the card company sued Doe, asserting that she had breached the contract she had with them. The judge tossed the case and reduced her debt to zero, saying she had been prey to "the plaintiff's unreasonable, unconscionable, and unjust business practices."

And yet it is still legal for these card companies to do exactly the types of things they did to Jane Doe. Not only that, but some card companies are working to place even stricter regulations in their contracts. Over limit fees, late fees, shorter grace periods, universal default clauses, as well as a slew of other sneaky practices leave cardholders bewildered and in a worse state of debt than at any time in American history.

But there is a ray of sunshine. There is a way to beat the banks at their own game, and let me tell you that they will hate you for it. You see, the only reason that their practices are legal is because they have to provide a loophole. They must provide a way for customers to avoid all of the predatory finance charges associated with their cards. And lucky for you, I'm going to tell you how!

Lesson One: Shop Around

Credit cards are like anything else, you can and must shop around for the best deal. All card companies are evil, but some are better than others. Also, many card companies offer incentives that might fit your needs.

Click here to visit Credit Land, a wonderful place where you can compare credit cards, apply for them, and even read their terms. Keep the following things in mind when searching for a credit card.

1) Don't sweat the APR. You'll see tons of cards that advertise "0% Introductory APR!". The introductory period generally lasts for a year, and then it's over. Most of those cards will tell you that once the intro period is over the rate will jump to a very modest 10.5% Don't pay attention to any of this for two reasons. First, if you're using your new card correctly, it won't matter (see the next section). Second, most cards these days have a "universal default clause" written in the fine print. What that means is that if you are late on any payment to any creditor or any utility, you will trigger an interest rate hike. As you will notice if you go to the site, some of the resulting APR's are absolutely horrendous...29% - 34% in many cases.

2) Look for the longest grace periods possible. The "grace period" is the amount of time, in days, from the statement date, during which there is no interest charged. Generally the due date is the end of the grace period, but that isn't always the case. You want to be looking for grace periods of at least 20 days, preferably 25.

3) Look for cards with no annual fees. This is self explanatory. Why pay fees when you don't have to?

4) Look for cards with incentive programs. Some offer flyer miles, some offer cash back on certain items, some offer points that can be redeemed for gifts certificates and the like. I found a card on there that had a flat 1% cash back on all purchases, and a 5% cash back on all gasoline and auto repair purchases. Not a bad deal for someone who drives a gas guzzler or an older vehicle that requires regular maintenance.

Lesson Two: Manage Your Cards

Not only is it possible to avoid ALL of the fees associated with credit cards, it is possible to actually make them pay you!! This is important enough to be worth repeating; ALL CREDIT CARD FEES ARE AVOIDABLE!!

It can be difficult to manage your cards effectively, especially when things get rough and you need to rely on them just to survive. However, if you can manage to stick to the following basic guidelines, you'll be just fine.

1) Whenever possible, pay the entire balance of your credit cards within the grace period. Doing this will avoid any interest you may have had to pay. Keep in mind, though, that this is where the phrase "a day late and a dollar short" originates. They won't be lenient with you, and if you come up short by one day or one dollar, they will charge you interest on the entire balance for that period. Not only that, but if the due date was the end of the grace period, you'll get slapped with a late fee also.
2) If you cannot pay the full balance during any one grace period, pay at least twice the minimum payment. Paying twice the minimum saves 95% of the interest you would pay if you paid just the minimum.
3) Try to keep all of your card balances at 30% of the limit or less. Not only does this keep your balance to a reasonable level, but it will also prevent undue damage to your credit score (which I will discuss in another post).

If you take the time to do all of these things, you will pay NO fees, NO interest, and you might even get up to 5% of your purchases back due to incentives. That's my ultimate goal...to go at least 6 full months where the credit card company pays me!!

Happy financing!

Introduction

As most of you know, I've begun an education process that will ultimately lead to a MBA in Business - Finance. Why? Well, I thought I knew in the beginning, but as I learn more and more on the subject, I realize how broad a scope it has in my personal life. The reasons, therefore, have begun to multiply.

There is a whole world of loopholes and pitfalls out there that I never paid attention to. I don't even want to know what it has cost me. In hind sight, that is my biggest reason. No matter what they say, money IS everything. Different people can happily survive on variable amounts, of course, but none of us can lead a reasonable life without it. It simply isn't possible in a civilized society. Sure, you could build yourself a log cabin in the mountains without any of the amennities that we all take for granted, but barring that money will always be the metaphorical nth member of your family.

The funny thing about money is that it almost acts of its own accord. If you don't pay attention to it, it will run off. Cash in your pocket has a habbit of disappearing, your accounts balances seem to shrink without warning. Fees and expense eat away at your nest egg, and you may not even realize it's happening.

But if you pay attention to your money, and offer it direction, you can accomplish two things. First, it will run where you want it to. Second, it will grow! I like to call it the Money Tree. Why? Because, like any other plant that you try to grow, it takes time. It takes nurturing, and you must keep it free from deadly parasites, bugs, and anything else that will eat it away.

That's what this blog is for. I want to share the knowledge I gain with you in the hope that you can use it to avoid the multitude of mistakes that we all make. With a little effort, you can make your money tree grow as well. And, of course, it will help me to learn if I explain it to you.

So read on, and I sincenerly hope that you find this information useful!