What's on your scorecard?

Imagine you are going to purchase a new car. You walk into the dealership, spot your great new ride, spend five hours negotiating an amazing price, and then head over to finance.  You sit down with pen in hand only to find out that the monthly payment you were expecting has skyrocketed. You break out in a cold sweat. What is happening and how do I immediately fix it, screams the voice in your head. 

If you've been in this situation you already know, there's not much you can immediately do about the great decider of interest rates when you have a low credit score. This number assigned to you, that follows you around everywhere you go, is an important topic, but one many people do not consider until it is too late.

What is a credit score?

A credit score is a three-digit number that rates a persons' creditworthiness. It allows lenders to assess how responsible you are with credit and debt and plays a key role in a lender's terms if they decide to offer you credit. A higher credit score generally suggests that you borrow and pay back what you owe on time and makes it more likely a lender will approve your loans and give you the best interest rates. A lower credit score may suggest that you struggle with managing your debt obligations, which lenders consider risky, and makes it more likely your loan requests will be denied and the interest rates you are offered are high.

Your credit score is calculated using the information in your credit reports, which includes information about your financial life obtained from creditors and publicly available information. Credit bureaus, such as Equifax, Experian, and TransUnion maintain credit reports.

Specifically, a credit report will contain:

• personal identifying information, including related addresses, birth date, social security number, and phone numbers
• your credit accounts, including the creditor, type of account, balance, credit limit, payment history, and how long you have had the account
• collection items, including missed payments, collections, and overdue child support
• public records such as liens, foreclosures, bankruptcies, and judgments
• inquiries on your credit report 

Whom can you blame for this number? The credit score model was created by the Fair Isaac Corp, now known as FICO, in the late 1980s in response to a need for an industry-wide standard credit score for evaluating risk.  Other credit scoring systems exist, but the FICO Score is the most commonly used.

A FICO score ranges from 300 to 850, with the categories as follows:

Your credit score may vary depending upon the data used to calculate it. Different types of loan products use different scoring models. The scoring model, in conjunction with the source of the data used and the day the score was calculated, can create a variance.

Why is your credit score important?

Credit scores are important because they dictate whether you will be offered credit and the terms of your loans. This includes car loans, home loans, and student loans.  Your credit score also impacts your ability to get insurance and the rates you will be offered, the size of deposit required to rent an apartment, and your ability to get a phone, cable, and utilities, among other things.

Individuals with higher credit scores will receive more favorable terms that can result in lower interest rates, meaning lower monthly payments and less interest paid over the life of the loan. When you consider how many loans you may receive over your lifetime that can add up to a lot of money saved. 

How is my credit score calculated?

Various factors impact your credit score. FICO developed a five point scoring system with a set weighted allocations assigned to each point.

Payment history (weighted 35%): This factor considers whether you pay your debts on time. This component examines your payments on credit cards, installment loans (i.e., auto, student loans), and mortgages. Public records and reports identifying bankruptcies, foreclosures, suits, liens, judgments, and wage attachments are also considered. Prompt payments help your score; late or missed payments harm your score.

Unpaid debt (weighted 30%): This factor indicates how much debt you have and helps determine if you can handle paying what you owe and whether you can take on more debt. Your credit score will be negatively affected if your outstanding balances are high. According to FINRA, "[a] good rule of thumb is not to exceed 30% of the credit limit on a credit card." With regard to installment loans, you should pay those back timely and consistently. Payment patterns demonstrate responsible debt management, which will positively affect your credit score.

Length of credit history (weighted 15%): This factor considers how long you have had your credit. Borrowers with longer credit histories that show responsible credit management will have a better score because they are able to establish a consistent and lengthy repayment pattern.

Type of credit (weighted 10%): You can hold credit in the form of credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans. While you do not have to have each type of credit, this factor considers the type of credit you have and whether you use it appropriately.

Credit Inquiries (weighted 10%): Inquiries about your credit suggest you intend to take on more debt. A new inquiry is registered on your credit report as a hard credit check. However, checking your own credit report will not trigger a hard credit check or affect your credit score.

How do I improve my credit score? 

If you are suffering from bad credit, there are steps you can take to improve your credit score.

• Review your credit reports and dispute inaccuracies: By law, you are entitled to a free copy of your credit report from Equifax, Experian, and TransUnion at least once a year. Review each one regularly to see if there are any red flags or discrepancies. It's hard enough maintaining a high credit score without misinformation plaguing your report. If you dispute any items, such as indications of late payments or credit you did not personally apply for, resolving these issues should help improve your credit score.

• Pay down balances and continue to pay balances monthly: Paying off balances will lower your existing debt and minimize ongoing debt. Clearing balances keeps your credit utilization low; which is recommended to be 30% or less. If you pay down your balances each statement period, you will also enjoy the added benefit of avoiding interest charges.

• Deal with or dispute debt in collections: If you believe you have been wrongly sent to collections, dispute the charge to prevent it from negatively impacting your credit score. If you have legitimate debt in collections, try to negotiate a lesser payment or pay the balance. Ignoring the debt can destroy credit and might even result in garnished wages or a lien against your property.

• Get a credit-builder loan: A credit-builder loan allows you to build credit and save money at the same time.  A lender puts money into a savings account, you pay towards the account in monthly installments, and then you receive the balance at the end of the loan term. When you pay off the loan, the lender will report your payment history to the credit bureaus, strengthening your credit. The added bonus is that you will have saved money along the way.

• Join an account as an authorized user: Authorized users are allowed to make purchases (if approved by the primary account holder), but are not responsible for making payments. Be sure to pick someone with good credit since the creditor will report authorized user accounts to the credit bureaus and the account's credit limit and payment history will appear on your credit report.

• Keep old accounts open: Old accounts help establish credit longevity and increase your total credit limit. Both of these factors will help improve your credit score.

• Limit requests for new credit: When you apply for a new credit card or loan, a hard credit will be added to your credit report. Only apply for credit cards or loans you truly believe you will qualify for to avoid stacking up the hard credit inquiries. Be cautious of how much credit you apply for as too many inquiries will concern lenders who will question whether you will be able to pay all your debts.

Now that you understand a bit about credit scores, let's go back to our scenario. After evaluating your credit score and taking steps to improve it, you can head back over to the car dealership, let them run your credit, and walk away with an interest rate that you can be proud of. 

Investing involves risks, and no investment strategy can guarantee success. The information provided here is for general purposes and should not be considered as legal, financial, or investment advice.