By Kelly Spors
Anyone who has ever needed a loan probably knows that credit scores are important. A score above 700 opens the door to easily obtaining a mortgage, a car loan or a credit card.
What’s more confusing is what goes into that score. Even small, seemingly unimportant actions – like opening a credit card just for the rewards (30,000 frequent-flier miles!) and then closing it a few months later, can take a toll on your credit score.
Lenders have many companies to choose from when it comes to crunching out a credit score on a prospective customer. But one of the most common sources of credit scores is Fair Isaac Corp. and its FICO score.
Fair Isaac Corp. calculates FICO based on credit reports. There are three companies — Experian, Equifax and Transunion — that each compile such reports, collecting information on what type of accounts people open, how much they use them, and whether they make payments on time.
So what goes into FICO? Fair Isaac Corp. provides a general breakdown at MyFICO.com: FICO is 35 percent payment history, 30 percent amounts owed, 15 percent length of credit history, 10 percent new credit, and 10 percent types of credit in use.
Here are lessons to learn from the breakdown:
- Pay on time — always. With payment history determining 35% of a score, establishing a history of paying debts on time is one of the best things one can do to have a good credit score. It does not matter if the money was eventually paid, either. A late payment is a black mark on a credit report. And it will stay on there for years. Ditto for an unpaid bill that goes into collections.
- Keep the balance down on your credit accounts. The “amounts owed” that goes into 30 percent of the score basically refers to utilization. Out of all the credit one has available, how much is being used? FICO also takes into account how much is owed on each account. So if one has three credit cards that each have a $10,000 credit limit, it is better to owe $2,000 on each than $6,000 on just one card. (It would be even better to owe nothing on the cards!)
- Do NOT close old, unused accounts. There’s a myth that old, unused credit accounts drag down a credit score. On the contrary, those old accounts provide extra available credit, improving utilization numbers. Let’s say a person has $1,000 in credit card debt, with a credit limit of $20,000 on all accounts. Only 5% of available credit is being used. Then, let’s say this person closed a card with a $10,000 limit, bringing the available credit down to $10,000. Now 10% of credit is being used. It looks worse. Plus, closing the old account hurts one’s ability to demonstrate “length of credit history,” another important factor behind a credit score.
- No fast moves. Quickly opening and closing cards in order to gain sign-up rewards could also hurt one’s credit score. This goes along with the 10% of the FICO score calculated based on “new credit.” The idea is that people who are financially strained will start applying for a string of accounts, hoping to score on extra credit. So try not to be too active opening and closing accounts.
- Know your information. Thanks to federal regulations, a person can go to AnnualCreditReport.com once a year and get a free copy of Experian, Equifax and TransUnion reports. The reports do not include a credit score, but they show the information that will be used to calculate the score. Make sure there is not any erroneous information or identity theft going that is dragging down credit scores. A person has a legal right to dispute false information in a credit report, and all three reporting companies have procedures for challenging credit report information. A person also has a right to insert a short statement into a credit report explaining an item such as a late payment. While the statement may not affect one’s score, it could better explain one’s situation to a lender digging deeper into the facts.
Kelly Spors writes for the leading Roth IRA and online retirement planning resource, RothIRA.com. She is a former Wall Street Journal reporter who has also written for The New York Times, Entrepreneur magazine, SmallBizTrends.com and Yahoo!. Kelly specializes in personal finance and small business issues.