Understanding your credit score: Part One

(Editor’s note: This is the first of two parts.)

Have today’s historically low interest rates caused you to consider refinancing your home mortgage? If so, you are certainly not alone.

Not surprising, 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 a refinancing at today’s historically low interest rates, you need to demonstrate a good credit history and a respectable credit score.

A Numbers Game: FICO® Scores

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 may be to repay debts on time and to 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.

A typical credit score will range between 300 points 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 of between 760 and 850 can expect to pay a rate of 3.072 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 4.661 percent, which amounts to an extra $273 in monthly payments and an additional $98,063 in total interest paid over the life of the mortgage.

Factors That Determine Your Credit Score

Credit reports—and the subsequent credit scores that are 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 available credit that is 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 credit card utilization. Simply using your card is enough to show activity, 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 you have 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 credit 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 sign to potential creditors that something is amiss in your financial life.

Categories: Finance