Make sure that when you need a loan, you'll get one—and cheap.
In our financial advice column for the centsless, Michael Fleck fields questions on how to get your money right. Send your queries to email@example.com.
I read your interview with Suze Orman last week, and thought it was very informative, but I still don’t really have a good understanding of how the credit score is calculated, and how they even get my information! I want to look into my own personal credit score, but it seems like every site out there is a scam. Are there any reliable places to pull this information?
No need to fret. Once Suze and I finished our interview, I realized we would need a crash course. Your credit score is a measure of your credit worthiness, one of many factors used by creditors—whoever you want to lend you money for a car, house or student loan—to assess how risky you are: Can you pay back a loan in the future? The score will not only affect whether or not you qualify for credit, but also the how high a price you’ll pay for it.
Calculating your credit score starts with all the accounts in your name: student loans, credit cards, home mortgages and other consumer loans. Each of your creditors shares your payment information with the three major credit bureaus—Equifax, Experian, and TransUnion. These bureaus create your credit report, a document showing each of these accounts, payment history, and various other tidbits of information. The information in your credit report is used by each to assign your credit score, a three digit number ranging from 300 to 850.
Obtaining your credit report from each of the three bureaus once a year is a smart idea for three reasons. First, it’s a great way to get a comprehensive list of all your debts. Hope you haven’t forgotten about any! Second, it can reinforce good behavior. It’s not always easy to recognize that paying on time can have positive tangible effects, but it does. Lastly, you can see if there were any creditors who’ve reported you late. This may provide the ass-kicking you need to start getting your debt, and your credit score, under control.
So how do you get your credit report? It’s remarkably simple. WEALTH CLUB RULE: If you want to see your credit report, the only place to go is annualcreditreport.com, a website jointly operated by the three main credit bureaus. It originated from the same law that requires Americans to have annual access to their credit reports. There other websites with similar names, but this one is the real deal. You’ll have to enter a few key pieces of information, including your Social Security number, and you’ll get your credit report within five minutes.
It can seem scary to request your credit report, but there’s nothing to be afraid of. I pulled my TransUnion credit report a couple weeks ago. As you can see in the snapshot below, American Express has not reported me 30 Days Late at any point in the last 32 months. If it had, instead of having ‘OK’ for a certain month, it would read “30” (Please ignore my terribly irresponsible ‘High Balance’ of $3,177. It was the early 2000s. Crazy stuff went down. It’s much lower now, I promise).
The most frustrating thing about obtaining your credit reports is that it won’t tell you your actual credit score. For that, you’ll have to pay. If not knowing your actual credit score is going to keep you up at night, go ahead, but honestly, it’s going to be anticlimactic. What’s important is the information on the credit report. From that, you can get a pretty good sense of how you look to potential creditors.
Here’s a rough outline of the metrics used to convert your credit report into your credit score:
Payment history (35 percent)—Not surprisingly, what matters most in calculating this score is whether or not you’ve been paying back your debts in a timely and complete manner. Complete, by the way, could mean that you’re simply paying the monthly minimum, which debtors love, but is terrible money management.
Outstanding debt & your utilization ratio (30 percent)—The actual dollar amount of debt you owe is not as important as the ratio of debt to your total limit, known as your "utilization ratio." Look in your fake wallet: Card A has a $1,000 limit with a $200 balance (20 percent ratio), and Card B has a $2,000 limit with an $800 balance (40 percent ratio), the overall utilization ratio would be $1000 (your total debt) divided into $3000 (your total credit), or 33.3 percent. Wealth Club thinks you should try to keep this ratio no higher than 20 percent.
Length of credit history (15 percent)—Simple. The longer you’ve maintained positive credit history, the better your score will be. This is why you’ll hear people say not to close your oldest credit card.
Credit inquiries (10 percent)—Checking your own credit score—known as a “soft” inquiry—has no bearing on your score. But when other people check it—“hard” inquiries from prospective lenders, insurance companies and future landlords, it can negatively affect your credit score. How come? It might be a signal that the first lender you asked for a car loan said no, and maybe the second one did too. That could very well be reflected in your score when the third lender inquires about you. To me, this is the most frustrating part of the whole credit score system, but sometimes we have to work within in the existing framework.
Type of credit (10 percent)—Not all debt is bad. Certainly student-loan debt can be a good thing, as can business loans. The key here is that creditors like to see different types of accounts, and having too many of the wrong type (i.e., credit cards) can hurt your score.
The three bureaus use this information to calculate your FICO score. The term FICO is derived from Fair Isaac Corporation, the company responsible for creating this scoring system. Experian, Equifax and TransUnion all have slightly different methods of calculating your FICO score, which is why you see those commercials with those three hunky men in the navy Spandex onesies, each with a slightly different number sprawled across their muscular chests. The three scores shouldn’t vary too much, though, since the five categories listed above are the only inputs.
The credit score was originally intended to be a ‘fairer’ way to judge someone’s creditworthiness; before its use became widespread in the 1980s, human judgment—and prejudice—was the primary way of discerning whether you were an acceptable debtor. Whether or not this goal has actually been achieved is certainly up for debate, but despite the shortcomings of the new calculation, it’s probably done more good than harm.
If you’re not happy with what you see in your credit report, it’s up to you to change your habits to make it right. In the event there’s a mistake on your credit report, it’s your legal right to dispute it with the credit bureau free of charge and free of negative impact on your score. If the blemishes are actually your doing, shake it off. Time heals all wounds, so just be sure do what you can to lower your balances, pay each month (please, please, please, pay more than just the monthly minimum!) and limit the number of new credit applications.
There are creative ways to help raise your credit score. A friend of mine is in the market for a new car, which her parents are subsidizing to the tune of $20,000. In the interest of creating a most robust credit report, my friend suggested that her parents put the $20,000 into a separate amount, get a car loan in her name, and automatically pay off the loan from the $20,000. Despite the fact that this would result in interest owed on the car loan, it’s an excellent idea in terms of strengthening her credit report. It will vary the types of accounts she owns, and there’s virtually no risk of nonpayment.
This is what everyone needs to start thinking about in order to achieve and maintain a good credit score. But don’t worry. You’ll always be an 850 in my eyes ;)