Credit Scoring Secrets

You lost, scoring only 550. Your dutiful neighbor won, with an 800, headed for that five-bedroom manse in the suburbs. Your sister is right on the cusp, with a 620, her loan application sitting in purgatory awaiting further review. 

This is the world of credit scoring, where a little-known three-digit number called your "FICO score" pretty much determines whether you'll get the house of your dreams or the car of your fantasies. It's not unlike high school, when SAT scores separated the most likely to succeed from the also-rans. Someone is still keeping tabs, in a decision-making process obscured from public view. 

Fair, Isaac & Co. of San Rafael, Calif., creator of the FICO credit-scoring system still won't disclose the precise methodology by which it determines the creditworthiness of borrowers, based on the amount of debt they have outstanding and their history of paying bills. But even though the scoring process may seem hard to fathom, knowing your FICO number is helpful in figuring out how to get the best deal on many types of loans. That's valuable information because 75 percent of all mortgage loans are sorted on the basis of FICO scores.

"Lenders are increasingly relying on these scores," says Chris Larsen, CEO of online lender E-Loan. Dependence on credit scores has deepened since the FICO model was established in 1988 as an increasing number of lenders moved to automated loan approvals. "Many loan products, including some home-equity loans and auto loans, are based almost entirely on your FICO score," adds Larsen. 

Despite their importance, FICO scores have largely been kept secret from consumers. But growing pressure from consumer groups led to congressional hearings to require lenders to disclose credit scores, along with an explanation of why scores weren't higher.

Now, armed with your FICO number, you will be able to review your credit practices and begin making adjustments to boost your scores.  You will learn that searching often for the best online mortgages can have a deleterious effect on your credit score, suggesting a hunger for debt that will unnerve potential lenders. 

Most of those lenders will be happy if your score is 700 or higher. Even though you may still qualify for a loan with a lower score, it will cost you. E-Loan recently examined auto loans and found that consumers with scores of 720 or higher could expect rates of about 7.1 percent, while those scoring between 680 and 719 were getting loans at 9 percent. Meanwhile, if you scored 640 to 679, you would have been charged 10 percent. Anything under 640 and you'd likely be looking at rates of 11 percent or more. The differences add up. A $20,000 car loan for five years at 11 percent will wind up costing you $5,500 more for the life of the loan than if financed at 7.1 percent. (We believe it will also cost you a great part of your wealth building capacity also!)

But what if your score falls below 680, the point at which many lenders begin examining an application more closely, or below 620, which many lenders consider problematic? What can you do to improve your score? First, you need to understand how your score is calculated: 

Payment history.
This is the key determinant of your score: Thirty- five percent of the number is based on whether you've paid your bills on time. Fortunately, most consumers do so. Sixty percent of borrowers score 700 or higher, which is considered good, if not excellent. Meanwhile, only 13 percent fall below 600. 

Debt levels.
Your total amount of debt, including balances on credit cards, car loans, and student loans, accounts for the next 30 percent of your score. "So keep balances low in general, especially on revolving debt," notes Fair, Isaac general manager Cheri St. John. That's exactly what Paul Makris did two years ago. In an effort to refinance his home mortgage at the lowest rate, the 48-year-old attorney in Huntington Beach, Calif., cashed in some stock market winnings and paid off about $46,000 on two outstanding car loans. He then used another $10,000 to pay off the balances on four credit cards. The move raised his score, already in the 700s, by about 20 points, his mortgage broker told him. 

Credit history.
How long you have had credit counts for 15 percent of the FICO score. In addition to keeping credit card balances at zero, many cardholders go the extra step and close out old accounts. While financial planners say this is a good move, it could end up lowering your score. FICO scores take into account both the age of your oldest account and the average age of all your accounts. By closing out old cards, you may inadvertently lower your score by shortening your credit history.  (We recommend cutting up the cards and never using the credit!)

Closing old accounts can hurt in another way. The FICO model rewards consumers who maintain a big cushion between their outstanding balances and their credit limits--say, $0 owed on a card with a $10,000 limit. But close out an old account with no balance, and you will also reduce the overall amount of credit available to you. At the very least, "Don't try to consolidate your accounts into one or two cards if that pushes you over the limits on those cards," recommends St. John. 

New debt.
When interest rates are falling, consumers often shop for lower-rate cards. While this may reduce your monthly minimum payments, it might hurt your score, of which 10 percent is based upon your application history. Each time you apply for credit, the lender pulls a credit report. All this shopping around makes it look as if you are hungry to take on more debt. 

Credit mix.
The final 10 percent of your score is based on how much credit you have and the types of debt you have incurred. Having too many accounts--say, a card from every store in town--could be harmful to your score. 

Now that the scores are becoming more widely available, lenders and credit counselors advise getting to know them. Mistakes do occur. Perhaps a lender credited an auto payment to the wrong account, or your payment got lost in the mail. It pays to recognize these instances and correct them. "I run my own score and my wife's twice a year every year to put my mind at ease," says Jeff Lazerson, a mortgage broker and president of Portfolio Mortgage in Lake Forest, Calif. In October, Lazerson discovered that some credit information belonging to his brother, whose Social Security number is just two digits different from his, found its way into his report. Luckily, it didn't affect his score because his brother also maintains good credit. 

Keep in mind that not all lenders report to the three credit bureaus. Because some information may be lacking from a credit report, the FICO score you get through Equifax may not be the same as the FICO scores associated with your Experian or Trans Union credit reports. 

If your lender rejects a loan because your Trans Union FICO score is, say, 600, but your Equifax score is 640, use that fact to negotiate with the lender. The bottom line: Take the same active role in managing your credit score as you would with any other financial matter, like your 401(k), for example. "People are really doing a good job of managing their assets," says E-Loan's Larsen. "We think consumers need to think about their debt the same way. They need to be opportunistic."