Tuesday, May 13, 2008

Credit Reports and Scores Explained

This is Part 2 in a series on Credit Card Education

Part 1: General Credit Card Information
Part 2: Credit Reports and Scores Explained
Part 3: Building Your Credit - Your First Credit Card
Part 4: Fixing Your Credit – Tips And Tricks
Part 5: Where To Check Your Credit Reports And Scores
Part 6: Amex Financial Review
Part 7: Store Credit Cards
Part 8: Churning Credit Cards - Tips and Tricks

Part 9: Credit Cards With Great Signup Bonuses

What Is A Credit Report / Why It’s Important

Your credit report and score are important. Very important.

Any time you apply for a credit card (or any other type of credit e.g. cell phone, car financing, home mortgage, or sometimes even when opening a bank account) the credit card company will ask one or more of the three Credit Reporting Agencies (CRA), Equifax, Transunion or Experian, for your credit report and score (which is based on your credit report), in order to see how much of a risk you pose. After all, they are giving you their money and they want to know what their chances are of getting it back…

Based on your report and score they decide whether you get approved and for how much credit (and your interest rates on a loan).

If the credit card company decides to give you a credit card, they will send in to the CRA’s all the information about your account and how much credit they gave you. When you apply for another credit card, that company will see this credit card info on your report.

The first time you apply for a credit card, when the credit card company tries to check your report, there won’t be anything on your report, which is why getting your first card can often prove to be difficult (especially in today’s delicate credit market).

So, in reality you have three separate credit reports, and in turn three separate scores.

Credit Scores Explained

Many companies create scores based on your three reports. The company most widely used by lenders, is FICO.

The Fico score is a number ranging from 300-850. The higher the number, the less risky you are to lenders. Your credit score is based solely on your credit report. So you will have one score for each CRA. (Whenever a credit card company looks into your credit report, they will either ask from one or more, if they ask from all three, they will usually consider the middle score to be your score.

Credit scores explained
These are the main things which affect your score according to the new scoring system (FICO 08) The exact formula for coming up with the credit score is not known, but this picture shows which things count for how much percent of your score. The first two things are what you should really be focusing on, as they make up the biggest chunk of your score.

Payment history = 35%

Pay your bills on time!

Paying late even once can really hurt your credit for a long time (stays on your report for 7 years, though after a few months it gradually starts effecting your score less and less). It will affect your credit score only if you are more than 30 days late, though every card can be different.
Note: Even if you do pay your bills on time every month, it can take up to a year for your credit score to go up substantially. (Either on a new card, or after a late payment)

Amounts Owed = 30%
Never use more than 20% of your total available credit

It looks risky if you are using too much of your available credit. It is best if you use less than 15% of your available credit (even better to keep it under 10%). So if you have a credit line of $5,000 and you make a $4,000 purchase, you will be using 80% of your credit. If you need to make a large purchase which uses up most of your credit limit, consider paying the bill before the statement closes, as the credit card companies tend to report your credit after each statement closes. If you spend money and pay it before the statement closes, it won't be reported as your balance.
This rule goes for each specific card, not just for the total available credit between all cards.
Tip: When you do decide to cancel a card, make sure to transfer the credit to another card (in the same company) before canceling, so your total available credit will not change.

Length of credit history = 15%
Leave old cards open.

The older you credit history is, the less risky you seem to be. This is judged by the age of your oldest credit account and the average age of all your accounts.
Tip: If you have some old no annual-fee cards which you are not using, don’t cancel them, like that the average age of your cards will be older.

New credit = 10%
Don’t apply too often for new credit.

Every time you apply for a card or any other type of credit (including a cell phone) your score will drop.
Tip: If you applied for a credit card and got accepted, then after a few weeks your score should go back up, because you now have more available credit.

Types of credit used = 10%
Don’t have just one credit card.

It is good for your credit to have a few cards, not just one. Or have some other type of credit as well, i.e. Installment loans (like when buying a car).
Tip: If you have only one card, it is very possible that that specific card only reports to one or two of the CRA's. At the third CRA, you might have an extremely low or non existent score!

Stay tuned for advice on how to build and fix your credit.


NNadiv said...

this is incredible!
thanks so much!
i am wagerly awaiting the next chapter...

Anonymous said...

Shumli, Can you post the best way for someone who has no credit history to get a credit card?

BuyRightSpendLess.com said...

Nadiv: You are very welcome!
Mendel: Coming up very soon...

Anonymous said...

A tip I learned about credit card payments:
If your not able to pay the full amount of the billing statement, you should still pay more then the minimum payment. Say you owe $637 and your minimum payment is $15, its a good idea to pay $30 instead of the bare minimum. This is because this all shows up in your credit report: your current balance, your minimum due, and the amount you actually paid. It looks much better when the creditor sees that your able and committed to pay more then the minimum.

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