The lowdown on credit scores: the good, the bad and the way to excellent

If you’ve ever applied for a loan or line of credit, whether it was for a mortgage, car or to score an extra 10 percent discount on an already great retail shop’s sale, then there’s a good chance you had a moment when you swallowed hard, your palms grew sweaty and your heart beat a little faster.
Truth is applying for credit is often a high-stress proposition. Most people apply only because they need to apply, because the money will help with a necessary expense, such as a home improvement project, caring for a sick family member or getting a son or daughter through college. The fact that the credit process is relatively unfamiliar and not clearly defined only contributes to this anxiety.
However, applying for a loan doesn’t need to be so stressful. It doesn’t need to feel like a showdown between consumer and loan officer. In fact, it’s not a showdown. Your loan officer wants to help get you the best rates available, because that’s the best way to earn your trust and win your business. And with a little knowledge and preparation, you can help make this happen and ensure a smooth transaction.
What is a FICO score?
The FICO score is the credit scoring system used by the major credit bureaus to predict a borrower’s credit worthiness. The formula, which is proprietary information and not known, was developed by Fair Isaac and Company. Still, the general principles about how the three-digit scoring system (ranging from 300 to 850) works are well understood. Here is a quick breakdown of the factors that are considered and the weight of each of these considerations.
• Payment history (35 percent) — This includes your bill paying history and the timeliness with which you pay your bills. Bills that are paid late and sent out for collection, as well as bankruptcy declarations, adversely affect your total score. The more recent this history, the more heavily it is weighted.
• Current debt (30 percent) — Accounts for your existing credit obligations, including credit cards, mortgages, car loans and any other debt you might be carrying. Obviously, the less debt you carry, the less fearful lenders will be of your inability to pay back a loan. A big culprit in this grouping that often accounts for lower than anticipated credit scores is credit card debt. Creditors look at both the number of cards you carry and the balances they carry in relationship to their credit limit. If you need to carry credit card debt, a good rule of thumb is to keep it below 25 percent of its maximum limit.
• Credit history (15 percent) — This is the length of time you’ve had credit. If you make on time payments, your credit history will improve with each report because you continue to establish a predictable pattern of responsible borrowing.
• Credit inquiries (10 percent) — FICO scores reflect only inquiries dating back one year. The reason why credit inquiries are weighed is because an unusual increase in credit requests can be a sign of financial troubles.
• Type of existing credit (10 percent) — This category looks at the types of credit you have, the prevalence with which you use that credit and recent activity. Of the categories that are weighted, this is perhaps the most vague and difficult to predict for potential borrowers.
To summarize, in order to earn a high credit rating it is important to have an established record of borrowing and timely repayment, to limit your borrowing activity and to carry as little debt as possible, particularly when it comes to credit cards.
What does the FICO score mean to you?
Your FICO score is a measurement of your borrowing power. The lower your rating, the more likelihood that securing a loan will be difficult and expensive. As much as a loan officer may want to help you, they cannot change your credit history. The higher your FICO rating, the more borrowing opportunities you will have, both in terms of accessing the lowest rates available and the ability to shop for the loan and terms that best suit your needs.
According to Fair Isaac, the median FICO score in the United States today is 723. Half of the population is above this number, the other half is below it.
In general, FICO scores above 700 are very good and will help you secure the best rates. Once you get below 700, you will likely not be able to secure the best terms available, which means higher rates and more money borrowed over the life of the loan.
What understanding the credit process can mean to you?
Remember the cold sweat and anxiety … the feeling of helplessness that can be part of the loan application process? Understanding your FICO score, both how it works and what it records, can take away some of the mystery. More important, knowing your approximate score can help you set realistic expectations. This is good for both you and the loan officer, as you can work within a well-defined set of parameters to secure the best loan at the best rate for your given situation. Over the life of the loan, that can mean a lot of money in your pocket…not the bank’s vault.
The way to excellent
According to FICO, the credit scoring system developed by the Fair Isaac Company and used by most major banks and credit bureaus, the difference between a 700 and a 699 FICO score on a 30-year fixed mortgage can be $56 a month. Do the math, and that one point differential adds up to an extra $20,160 over the life of the mortgage. The difference between a 700 and a 659, as estimated on the FICO Web site (www.myFICO.com), is $78,480 over the life of a 30-year fixed mortgage. So paying attention and working your credit score from bad to good to excellent really does pay. And here are five tips that can help you do it.
1. Correct any errors or inaccuracies on your credit reports. For example, I once had a client who had a vehicle on his report that the leasing company never took off after the car was turned back in. The correction resulted in a better rate. You can request your free credit report from www.annualcreditreport.com.
2. Pay down your credit card balances. It’s obvious, but it makes a big difference.
3. Make on time payments. One late report on your FICO score can be costly, dropping you from a good standing to a fair standing.
4. Do not close unused accounts. Unused accounts help establish your credit history and help maintain a lower credit available to debt ratio.
5. Spread out your credit card debt among a number of cards to keep your balance-to- credit ratio below 25 percent. Of course paying your cards down is the preferred option, but this approach of spreading out debt could be a short-term, quick-fix approach that can save you thousands in the long run.
Cheri Doak is senior vice president and retail banking leader at Key Bank. She works out of the Presque Isle office and can be reached at (207) 764-9425 or cheri_doak@keybank.com.