Understanding Your Credit Score
The credit scoring system used by lenders and other institutions is a mathematical evaluation concerning someone's use of credit. The mathematical formulas may vary slightly among the different rating agencies but the concept is still the same. The scoring model takes into account the different types of credit a consumer uses such as mortgages for real estate, installment loans for automobiles, education loans for college, general unsecured credit for credit cards, utilities etc.
Anytime a consumer buys an item on credit or opens an account such as a cell phone or cable television account there is always the possibility that any late payments will be reported to a credit bureau. The reporting by any source of late payments will have a negative impact on a person's credit score.
The credit score models take into account how much credit is available and how much of the available credit is being used. In addition, these models factor in any negative reports about a person's willingness to pay their accounts on time. The weight that any one item has on the overall score may change with the economic times. Where at one point, the mortgage history was the highest impact factor on the credit score, the use of credit card debt seems to be more important today.
The scoring models then take into account all the financial variables concerning how a person manages their payments and determines a mathematical score. The score ranges in value from a low of 350 to a high of 850 at this point in time. Obviously, the lower the score the less likely someone has managed their financial affairs in a timely and prudent manner.
Why Credit Scores Are So Important
As indicated above, credit scores fall with a certain range of values. These values indicate how effectively a consumer manages their financial obligations based primarily on their willingness to pay. If accounts are continually being paid late or not paid at all then that consumer will have a lower score than someone who continually pays their bills on time.
The scoring system has become extremely important over the past few years as the credit score has been proven to be a successful indicator of who will pay their bills/debts on time. When deciding if someone should be lent money, a lender is going to look more favorably to a higher score consumer as they have a proven track record of being willing to pay their debts on time.
It is the use of this scoring system that has led to risk based pricing. Someone who has a proven track record of repaying their debts on time will usually be given a lower rate of interest compared to someone who has proven that they will pay their payments late if at all. The higher interest rate compensates the lender for the added costs of trying to collect on the debt as the consumer with the lower score has already proven that they are not willing to pay their debts on time.
With the credit score being a mathematical calculation of financial behavior, other industries have performed various mathematical analyses of credit score to see if there is a relationship between a consumer's credit score and other types of behavior. For instance, the insurance industry has determined that drivers with good driving records tend to have better credit scores that drivers with numerous tickets and accidents thus they set insurance rates based on credit score.
Since we live in an age of information being more readily available than in the past, there will continue to be attempts to link behavioral traits among different types of industries. It appears that the common denominator being used in theses analyses is the consumer credit score. That being the case, it is even more important to keep your credit score in what is considered to be an acceptable range. As more data becomes available, what is considered an acceptable score has also changed. It used to be that a score of 620 was considered to be an excellent borrower, now that score has moved to 680 and in some cases 720.
How To Improve Your Credit Score
How to Repair My Credit and Improve My FICO Scores
It's important to note that repairing bad credit is a bit like losing weight: It takes time and there is no quick way to fix a credit score. In fact, out of all of the ways to improve a credit score, quick-fix efforts are the most likely to backfire, so beware of any advice that claims to improve your credit score fast. The best advice for rebuilding credit is to manage it responsibly over time. If you haven't done that, then you need to repair your credit history before you see credit score improvement. The tips below will help you do that. They are divided up into categories based on the data used to calculate your credit score.
3 Important Things You Can Do Right Now
Check Your Credit Report – Credit score repair begins with your credit report. If you haven't already, request a free copy of your credit report and check it for errors. Your credit report contains the data used to calculate your credit score and it may contain errors. In particular, check to make sure that there are no late payments incorrectly listed for any of your accounts and that the amounts owed for each of your open accounts is correct. If you find errors on any of your reports, dispute them with the credit bureau.
Setup Payment Reminders – Making your credit payments on time is one of the biggest contributing factors to your credit scores. Some banks offer payment reminders through their online banking portals that can send you an email or text message reminding you when a payment is due. You could also consider enrolling in automatic payments through your credit card and loan providers to have payments automatically debited from your bank account, but this only makes the minimum payment on your credit cards and does not help instill a sense of money management.
Reduce the Amount of Debt You Owe – This is easier said than done, but reducing the amount that you owe is going to be a far more satisfying achievement than improving your credit score. The first thing you need to do is stop using your credit cards. Use your credit report to make a list of all of your accounts and then go online or check recent statements to determine how much you owe on each account and what interest rate they are charging you. Come up with a payment plan that puts most of your available budget for debt payments towards the highest interest cards first, while maintaining minimum payments on your other accounts.
More Tips on How to Fix a Credit Score & Maintain Good Credit
Payment History Tips
Contributing 35% to a FICO Score calculation, this category has the greatest effect on improving your scores, but past problems like missed or late payments are not easily fixed.
Pay your bills on time.
Delinquent payments, even if only a few days late, and collections can have a major negative impact on your FICO Scores.
If you have missed payments, get current and stay current.
The longer you pay your bills on time after being late, the more your FICO Scores should increase. Older credit problems count for less, so poor credit performance won't haunt you forever. The impact of past credit problems on your FICO Scores fades as time passes and as recent good payment patterns show up on your credit report. And good FICO Scores weigh any credit problems against the positive information that says you're managing your credit well.
Be aware that paying off a collection account will not remove it from your credit report.It will stay on your report for seven years. (Note that judgements, bankruptcy and all public records remain on your credit report for ten years.)
If you are having trouble making ends meet, contact your creditors or see a legitimate credit counselor.
This won't rebuild your credit score immediately, but if you can begin to manage your credit and pay on time, your score should increase over time. And seeking assistance from a credit counseling service will not hurt your FICO Scores.
Amounts Owed Tips
This category contributes 30% to a FICO Score's calculation and can be easier to clean up than payment history, but that requires financial discipline and understanding the tips below.
Keep balances low on credit cards and other "revolving credit".
High outstanding debt can affect a credit score.
Pay off debt rather than moving it around.
The most effective way to improve your credit scores in this area is by paying down your revolving (credit cards) debt. In fact, owing the same amount but having fewer open accounts may lower your scores.
Don't close unused credit cards as a short-term strategy to raise your scores.
Don't open a number of new credit cards that you don't need, just to increase your available credit.
This approach could backfire and actually lower your credit scores.
Length of Credit History Tip
If you have been managing credit for a short time, don't open a lot of new accounts too rapidly.
New accounts will lower your average account age, which will have a larger effect on your scores if you don't have a lot of other credit information. Also, rapid account buildup can look risky if you are a new credit user.
New Credit Tips
Do your rate shopping for a given loan within a focused period of time.
FICO Scores distinguish between a search for a single loan and a search for many new credit lines, in part by the length of time over which inquiries occur.
Re-establish your credit history if you have had problems.
Opening new accounts responsibly and paying them off on time will raise your credit score in the long term.
Note that it's OK to request and check your own credit report.
This won't affect a score, as long as you order your credit report directly from the credit reporting agency or through an organization authorized to provide credit reports to consumers.
Types of Credit Use Tips
Apply for and open new credit accounts only as needed.
Don't open accounts just to have a better credit mix – it probably won't raise your credit score.
Have credit cards – but manage them responsibly.
In general, having credit cards and installment loans (and paying timely payments) will rebuild your credit scores. Someone with no credit cards, for example, tends to be higher risk than someone who has managed credit cards responsibly.
Note that closing an account doesn't make it go away.
A closed account will still show up on your credit report, and may be considered by a score.
To summarize, "fixing" a credit score is more about fixing errors in your credit history (if they exist) and then following the guidelines above to maintain consistent, good credit history. Raising your scores after a poor mark on your report or building credit for the first time will take patience and discipline.
How You Handle Unexpected Financial Events
At some point in our lives most of us will face some sort of unexpected financial situation. Whether it is a loss of job, a major repair bill, auto accident or some other event, it is important that you plan for this occurrence. Plans for such an occurrence are having some money in savings, asking family members for assistance and possibly having a credit card that is not used unless such an emergency arises. It is having such a plan that will mitigate damage to your credit score while you work your way through whatever unfortunate situation you face. While you may not have sufficient resources to weather a long term financial problem, to the extent the problems can be isolated the easier it will be to improve your credit score and/or explain the situation in an effort to re-establish your credit standing. It is extremely important to remember that once the crisis is solved that further late payments are not allowed to occur. Unfortunately, once people miss a few payments without serious consequences such as loss of collateral (house or car) they fall into the trap of thinking they can occasionally miss a few more payments here and there. This is a huge mistake and should be avoided as sporadic late payments are much worse that an isolated event when trying to establish a willingness to pay.
Financial Responsibility - Take it Seriously
As you incur debt, the companies that lend you money expect and rightfully so that they will be paid back according to the terms of the contract. While no one enters into these contracts without the intent to repay them, it becomes very easy to get priorities mixed up. Taking a vacation becomes more important than paying the car payment, Christmas presents take priority over the house payment in December and so on. While it may be easy to say "they are a big company they won't miss my payment for a month", it is this kind of thinking that will destroy your future from a credit worthiness standpoint. While vacations and Christmas presents are important, these things need to be a result of a savings pattern and taken at the expense of the debt holders. It is incumbent about you the borrower to insure that you do not over extend yourself from a credit perspective. Do not wait for a lender to say no you have enough credit to determine the maximum amount of credit that is right for you. Borrowing money is a major undertaking so insure you are ready to make the payments before you ask for the funds. Remember, if someone asked you for a loan even if it was only $5.00, you would want to know when they are going to pay you back. The fact that the lender is a company as opposed to a personal friend does not change the fact that they are entitled to be repaid and repaid in a timely manner.
Communicating With Your Loan Servicing Company
When you run into an unfortunate financial crisis, this is the time to communicate with those companies to whom you owe money. This is not the time to try and run and hide due to embarrassment or thinking if they cannot talk to you then they cannot hurt you. While many companies will not enter into any type of reduced payment plan until you stop paying, it is very important for you to open the lines of communication so the debt holder knows you are not trying to avoid your financial obligations. When they know you care about paying your bills they will listen as you try to distribute your available cash in a fair manner. Obviously, the length of time it takes to resolve the financial crisis and the severity of the cash flow problem will dictate what type of plans you can realistically negotiate. Do not enter into any arrangements that you cannot meet. It is better to agree to pay $100.00 that you know you can do than to continually try to explain why you are failing to keep your promises of paying a higher amount. In order to work out these issues, it is extremely important to show your credibility to the debt holder by keeping whatever promises you make. While they will be trying to get as much money as soon as they can, they will respect you if you explain the situation honestly so they know you are not trying to short change them but merely trying to partially meet as many obligations as possible.
Letters of Explanation
With the credit score being a mathematical calculation that uses past events to determine the credit score, there really is not a way to account for unfortunate life events. In other words, the poor credit score could be a result of job loss or illness that reduced earnings. These unfortunate events may have forced a consumer to miss many of their payments simply because they did not have the cash coming into the household to make the necessary payments. When this occurs a detailed letter of explanation is required so the lender knows the story behind the poor credit score.
The letter of explanation needs to make sense to the items reported on the credit report. In other words, losing a job in 2006 and being currently employed in 2007, the job loss would not explain late payments in 2007. The letter of explanation needs to address all late payments on the credit report. If there is not a good reason for the late payments then the consumer should understand the reluctance of a lender to provide more funds when repayment is questionable.
While credit score is one of the most important pieces of the lending decision it is not the only factor in making a loan decision. One of the other important factors is payment shock. Payment shock is the percentage and dollar amount of increase in the consumer's current payment for either a mortgage or rent compared to their new mortgage payment. Example: the consumers current rent payment is $500.00 per month. The new mortgage payment is $1,500.00. This means that the housing payments are increasing $1,000.00 or 200% (($1,500.00-$500.00)/$500.00)) this means that the new payment is three times the amount of the old payment. This increase has to be an amount that the borrower can easily afford based on their earnings or else the loan approval is in jeopardy. The compensating factor to offset payment shock would be a savings pattern. If at the $500.00 per month housing expense level, the consumer is saving approximately that much or more per month based on their bank account, then there is a good chance they can afford the increase payment amount. If on the other hand, the consumer has no money in the bank while making a $500.00 per month housing payment then it is unlikely they will be able or at least willing to make the higher payment if they are given such a loan.
Another way to determine the affect of payment shock is through the use of a budget letter. A budget letter is actually a worksheet that identifies the ongoing monthly expenses and determines how much excess cash if any will be available. The best approach to a budget is to identify all the current monthly bills including gas for the cars and food. Then factor in utility bills that may not be part of the monthly expenses due to how the rent is structured and add in a monthly maintenance amount. Once the expenses are all identified subtract them from the monthly take home pay. The answer to the equation will then yield the amount that will be available for a house payment. Once a monthly house payment is identified then you can compute the amount of a mortgage that yields that type of monthly payment. From there, you can determine the sales price of a house that you should be looking to buy. Even though all mortgage ratios are based on gross income, we all know there are taxes to be paid and that it is the take home amount that we have available for living. One thing to keep in mind is that once you determine you want to buy a house, you can increase the amount of your deductions so your take home pay is greater. This approach eliminates a big tax return each year but makes it easier to handle your monthly obligations.
Now You Are Ready To Buy A House
Having read through the above material, you should now be aware that you are making a major financial and personal decision when you ask to borrow money. If you have prepared a budget letter, understand the amount of money you can make in payments monthly and have adequately corrected any past credit problems then you are ready to move forward with a home purchase. It is important to understand that while past problems will be questioned they are not insurmountable provided you have demonstrated a willingness to pay. When a creditor evaluates your application for money, they are looking for your demonstrated willingness and ability to pay. So if you have had past credit problems, it is important to quickly get back on track so the creditors know you take your financial obligations seriously. Good luck with the house hunting!