In today’s world, everybody is always talking about how good or bad their credit score is. As society is rapidly moving away from cash transactions and credit cards are becoming the norm for everyday purchases, people’s desire to maintain a good credit score is a daily concern. Speaking with Suncrest Bank’s Yuba-Sutter Market President Aman Bains, he stated how maintaining a good credit history is important to everyone. “Using a credit card over cash has many advantages such as reward points/miles, cash management tools, and general safety. The internet has also played a large role in the shift from cash to credit cards. Without maintaining a good credit history, your options in life will be limited” Bains stated.
In addition to the day-to-day necessity of having and using credit cards, all people will at some point in their lives need to apply for a loan to finance a significant purchase. “You don’t realize how important credit is until you need it for a large expense. “Everyone will need credit several times in his/her life, whether it’s financing a car, home, education, furniture, or even electronics. Landlords generally pull your credit and can deny you based on the results” said Bains. Being it that credit scores are so vastly important in our daily lives, understanding what surrounds the credit score is crucial.
I regularly hear comments such as “My FICO score is only 550”, “I tried to buy a new car but the dealer denied me because my credit score was too low”, and “I only have a $500 limit on my credit card so I can’t improve my score”. Hearing statements like this I immediately start to wonder if people actually understand what a credit score is, how it’s determined, and why it’s so important in today’s day-and-age.
What is a FICO credit score?
FICO is a term that is thrown around daily but the acronym might actually surprise people. FICO stands for Fair Isaac & Company, the analytics software company that helps approximately 90% of U.S. lenders make accurate, dependable, and quick credit risk decisions based on the particular consumer. FICO has developed a complex algorithm that uses several types of information from your credit report, compares it with patterns in a considerable number of past credit reports, and develops a FICO credit score that estimates your level of future risk. The higher your credit score, the lower your future risk. There are other models to determine one’s credit score but FICO is the most widely used.
Generally speaking, FICO credit scores range from 300-850. However, some lenders use industry specific FICO scores when evaluating a consumer’s credit. For example, an auto lender could use a FICO Auto Score when determining whether you qualify to buy that brand new $50,000.00 car. Even though the different FICO score models won’t provide the exact same scores, they generally use similar criteria and thus the scores will be relatively similar regardless of which model is used.
How is a FICO credit score determined?
The best way to understand how the FICO score is established? Become a highly educated mathematician who specializes in the study of algorithms, take that knowledge and breakdown all FICO scores that have been created, and then run an analysis of those scores to determine how they were established. If that doesn’t work out, continue reading below!
FICO scores use several pieces of information when calculating your score. However, there are 5 main categories of information that are used. Each category is given a certain amount of weight in the calculation. Together, the 5 categories are combined to give you your overall FICO score. Below you will find a breakdown of each of the 5 main categories that are used to calculate your score.
- Payment History – 35%
A consumer’s payment history is typically the most important aspect of their FICO credit score. This takes into consideration questions such as whether you paid your bills (i.e. credit cards, store cards, car loans, mortgages, etc.) on time, whether you’ve missed payments in the past or regularly miss payments, how late your payments were (i.e. were they only 30 days late or were they 90 days late?), and how many different accounts you missed payments on. According to myfico.com, of the people in the highest bracket of FICO credit scores (800 and above), 96% have missed no payments at all and only approximately 1% have a collection account on their credit report.
- Amount of Debt – 30%
The second most important factor in determining your FICO credit score is the amount of debt you currently have. A lender will want to know how much debt you are currently liable for when determining whether they want to give you additional credit. Credit utilization plays a big role as well, which is how much of the available credit you are currently using. According to myfico.com, consumers with FICO scores of 800 and above share some common characteristics: their average revolving credit utilization ratio is less than 6% and they have an average of 3 accounts with a balance
- Length of Credit History – 15%
The third most important category in the FICO credit score determination is the length of your credit history. FICO scores take into consideration the average age of each open account and the age of your oldest open account.
- New Credit – 10%
Factoring in with only 10% weight given, the amount of new credit still is an important part of your FICO credit score. The algorithm uses new credit to determine how many new accounts you’ve recently opened and whether you are rate shopping for a single loan (i.e. mortgage). According to myfico.com, less than 35% of exceptional FICO score earners applied for new credit in the past year.
- Credit Mix – 10%
The final factor in your FICO credit score is the mix of credit that you currently have (i.e. credit cards, store accounts, car loans, etc). This will generally be more important if your credit report lacks sufficient information to calculate a score.
Why is your credit score important?
Credit scores allow lenders to make educated decisions on not only whether they will approve your credit application but also at what interest rate they will approve you. Being approved at 5% rather than 3.5% might not seem like much of a difference to the naked eye, but when considered over the life of the loan, that small difference of 1.5% will save you an incredible amount of money.
Consider the following example: Person A and B are both looking to purchase a home. Both Person A and B have found their dream homes and both homes happen to be $350,000.00. Again, both Person A and Person B have down payments of $35,000.00 but will need to finance the remaining $315,000.00 through a traditional lender.
Person A has a FICO credit score of 650 and has been approved for financing of $315,000.00 on a 30-year fixed-rate mortgage at 5.00% APR. Person A accepts the loan and purchases the home. Person A is to pay $1,690.99 per month for 30 years. In total, Person A will pay $608,756.40 back to the lender.
On the other hand, Person B has a FICO credit score of 750. He too has been approved for financing of $315,000.00 on a 30-year fixed-rate mortgage. His rate, however, is 3.50% APR. Person B also accepts the loan and purchases the home. Person B will be paying $1,414.49 per month for 30 years. In total, Person B will pay $509,216.40.
As you can see from the above example, even though the difference in interest rate is only 1.5%, the savings is huge! Person B saved $276.50 per month and $99,540.00 over the life of the loan.
How do you improve your credit score?
Now that we have discussed what a FICO credit score is, what factors are used in determining the score, and why it’s so important in our society today, we must next analyze how one can improve their score. Unfortunately, there isn’t an overnight miracle way to improve your credit score and that is why making sure it remains in good standing is so vitally important. However, that doesn’t mean that if your credit score takes a hit, you are doomed for life. There are several things a consumer with a low credit score can do and if consistently done, will improve their score.
- Avoid overextending yourself
- Don’t apply for several credit accounts at once
- Don’t open new credit cards just for the sole reason of increasing your available credit
- Eliminate small credit balances for cards that are rarely or never used
- Get a secured credit card from a bank that will report those payments to the three traditional credit bureaus
- If you miss a payment, get current on the payment and remain current
- Keep balances low on your active credit cards and if possible, pay the debt off
- Monitor your credit utilization rate. The lower that number is, the better your score will be
- Negotiate with creditors. If you have a negative inquiry from a specific account, write them and request that they remove that negative inquiry if you pay the account in full.
- Pay bills on time
- Regularly check your credit report and dispute any inaccuracies you see, no matter how small the inaccuracy is
- Request to increase your credit limits on your credit cards.
- Settle any collection accounts, old or new
Maintaining a good FICO score is paramount in today’s society. Even if you aren’t purchasing a car or home anytime soon, the day will come when you will and on that day, a small difference in interest rates can save you tens of thousands of dollars. Moreover, as technology progresses and we are using less and less cash for standard transactions, we are steadily becoming more reliant on credit cards. Some purchases actually require that the transaction has a credit card on file in order to complete it (i.e. car rental, hotel check-in, etc).
However, keep in mind that just because your credit score is lower than the next person doesn’t necessarily mean a lender will deny you for credit. “As important as credit scores are, a lot of our decisions are also based on relationships. If a customer has a good standing relationship with Suncrest Bank and has paid back prior loans to us without any issues, we will take that into consideration. Community banks put a lot of significance in relationships” stated Aman Bains, Yuba-Sutter Market President of Suncrest Bank. Therefore, as much as we strive to maintain a good FICO score, always remember that this will not be the only factor that lenders use in reviewing your application.
If you are currently overburdened with debt and are worried that your FICO score will never increase, please contact Sacramento Bankruptcy Lawyer, and allow attorney Pauldeep Bains to review your case.