Thursday, January 6, 2011

Credit Score Calculation

These past few years, due to the financial crisis caused by subprime loans, mortgage lenders have tightened  their standards. Now it is hard to find someone who will loan you money for a house if your FICO credit score is below 620. Even if you do find a lender, your interest rate will be significantly higher than someone with an excellent score of 760. For a 30 year mortgage you may be paying tens or hundreds of thousands more in interest.

This means it's time to pay attention to your credit score!

I remember going to the bank with my mother right before I headed off to college to apply for a credit card. She told me it was time for me to build a credit history. I happily obliged. When I received my card in the mail, she reminded me time and time again that I must use it responsibly. Building a credit history is important, but you don't want to build a bad history. Mistakes can stay with you for 7 years!

FICO Score
The FICO score was developed by the Fair Isaac Corporation in the 1980s. Not only is it the original credit score, most companies still base their evaluation of creditworthiness on it.
This score can be as low as 300 and as high as 850. Generally, a score above 760 is considered excellent, and a score below 620 is seen as bad. Starting at around the mid-600 range, it becomes hard for a borrower to get credit. According to Fair Isaac, the median score is 723. There are 5 scoring categories: credit history, credit utilization, length of credit, types of credit, recent searches.

  • Credit History (35%): The largest piece of your score. It looks at whether your payments are on time or not, and how consistent you are with it.
  • Credit Utilization (30%): I explained this in a previous post. It shows how much of your given credit is being used and how much is available to you.
  • Length of Credit (15%): It shows how long your credit history has been building. Most likely it'll start counting when you received your first credit card. Since this makes up 15% of your score, try not to close your first credit card even if you have a new one. That'll make sure your history traces back to this card.
  • Types of Credit (10%): Lenders like to see a variety of credit types. Revolving (credit cards), installment loan (car loan), mortgage, and flex spending (something between a revolving and installment loan, like no pre-set limit credit card). This means, sometimes, when interest rates are low enough, it might make sense to get a loan to boost even when you don't necessarily need it to boost your score. However, be careful if you do this. Calculate to make sure it won't cost you too much more, and only do it if you're certain you'll be able to pay it off.
  • Recent Searches (10%): The number of voluntary inquiries, "hard pulls," made on your account.  

VantageScore was created in 2006 by the collaborative effort of 3 major national credit bureaus: Equifax, TransUnion, and Experian. The 3 companies claim this to be a more consistent scoring system compared to FICO. Due to a dispute with FICO, Experian no longer provides FICO scores, and uses Vantagescore instead. The other companies will provide both.

Scores can range from 501 to 990, divided into "grades." Those who score 901 and above get an "A," meaning excellent credit. The rest of the grades are presented as follows:

B= 801-900
C= 701-800
D= 601-700
F= 501-600

Unlike FICO, there are 6 categories used to calculate VantageScore. Four of them of are the same as FICO: payment history (32%), credit utilization (23%), length (depths) of credit (13%), recent credit (10%). It does not count the types of credit a person has. Two additional areas being counted are:

  • Available Credit (7%): How much credit you can access if you need the money immediately.
  • Credit Balances (15%): Total amount of debt.

Here's a FICO vs. VantageScore comparison chart:

Payment History
Credit Utilization
Length (Depth) of Credit
Types of Credit
Recent Search for Credit
Available Credit
Credit Balances

Remember, getting a card early can build credit history, but avoid reckless spending. It'll cost you much more in interest, credit utilization, and perhaps payment history. Best of luck keeping your scores up so you can be a low risk borrower!


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