Here we are getting ready to start with the first part of our 8 part series on MONEY & CREDIT with Darrell Hornbacher of Midas Financial. Darrell and I have spent a lot of time discussing what would be in the best interests of everyone as we begin this series. Together we came to the conclusion that the best way to start is to make sure everyone understands how personal credit works.
According to Darrell, there is more misinformation out there about the workings of personal credit than anything else. Most of us shoot from the hip on this, even though it is arguably the most important number in our adult life. Below Darrell explains the absolute facts about your personal credit. Please be advised that this is a LONG article. It will probably take you 10 minutes to read over, but a few minutes of your time is a small price to pay for the knowledge you'll gain.
In our next chapter, we're going to discuss fixing any challenges you might have with your personal credit. Stay tuned! And watch your inbox.
Enjoy........
Understanding Your Credit
There are many myths out there about personal and business credit. What you read here are purely the facts that come directly from the Fair Isaac rules. Do not be misled by any other information.
Before we get stared, I want you to go get your bureau reports and scores right now to see where you stand. I require all of my clients (and so will most lenders) to get all three scores. This is going to be especially important if you ask me or someone like me to analyze your personal credit history. I have found the most reliable and accurate to be from
TrueCredit by Transunion. You can pull your free credit report by
clicking here.
Your credit is made up of five different categories listed in the chart below. Each credit bureau has a specific individual scoring model not known to the general public, however they all follow the standards set in this chart provided by Fair Isaac.
Type of Credit Used
The mix of credit you utilize is responsible for 10% of your score. The two types of credit reflected in your credit mix are "secured" and "unsecured". Secured credit includes homes, cars and like items that "secure" your loan. Unsecured credit is made up of credit cards, department store cards, and personal loans. If you have not pledged some sort of collateral, it is considered to be unsecured. Lenders have become wary of too much unsecured credit as default rates tend to be higher. A perfect credit mix is a mortgage, a vehicle payment and one each of Visa, MasterCard and Discover.
New Credit
New credit makes up 10% of your score. New credit is directly related to the amount of inquiries you've incurred over the last several years. Each time you apply for a loan of any sort, the lender will "inquire" as to your credit worthiness. Each of these inquiries can result in up to five points being deducted from your credit score.
There are two things to know here. First, pulling your own credit score DOES NOT count as a hard inquiry. It WILL NOT damage your score. Second, built in to the scoring system is a mechanism which allows a lender to pull your reports multiple times without devastating effects. For example, if you are shopping for a mortgage chances are you will want to check pricing from several mortgage vendors. Each vendor will need to pull your credit, but generally speaking if this is within a two week period your score will only suffer from the first inquiry. Each inquiry will show and will remain on your report for two years, however your score will not go down as a result of each individual pull. The same principle applies for a vehicle or other secured loan. I always counsel my clients to obtain all needed credit within this two week time frame.
Length of Credit History
The length of your credit history and the amounts of credit granted account for 15% of your score. DO NOT close old accounts. Closing old unused accounts can have a negative effect on your score. Old accounts are very valuable. As a matter of fact, if you have a credit card from years ago that is still open, keep it open. Charge small items regularly and pay the statement in full each month. The longer you maintain an account the better for your score. Lenders like history, and this demonstrates to future lenders your ability to maintain credit on a long term basis. You should also know how credit limits can help your score. Higher limits put a greater value on your credibility. Open accounts with high available credit show someone else has already put their trust in you. If high limits have already been granted, a lender will feel more at ease when contemplate extending large amounts of new credit.
Payment History
Your payment history accounts for 35% of your credit score. It is the biggest factor in the Fair Isaac scoring system. It's really quite simple. PAY YOUR BILLS ON TIME! That doesn't mean putting your payment "in the mail" on the due date. It is imperative your payment be in their hands on or before the due date. Even a day late can cause adverse issues. Yes, all credit purveyors are required to offer a grace period which is typically ten days but can be as much as 30. The exact date you make your payment is recorded in the lenders database. If you need to get funding from that specific lender they will take into account when and how you have paid them in the past. I counsel my clients to take advantage of the electronic payment systems most creditors have in place. They are safe and secure, and if you need to wait until the due date to make a payment, you can do it online and be guaranteed it will be where it should be at the exact time. Some creditors even give you a discount to pay online and eliminate paper billing.
Credit Utilization Ratio (CUR)
Finally, and the most misunderstood part of your credit score, are the amounts you owe. They account for 30% of your score. Constantly, my clients come to me and ask "how can my scores be so low, I've paid all my bills on time?" The answer lies in what I call the Credit Utilization Ratio.
A lender has granted you a credit line of $10,000. If you have charged $2000 against the line, your credit utilization ratio is 20%. If your CUR exceeds 30%, lenders start to get nervous. Your credit score will suffer a few points. If your ratio exceeds 50%, a red flag goes up and your scores will go down drastically. Anything above 70% will cause your scores to plummet, especially if you have multiple revolving lines with high balances on each.
The average American has 4.3 credit cards. Let's say with each card there is a 55% CUR. Further, let's say that each card in that position causes your score to go down 10 points. NOW MULTIPLY BY 4.3! A nice score of 730 will go into the 680's and your good credit is now average. On a daily basis I encounter clients who have an unblemished credit history yet have scores in the high 500's or low 600's. The culprit is their CUR. In today's world it can also prevent you from getting any new unsecured credit. When you pay these balances back below the thresh holds, your scores will immediately go back up. However, the previous high balances are noted on your credit bureau report for future lenders to see. Strive to keep your balances below 30%. Don't fall into the trap of moving all your balances to one card due to a low interest rate. Spread balances out to keep below the first break point.
How HELOC'S Can Affect Your Credit
Many of my clients have a Home Equity Line of Credit or HELOC. Be warned that many banks report your HELOC as revolving debt. The same rule applies. Use over 30% of your HELOC and you've got a potential problem. The high limits of most HELOCS make it easy to get in over your head. This can have devastating effects on your credit score. Extremely high balances normally associated with HELOCS will put your CUR way out of the norm, so make sure you check with the lender (prior to applying) as to how they will report HELOCS to the credit bureaus. Make sure they are going to report as "real estate secured." Better yet, you may want to get a second mortgage instead. Second mortgages are always reported as real estate related.
There is little more to understand about your personal credit. Although many myths exist, what you've just read is the exact information you need to know. If you strive to meet these guidelines you will have excellent credit.
Darrell Hornbacher
