• A Simplified Guide to Your Credit Score

    Brandon Cornett

    By Brandon Cornett
    © 2011 All rights reserved

    If you've tried to apply for a mortgage or car loan lately, you know how important your credit score is. This three-digit number can make or break your chances of getting a loan. But where does it come from? What do the numbers mean? How can you improve it? You'll find answers to these questions and more in this tutorial.

    Definition of a FICO Credit Score

    In this guide, I'll be talking about the FICO credit score exclusively. This is the one used by most mortgage lenders. So it's the one you should care about the most. There are other types of scores, and we will discuss them briefly in this article. But most of the lesson revolves around your FICO number. So what is it? Here's a quick definition:

    Your FICO credit score is a three-digit number between 300 and 850 (higher is better). Lenders and creditors use this score to determine how likely you are to repay your loan, based on how you've borrowed money in the past. If you've been responsible with your borrowing in the past, you should have a good score. If you have a habit of neglecting your bills, you'll have a lower number. This will all make more sense as we progress through the lesson.

    Where It Comes From

    Believe it or not, your credit score comes from you. It is based on your history of borrowing money. That's why lenders care about it so much. It shows them how likely you are to repay your debts.

    There are three pieces of the puzzle:

    • Consumer -- You're the consumer. Your credit score starts with you, and how you borrow money. I'll refer to this as your borrowing activity.
    • Credit Bureaus -- Creditors report your borrowing activity to the three credit bureaus, TransUnion, Experian and Equifax. These are private-sector companies. They are not government agencies, like many people think they are. They gather data on payment history, debt collections, bankruptcies, etc.
    • Scoring Software -- Credit bureaus take the information they've gathered and run it through a software program to produce a three-digit number. And behold, your credit score is born. The bureaus use different scoring systems, but the FICO system is the one that most lenders rely on. That's why I'm focusing on your FICO credit score in this lesson.

    A picture is worth a thousands words. So here's a handy diagram that shows you what I've just explained. This picture also restates a point I made earlier. Your credit score starts with you, and how you manage your financial responsibilities.

    The Credit Reporting Process

    So you use a credit card. You take out a loan to buy a car. You get a store card at Macy's. And then you start paying these things back (hopefully). All of this gets reported to the three credit bureaus shown in the picture above. They put this raw data through a software program, like the one designed by the FICO company. This creates your credit score.

    This also explains why you have three different scores -- one for each of the bureaus. And they don't always match, either. Some creditors report payment information to all three bureaus, while others only report to one. As a result, the information in your three credit reports might be slightly different.

    Your three scores will vary as well. In fact, I have never seen a case where a person had the exact same score across all three bureaus. So don't be surprised if you find differences with yours.

    Side note: Experian, TransUnion and Equifax have other software programs they can use, aside from the FICO scoring model. In 2006, the three bureaus collaborated and produced something called the VantageScore (their own version of the FICO score). But mortgage lenders have been slow to adopt the VantageScore. Their underwriting procedures are built around the FICO score, so they seem to be sticking with it for now. Translation: Don't worry about your VantageScore. It's your FICO score that counts when applying for a mortgage loan.

    How Your Credit Score is Determined

    So, how does all that data become a three-digit number? How do they convert your financial activity into a score? This is where things get a little complicated. But don't worry. I'll tell you what you need to know, but nothing more. Unless you're a computer programmer with an insatiable curiosity, there's no need to get lost in the weeds here.

    Your credit score is based on five categories of information. Within each category, there are many different factors. Each of these categories is given different weight in the overall scoring model. Some will affect your score a lot, while others only affect it a little. Here are the five items:

    FICO Score Chart

    Let's take a closer look at these five factors:

    1. Payment History: How responsible are you with paying back your debts? Do you make all of your loan and credit card payments on time? If so, you should have a good credit score. But if you have a habit of neglecting your payments, you may have a low score. The same goes for debt collections, bankruptcies and foreclosures -- all of these things can drag down your credit score. This category influences your FICO number more than anything else. You can see this from the pie chart above. So we've just unlocked the "secret" to getting a good score. Pay your bills on time!

    2. Amounts Owed: This includes the amount of money you owe on your credit cards and other types of revolving credit. In short, a lower balance is better. It shows that you know how to manage your finances, and that you use credit responsibly (and sparingly). On the other hand, if you have high balances in relation to your available credit limits, you can damage your score. The worst thing you can do is "max out" your cards. This will seriously lower your FICO score. You can see from the pie chart that this category accounts for 30 percent of your overall score.

    3. Credit History: This is the amount of time you've been using credit. Your history probably began the first time you took out a loan or signed up for a credit card. With all other things being equal, a longer history is better. There's not much you can do about this item. A word of warning though: If you close your oldest account, you will essentially shorten the length of your history. This could lower your credit score.

    4. New Accounts: As you might have guessed, this category includes your most recent credit activity (new accounts, recent credit inquiries, etc.). Use credit sparingly. Don't open any new accounts unless you need to. When rate shopping for a mortgage loan, get quotes within a short period of time. This will minimize the impact on your score. Of course, it only accounts for 10 percent of your credit score. So it's not as important as the "big three" above.

    5. Types of Credit: This refers to the different types of credit you are using (cards, installment loans, etc.). With all other things being equal, it will help your score to have a mix of installment loans and revolving credit accounts. This doesn't mean you should go out and open a bunch of new accounts in an attempt to boost your score. That's just silly. You're probably better off keeping your current accounts in place, and paying all of your bills on time. Again, you should focus on the top three items on this list. This item is only ten percent of your total score.

    How It Affects You

    Now you know where your credit score comes from. But what does it mean to you, as a consumer and a future home buyer? How does it affect you? How much weight does it carry? All good questions! Here are some answers...

    From a mortgage standpoint, your credit score affects you in two ways:

    • It is one of several factors that will determine if you get approved for the loan.
    • It is partly responsible for the interest rate you receive from the lender.

    So it affects your chances for mortgage approval, as well as the interest rate you get. I think we can agree that both of these things are important. Let's dig a little deeper into each item.

    How It Affects Mortgage Approval

    When you apply for a loan, the lender will look at you like a walking risk. (Imagine yourself walking into a bank with a white shirt that says "RISK" in big red letters, and you've got the idea.) All borrowers are a potential risk for lenders -- that's how the industry works. But they want to know how much of a risk you are. One of the ways they do this is by looking at your credit score.

    Remember, the whole purpose of the FICO scoring model is to predict risk. It does this by evaluating your borrowing history. Think of it as the computer's version of an educated guess. It can't truly predict whether or not you'll pay back your loan. But it can make an educated guess based on how you've repaid debts in the past. So a higher score increases your chance of getting approved.

    How It Affects Your Interest Rate

    When you take out a loan, you'll be assigned an interest rate. This is basically the cost of borrowing money. You want to get the lowest rate possible, because it reduces the size of your monthly payment. A higher credit score will help you qualify for a lower rate.

    Lenders use several factors to determine the interest rate on a loan. The three biggest factors are the loan-to-value ratio, your debt-to-income ratio, and your credit score. Loan to value is simply the amount you are borrowing in relation to the purchase price. Your debt-to-income ratio is a comparison between the amount of money you make, and the amount you spend on your debts. Your FICO score rounds out the top-three factors. 

    Here's a real-world scenario that shows how much you could save:

    Credit Score Needed to Get a Mortgage

    Some people can go their entire lives without worrying about their credit scores. These are people who can afford to pay cash for everything -- including houses. But for the rest of "regular folk," this three-digit number is very important. It can make or break our chances of getting a mortgage loan.

    Depending on the type of home loan you choose, you'll probably need a credit score of 620 or higher to qualify. This number is not set in stone. But it's the closest thing to a "rule of thumb" I can give you. You might qualify for an FHA loan with a lower FICO number. The cutoff for the FHA program starts at 500, though most FHA-approved lenders will require a higher score. Here's what other experts have to say about this subject.

    How to Improve Your FICO Number

    Refer back to the pie chart above. Do you see those three biggest factors that determine your score? That's where you should focus most of your energy, if you want to improve your FICO number.

    Here they are again:

    • Payment History -- All of your other efforts will be in vain if you keep missing payments. This is the most important factor when it comes to the FICO scoring model. Pay your bills on time. If you're a few days late, don't freak out about it. Just resolve the issue ASAP. Most creditors don't report late payments to the bureaus until they are more than 30 days late. Set up payment reminders or use auto-pay, if you have to. Just don't let them slip under the radar.
    • Amounts Owed -- Want to boost your credit score? Pay down some of your debts. I know, it's easier said than done. But it's worth the effort. And just think how good you'll feel when you have smaller credit card balances! When paying down your balances, focus on the accounts that are showing up in your credit reports. Those are the ones affecting your score. You should also pay down the credit cards with the highest interest rates first -- this will save you money in the long run. Just be careful about closing your accounts (see next item).
    • Length of History -- You might want to keep your oldest credit accounts open for now, at least until you're done with the mortgage process. Closing your older accounts can shorten your history (as far as the FICO scoring software is concerned). Also, if you have a fairly short history right now, you should avoid opening a lot of new accounts too quickly. This sends a signal that you are over-relying on credit, which can lower your score.

    I hope you've enjoyed this tutorial, and I wish you all the best in improving your credit score. If you would like to learn more about this topic, you can use the search tool at the top of this page. This subject is widely covered on the site. At last count, there were more than 50 articles related to credit in some way. The search tool is the easiest way to find what you need. Good luck.

2011 Home Buyer's Guide