Posted: March 19, 2013
Understanding your credit score: Part Two
Know your rightsTodd Hauer
(Editor's note: This is the second of two parts. Read Part One.)
How FICO Scores Break Down
The percentages in the chart below reflect how important each of the five main categories is in determining how your FICO score is calculated. 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.
Sources: myFICO.com; Fair Isaac Corporation; December 2012.
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 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 the calculation of a credit 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.
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, your pay stubs and/or your IRS Form W-2. It is also easy to do it yourself. Simply add up all of your monthly debt, such as a home mortgage, car and/or student loan payments as well as any credit card payments, and then divide the total by your gross monthly income. This percentage is your debt-to-income ratio.
First Things First
Since lenders will typically compare your credit scores from the big three credit reporting agencies—Equifax, Experian and TransUnion—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 of these agencies. You can request your reports at www.AnnualCreditReport.com.
Note, however, that unlike credit reports, your credit score is not free. You can purchase your score from one of the above-mentioned 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. Please contact me for more information about managing credit and debt.
Callout: Know Your Rights
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, you have a right to see your credit score for free if you have been denied a credit card or received a poor mortgage interest rate. The company or lender who denied you credit has to disclose your score at no cost to you.
Todd Hauer is a Financial Advisor with the Global Wealth Management Division of Morgan Stanley Smith Barney in the Denver Tech Center. He can be reached at 720-488-2406 or toll free at 1-800-347-5099, or you can email him at Todd.Hauer@morganstanleysmithbarney.com.