By Robert DeHollander
As consumers and business owners, we know that having a good credit score is important. Your credit score plays a major role in determining whether you will be approved for a loan as well as the terms and borrowing costs.
What is a credit score?
When you borrow money from a lender or sign a contract pledging to make payments, the other party needs to assess how likely it is that you will fulfill your obligations. Your credit score is a measure of risk that helps lenders quantify this likelihood in real time.
In order to make a decision about whether to lend money, a lender needs to gather a great deal of information. The credit score speeds up this process immensely by giving the lender a quantifiable measure without having to collect all the data.
Types of credit scores
The FICO score, created by Fair Isaac Corp., is the most commonly used credit measure. Although in this column we focus on FICO, you should be aware that other scores — for example, VantageScore and PLUS Score — evaluate credit worthiness using their own methodologies.
A consumer’s base FICO score ranges from 300 to 850 — the higher the consumer’s score, the lower his risk to lenders. During the past 25 years, the base FICO score has undergone many revisions, and the scoring methodology has evolved to account for new data points. Currently, the most widely used measure is the FICO 8 score.
Calculating your FICO score
When a consumer obtains credit, the lender reports the information to the three major U.S. credit bureaus: Equifax, Experian, and TransUnion. The information then goes into the individual’s credit report, which provides the raw data used to calculate the credit score.
The credit report includes a consumer’s personal information (for example, date of birth and Social Security number), all of his account information, information about credit inquiries, and negative information such as bankruptcies and late payments. For calculating an individual’s credit score, the FICO formula looks at five primary categories of information:
- The consumer’s total amount of debt.
- The combination of different types of accounts.
- The consumer’s history of making payments on time.
- How old the consumer’s credit history is.
- The amount of new credit applied or shopped for.
Although some categories like payment history and amount of debt are more heavily weighted in determining the FICO score, the relative importance of a category can be affected by the aggregated information in the consumer’s credit report.
Improving your score
Consumers may request their credit reports once a year from each credit bureau. There is no cost, and they can be obtained easily online through www.annualcreditreport.com.
Once you receive your reports, check them diligently for accuracy. Cross-reference them with each other to be sure that the information is correct across the three bureaus. If you find inaccurate information — especially incorrect negative information — contact the credit bureaus to dispute the data.
Here are a few tips for improving your credit score:
- Do your best to keep balances on credit cards low compared with your total available credit line. High balances can hurt your credit score.
- Create a system to ensure that you consistently pay your bills on time. This will have a positive effect on your score.
- Do not move debt around to avoid payments. Work on a system to pay down debt rather than move it.
- Use credit cards, but use them properly and pay on time. Lenders want to see a track record that demonstrates your ability to manage debt responsibly.
- If you are looking to obtain a loan, shop around within a short period of time. If you spread your search out over a long time frame, lenders may infer that you are shopping for many credit lines rather than for just one loan.
- If you are unable to make payments, contact the lenders to try to come up with a plan. Consider working with a credit counselor to develop a strategy for paying down your debt.
Considering the importance of credit scores, consumers should make a concerted effort to monitor and protect the information that makes up their scores. Request your credit reports at least annually and diligently check the information for accuracy. Take pride in having a good score and enjoy the benefits that come along with it.
Robert DeHollander is a managing partner and co-founder of the DeHollander & Janse Financial Group in Greenville.