Wednesday, January 26, 2011

Credit Card Series: Your Credit Score

If you envision yourself ever purchasing a house, a car, renting a new apartment or getting your kid braces you should be aware that these are all instances in which your credit score may be checked. There are many other as well. Therefore it is really important to understand how your credit score is affected by the decisions you make and how you can improve it.

Never had a credit card/loan/any other form of borrowing in your life? Well, that doesn't mean you have a pristine credit score. It means you have nothing in your credit score and you will have a tough time getting a mortgage or a loan on a car.

What is your credit score? Your credit score is a number generated by an algorithm that takes into account your payment history, amounts owed, length of credit history, new credit and types of credit used. This number is supposed to reflect your likelihood of paying your bills on time.

Why do you care? Your score is used by potential landlords to see if you can afford your rent and potential lenders to determine if you can afford your mortgage and car payment. If you have a lousy credit score you are likely to not get a loan or to get one with a very high interest rate. Having a score, using the FICO system, of above 720 is likely to get you the best rates on your loans.

How do they calculate the score? Nobody really knowns. The exact algorithm is not released to the general public and each of the three major credit scoring agencies (Equifax, Experian and Transuion) have tweaked the algorithm in their own way so your credit score will likely not be identical from each agency. However there are some basic thing that are known about credit scores, and these determine actions you can take to improve your score.

The fastest way to build up a good credit score is to have a reputable credit card that you pay regularly and on time. This should not cost you any money: you can get a card with no annual fee and charge items you were going to buy anyway. If you pay the full balance on time you will not have to pay interest.

Paying bills late or having bills sent to collection is very bad for your credit score.

The second most important area is your outstanding debt -- how much money you owe on credit cards, car loans, mortgages, home equity lines, etc. Also considered is the total amount of credit you have available. If you have 10 credit cards that each have $10,000 credit limits, that's $100,000 of available credit. Statistically, people who have a lot of credit available tend to use it, which makes them a less attractive credit risk. However, if you only use a small fraction of your available credit this is viewed as responsible behavior. If you constantly max out your credit then you look risky. If you don't have any credit available then you have no track record and look risky. If you have credit available and use it sparingly and keep your balance low by paying on time every time you look good.

The longer your history the better, especially if it is with the same issuer. The longer you have a particular card the better it looks. Even if you don't use it. So if you have a card that has no annual fee that you have had for a while, it may pay to keep it even if you currently use a different card.

When you close a card it also causes a small ding on your score - no one knows how the big this ding is or how long it lasts. Closing a card also lowers your total credit available thus possibly improving your score in the long term.

When someone (landlord, potential mortgage lender etc.) checks your credit score it causes a small ding on your account. Not much you can do to avoid that.

Each credit scoring company is required to provide you with a free look at your credit report once every twelve months. To get your free report (s) visit the government website. Do not fall for scams like This website claims to be free but in fact signs you up for a credit reporting service and will charge you. It is a perversion of the consumer protection law that allows you to get your free report and you should avoid it like the plague. Stick to the official government site for instructions!

There are some thing that lenders take into account that have nothing to do with your credit score: age, income, gender, employment status, education, marital status, length at current address, whether you own a home etc. All these factors do not go into your credit score but are often looked at by lenders.

So when applying for a new card, shutting down a card or refusing to ever use a card think about the repercussion this will have for your credit score and your future ability to borrow for things like a mortgage or car.


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