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Your Credit Score-
More Important than You Think

Financial Planning

May 2007

Your Credit Score-
More Important than You Think

How often during the day to you hear about credit scores? It seems you just can’t get away from the advertisements. Whether in the car, watching television or on the computer, you see and hear about offers to help monitor or increase your credit score. To help you determine if you want to take any of these offers seriously, we are going to discuss this month just what the credit score is and how it affects your life.

The credit score, which ranges from 300 to 850, is computed from information included in your credit report and based on a model created by Fair Isaac Corporation. For this reason, you may hear the credit score referred to as the FICO® score. The median score is 723. Since the score is computed separately by each of the three main credit reporting agencies, you will find that you have three separate scores as follows:
  • Experian – Experian/Fair Isaac Risk Model

  • Equifax – BEACON®

  • TransUnion – FICO® Risk Score, Classic
The scoring model used by each agency was developed specifically for that agency. Additionally, it’s not unusual for each of them to have slightly different credit information on file for a given individual, so there will be differences in your score among the agencies.

Whenever you apply for credit at a bank, mortgage company, credit card company, or retail outlet, the lender will probably pull your credit score as one indicator of its risk in extending credit to you. Though the credit score generally is not the only factor in making a final lending decision, it will be a factor in determining the amount of credit, interest rate and other terms the lender will offer you. For this reason, Fair Isaac Corporation suggests you monitor your score and take action to improve it six months to a year before a major purchase involving credit.

The FICO® credit scoring model is based on five factors detailed in your credit report:
  • Amounts currently owed to creditors;

  • Payment history;

  • Length of credit history;

  • Types of credit currently in use; and

  • Whether you are looking for new credit.
The total amount you currently owe to creditors makes up about 30% of your credit score. It’s important to note that even if you pay off all your credit card bills each month, your credit report may still show a balance based on your last statement. In addition to the amount owed, an important indicator of your ability to repay debt is how much of your available credit is used, the number of accounts that have outstanding balances, and the mix between long-term installment contracts and short-term revolving credit card balances.

The single most important factor in the credit model is your payment history, accounting for approximately 35%. The lender’s main concern in any credit decision is the borrower’s ability to repay the loan. For this reason, your track record in paying past loans is a key factor in calculating your credit score. Within this category, more weight is given to your current payment history than to your older payment patterns. Accordingly, credit problems that are far in your past will not be as significant as you may fear.

The length of your credit history accounts for about 15% of your credit score. Obviously, the longer your track record, the more likely the model will be able to accurately calculate your score.

If you are looking for new credit, lenders want to know this. Taking on more debt is not necessarily a bad thing, but if you continually get deeper into debt, it could indicate future credit problems. The number of accounts you presently have, the last time you opened a new account, the number of current credit inquiries and other items on your credit report are evaluated to determine if it appears you are in the market to increase your debt. This category accounts for about 10% of your score.

The type of debt you owe or are seeking to issue accounts for about 10% of your score. Have you effectively managed both long-term installment debt and revolving credit card debt in the past? Do you currently have a healthy mix of both so that the repayment of each will not put a strain on your cash flow? Remember, the lender wants to know how well you will adhere to your repayment terms.

The credit score does not take into account your race, gender, nationality, marital states or even your income. In fact, with the exception of income, the Equal Credit Opportunity Act prohibits consideration of these factors in making a credit decision.

According to myFICO.com, on a $300,000 30-year mortgage, the difference between an excellent credit score and a bad score can cost as much as $778 per month based on rates as of April 29, 2007. This underscores the importance of doing all you can to enhance your FICO® score before seeking new credit. For some tips on enhancing your score, go to www.myFICO.com.

The stated goal of this article was to help you determine if any of the monitoring solutions you hear advertised are worth considering. Truthfully, it would be difficult for us to help you evaluate one solution over another. However, we hope this article illustrates to you the importance of using some method of monitoring your credit score. Let us know if we can be of assistance to you in helping secure your financial future.

Happy May!

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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