It’s important to know your score, what factors affect it, and how you can keep it in good standing.
Have historically low interest rates caused you to consider refinancing your home mortgage? If so, you are certainly not alone. Unsurprisingly, however, the financial standards imposed by lenders are considerably more stringent today than they were in the go-go days prior to the housing crisis. And to qualify for refinancing at today’s historically low interest rates, you must demonstrate a good credit history and respectable credit score.
FICO Scores: A Numbers Game
The FICO score (an acronym for its creators, the Fair Isaac Corporation) is a number that summarizes your credit risk. Lenders use it to gauge how likely you are to repay debts on time and make credit decisions, such as the interest rate you get when you apply for a loan. How widespread is the use of FICO scores? Ninety of the top 100 largest U.S. financial institutions use the FICO score to make consumer credit decisions, according to myFICO.com.
A typical credit score will range between 300 and 850 points. Generally speaking, higher scores are presumed to represent lower risks—the more attractive your score might be to a lender, the better the pricing you may be offered and the more money you may save over time.
For instance, at current rates, a borrower with a credit score between 760 and 850 can expect to pay a rate of 3.936 percent on a 30-year, $300,000 fixed-rate mortgage, according to myFICO.com’s Loan Savings Calculator. By contrast, an individual with a score of between 620 and 639 can expect a rate of 5.525 percent, which amounts to an extra $287 in monthly payments and an additional $103,275 in total interest paid over the life of the mortgage.
Factors That Determine Your Score
Credit reports—and the credit scores generated from them—are compiled by the three major credit reporting agencies, Equifax, Experian and TransUnion, based on information provided by creditors. These agencies generate scores using a proprietary formula that assigns weightings to five main factors:
- Payment history. On-time payments are an important component of your credit score. Using your credit responsibly and paying bills on time are great ways to maintain a good credit score.
- Credit utilization. Credit utilization is defined as the total debt you have divided by the total credit available to you. High credit utilization can be a warning sign of credit risk. (Note: You do not have to carry a credit card balance from month to month to show utilization. Simply using your card is enough, even if you pay the balance in full and never accrue interest. Credit card balances are reported by the issuer every 30 days based on the balance on that particular day. There is no distinction between revolving and paid-in-full balances on your credit report.)
- Length of credit history. Credit history is a significant component of your credit score. Accordingly, the average age of your credit cards can be a strong indication of your credit history. Care should be used in keeping old accounts open and in good standing.
- Mix of credit accounts. Both the total number of credit accounts and the mix of credit you have will affect your credit score. A healthy mix of revolving credit cards, charge cards, installment loans and mortgages will also impact your score.
- The amount of new credit on your record. While opening one new credit card might be normal, opening several in a short span of time could be a warning to potential creditors that something is amiss in your financial life.
How FICO Scores Break Down
The percentages in the chart above reflect how important each of the five main categories is in determining your FICO score. These percentages are based on the importance of the categories for the general population. For particular groups—for example, people who have not been using credit long—the relative importance of these categories may be different.
Additional Considerations
While the above are considered standard elements for lenders to scrutinize in the approval process, the following additional types of information may weigh in lenders’ deliberations:
Credit inquiries. Credit inquiries are placed on your credit report when an individual or agency has requested to view your credit file. “Hard” inquiries, which appear whenever you apply for a loan or credit card, may have a negative impact on your credit score. “Soft” inquiries, which are unrelated to a new financial obligation (e.g., a credit check by a prospective employer or your own request to review your credit report), have a lesser impact on your credit score. While inquiries don’t count as much as payment history, credit utilization and other factors that contribute to your score, a high number of inquiries may indicate that you are struggling financially or are attempting to secure more credit than you can reasonably afford.
Debt-to-income ratio. Your debt-to-income (DTI) ratio compares the difference between your gross monthly income and the monthly amount you spend to maintain all types of debt. Banks and other lenders study how much debt their customers can take on before they may start having financial difficulties, and use this knowledge to set lending amounts. The preferred maximum DTI ratio varies from lender to lender, but it is often around 36 percent. Because your DTI ratio is not typically included in credit reports, prospective lenders may calculate it using your loan application, paystubs and/or your W-2. It’s also easy to do yourself: simply add up all of your monthly debt and divide the total by your gross monthly income. This is your debt-to-income ratio.
First Things First
Since lenders will typically compare your credit scores from the big three credit reporting agencies, your first move should be to obtain current copies of your credit reports and review them for accuracy. All U.S. consumers are entitled to a free credit report each year from all three. You can request your reports at AnnualCreditReport.com. Note, however, that unlike credit reports, your credit score is not free. You can purchase your score from one of the credit agencies or from myFICO.com.
Credit Score Housekeeping
Here are a few takeaways for raising or maintaining a higher credit score:
- Pay your accounts on time and keep your balances low. Lenders are looking for a proven track record of making timely payments. Remember, payment history accounts for about 35 percent of your credit score.
- Be conservative in the amount of available credit you use at any given time. About 30 percent of your credit score is determined by the amount you owe in relation to the amount of credit available to you. If that percentage is more than 50 percent, your score will be lower.
- Hold on to older, unused accounts. The longer an account has been open and managed responsibly, the higher your score will be.
- Maintain a diversified credit mix. If you hold an auto loan, a home mortgage and credit cards that are well-managed, you will generally have a higher credit score than someone whose credit consists mainly of credit card debt.
Understanding your credit score and how it affects your overall financial well-being is vital to sound financial management. Contact your financial advisor for more information about managing credit and debt. iBi
Cathy S. Butler, CFP, CRPC is a financial advisor with the Butler/Luthy Group of Morgan Stanley. For more information, visit morganstanleyfa.com/thebutlerluthygroup.
