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Know The Score: How Your Credit Score Impacts Your Financial Future
By John M. Gannon
Summer 2007
Are you thinking about making a major purchase such as buying a home? Purchasing a home and securing credit to buy it tend to go hand in hand. Did you know your credit score is one of the key factors that determines the rate of interest you will pay for a home loan – and whether or not you get that loan?
Credit Score Basics
Many people do not know about the credit scoring system – much less their credit score – until they attempt to buy a home, take out a loan to start a business or make a major purchase. A credit score is usually a three-digit number that lenders use to help them decide whether you get a mortgage, a credit card or some other line of credit, and the interest rate you are charged for this credit. The score is a picture of you as a credit risk to the lender at the time of your application. The riskier you appear to the lender, the less likely you will be to get credit or, if you are approved, the more that credit will cost you. In other words, you will pay more to borrow money.
Note: Each individual has his or her own credit score. If you are married, both you and your spouse will have an individual score; if you are co-signers on a loan, both scores will be scrutinized.
The most well-known credit scoring system was developed by Fair Isaac Corp. and is called the FICO® score. The three major credit bureaus – Equifax, TransUnion and Experian – use the FICO scoring model for their proprietary systems. Since each scoring system uses a slightly different statistical model, your scores may vary from system to system. Lenders and other businesses report information to the credit reporting agencies in different ways, and the agencies may present the information differently through their proprietary systems.
Because different lenders have different criteria for making a loan, where you stand depends on the credit bureau your lender consults for credit scores. According to Experian’s National Score Index, the national average credit score is 674. But a score of 720 and above can give you access to some of the best rates and most favorable terms.
Suppose you want to borrow $150,000 in the form of a fixed-rate 30-year mortgage. If your credit score is in the highest category, 760-850, a lender might charge you 5.778 percent interest for the loan (scores and rates as of March 19, 2007, as reported on www.myfico.com). This means a monthly payment of $878. If, however, your credit score is in a lower range – 620-659, for example – lenders might charge you 7.094 percent, resulting in a $1,007 monthly payment. The lower score would cost you $129 more per month and $46,440 more through the life of the loan.
Think about what you could achieve with that extra $129 per month. You could invest in a mutual fund or college fund; certainly you could use it in some way to significantly increase your net worth in the long term. You’ve heard the saying, “It takes money to make money.” Now you can see what that concept really means!
What Helps, What Hurts
Fair Isaac’s credit scoring system takes five components into account. Here is what each component says about you:
Payment history (weighted 35 percent) details your track record of paying your debts on time. This component encompasses your payments on credit cards, retail accounts, installment loans such as automobile loans, finance company accounts and mortgages. Public records and reports detailing such items as bankruptcies, foreclosures, suits, liens, judgments and wage attachments also are considered. A history of prompt payments of at least the minimum amount due helps your score. Late or missed payments hurt your score.
How much you owe (30 percent) reveals the extent of your debt and helps determine if you can handle what you owe. If you have high outstanding balances or are nearly “maxed out” on your credit cards, your score will be negatively affected. A good rule of thumb is not to exceed 30 percent of the credit limit on a credit card. Paying down an installment loan is looked upon with favor. For example, if you borrowed $20,000 to buy a car and have paid back $5,000 of it on time, your payment pattern demonstrates responsible debt management, which favorably affects your credit score.
Length of credit history (15 percent) refers to how long you have had credit and used it. The longer your history of responsible credit management, the better your score because lenders have a better opportunity to see your repayment pattern. If you have paid on time, every time, then you will look particularly good in this area.
Type of credit (10 percent) concerns the “mix” of credit you access, including credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. You do not need each type of account. Instead, this factor considers your various types of credit and whether you use that credit appropriately. For example, using a credit card to purchase a boat could hurt your score.
New credit or inquiries (10 percent) suggests that you have added more debt or are about to do so. Opening many credit accounts in a short amount of time can prove risky, especially for people without a long-established credit history. Each time you apply for a new line of credit, it counts as an inquiry or a “hard” hit. Multiple inquiries may result when you shop for a rate on a mortgage or car loan. However, because you are looking for only one loan, inquiries of this sort in any 14-day period count as a single hard hit. By contrast, applying for numerous credit cards in a short period of time will count as multiple hard hits and potentially lower your score. “Soft” hits – including your personal request for your credit report and requests from employers or lenders wanting to extend “pre-approved” credit offers – will not affect your score.
Good Credit Puts Money In Your Pocket
Living within your means, using debt wisely and paying all bills – including credit card minimum payments – on time, every time are smart financial moves. You will help improve your credit score, reduce the amount you pay for the money you borrow and put more money in your pocket to save and invest.
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John Gannon is Senior Vice President of NASD, the world’s leading private-sector provider of financial regulatory services. Visit www.saveandinvest.org, a comprehensive website to help servicemembers manage their money with confidence.
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Where Do You Stand?
How does your credit look? You can request a free credit report once every 12 months from each of the nationwide consumer credit reporting agencies: Equifax, Experian and TransUnion – and for a fee, you can also obtain your credit score – by calling 877-322-8228 or visiting www.annualcreditreport.com.
Scores range from approximately 300 to 850. When it comes to locking in an interest rate, the higher your score, the better the terms of credit you are likely to receive.
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