Credit Scores: What Is It Good For?

A credit score is an extremely important financial tool. It provides access to the financing you need in order to buy a car, a home, or pay for college tuition, among other things. Since higher scores equate to lower financing costs and vice versa, it’s vital to understand the factors involved in calculating your score.

A credit score is a numerical expression based on a statistical analysis of a person’s credit files, to represent the creditworthiness of that person. A credit score is primarily based on credit report information typically sourced from credit bureaus.

Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers and to mitigate losses due to bad debt. Lenders use credit scores to determine who qualifies for a loan, at what interest rate, and what credit limits. Lenders also use credit scores to determine which customers are likely to bring in the most revenue. The use of credit or identity scoring prior to authorizing access or granting credit is an implementation of a trusted system.

Credit scoring is not limited to banks. Other organizations, such as mobile phone companies, insurance companies, landlords, and government departments employ the same techniques. FICO is a publicly traded corporation (under the ticker symbol FICO) that created the best-known and most widely used credit score model in the United States.

Here are the five elements that make up a credit score, in order of importance:

Payment History

35% impact. Paying debt on time has a positive impact. Late payments, judgments, and charge-offs have a negative impact. Delinquencies that have occurred in the last two years carry more weight than older items. When applying for a mortgage, every point in your credit score can make a big difference. So don’t make any major financial or credit decisions – even paying off an old debt or delinquency – without first discussing it with your mortgage professional.

Outstanding Credit Balances

30% impact. This factor marks the ratio between the outstanding balance and available credit. Ideally, consumers should make an effort to keep balances as close to zero as possible, and definitely below 30% of the available credit limit when planning to enter into a loan transaction within 3-6 months.

Credit History

15% impact. This marks the length of time since a particular credit line was established. A seasoned borrower is stronger in this area.

Type of Credit

10% impact. A mix of auto loans, credit cards, and mortgages is more positive than a concentration of debt from credit cards alone.

Inquiries

10% impact. This quantifies the number of inquiries (or requests for credit) that have been made on a consumer’s credit history within a 6-12 month period. Each individual inquiry – up to 10 – can hurt your credit score by as much as 5 to 30 points. Any additional inquiries thereafter will not affect your credit score.

In other words, don’t start the loan process until you’re ready to act. Otherwise each individual credit inquiry could cost you. However, scoring models have now been adjusted to count multiple “hard” inquiries within a 45-day period as a single request. So, when you’re ready, your credit will be too.

If you or anyone you know has any questions about credit scores or what can be done to repair them, please don’t hesitate to contact me. I work with several mortgage brokers and lenders that can assist you in your financing needs.

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