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Managing Your Credit Reputation

Part of everyday life involves managing your finances. This could range from administering an investment portfolio to clipping coupons.  Yet very few people take the time to manage a very important part of their financial situation – their credit reputation. 

Your credit reputation – your experience in borrowing money – will impact the interest rate you pay on any type of loan - real estate loans, car loans, credit cards, installment loans, and so on. In addition, many insurance companies are now using your credit to determine the premium you pay on property insurance and auto insurance. A person with a poor credit reputation will pay thousands of dollars more in interest payments and insurance premiums than a person with a good credit reputation.  

Is Your Credit Information Correct?

The first step in managing your credit reputation is making sure the information in your credit file is accurate. This involves obtaining a credit report. There are three credit repositories in the USA that maintain credit information  – Experian, TransUnion, and Equifax. Most of the information they receive comes from creditors who report information to the repositories. Because not all creditors report to each of the three repositories, it is a good idea to obtain a separate credit report from each repository.

An additional benefit of obtaining your credit report is spotting “identity theft”. As this becomes more common, reviewing your credit file on a frequent basis is a must. And if you are an identity theft victim, finding the theft early is the best way to stop this event from getting out of hand. 

There are numerous ways to obtain a credit report. The fastest and easiest way is to simply go to the websites of the credit repositories. Using this method will involve a total cost of around $35 to obtain reports from all three repositories.

Another way to obtain a credit report – which is free – is to call the repositories. Colorado is one of a handful of states where the credit repositories are required to provide Colorado residents with one copy of their credit report each year at no charge.  The automated phone service will ask that you provide personal information – name, social security number, address, etc – so the repository can confirm your identity. You will receive the report in 2-3 weeks. The phone numbers to call are as follows:

§        TransUnion - 800-916-880

§        Equifax - 800-685-1111

§        Experian - 888-397-3742

Once you have obtained your credit report, there are two areas within the report to review carefully. First, look to see if there any derogatory items (late pays, collection accounts, etc) that are incorrect. Second, review the report for any open accounts that do not belong to you. You should ignore items on the report such as the high balance, current balance, and payment amount, unless they are significantly inaccurate. Also, do not be concerned with previous address information or employment information, as this data is not used by anyone in determining your credit reputation.

If you do have incorrect derogatory information, or an open account that does not belong to you, you will need to “dispute” the inaccurate information with the repository. The credit report you receive will most likely include a form that you can complete and return. Or you can write a separate letter and send this to the repository. It is usually best to send the form or letter via certified or registered mail.

If you do decide to write a separate letter, there are three key items to put in your letter.

1. State that you are disputing information in your credit file

2. Specifically reference the account in question – name and account number

3. Tell the repository exactly what you want done – change the information, delete the information, etc.

Once the repository has received the form or letter disputing the information, the repository will contact the creditor in question to confirm the accuracy of the dispute. Unfortunately, under the law, the creditor has the final say as to the accuracy of the information. So if the creditor states the information is accurate, it will stay in your credit file. Regardless of the result, the repository is required by law to respond to your dispute within 30 days.

Be forewarned – correcting mistakes in your credit file could be a very time consuming and frustrating process, especially if you no longer have a relationship with the creditor. But given the financial benefits, it will be time well spent.

Credit Scores

A credit score is the numeric value of your credit reputation, with the higher the score the better the credit reputation.  A credit score takes all the information in your credit file and assigns it a 3 digit numeric rating. Credit scores will range between 300 and 850, although it is rare to see scores below 400 and over 825. 

Long before credit scores, human judgment was the sole factor in analyzing an individual’s credit. Lenders used their past experience at observing consumer credit behavior as the basis for judging an applicant. Not only was this a slow process, but it was also unreliable because of human error. In addition, the process was not objective or consistent.

Credit granting took a huge leap forward when statistical models were built that considered numerous variables and combinations of variables. These models were built using payment information from thousands of actual consumers, which made credit scores highly effective in predicting consumer credit behavior.

Credit scoring has been in existence since the 1950s, and credit scores have been widely used by retail merchants, credit card companies, and other non-mortgage lenders since the 1980s. The use of credit scores for mortgage loans began in the mid-1990s, and almost all mortgage lenders now use credit scores in some fashion. 

The original credit score model was developed by the Fair Issac Company – thus credit scores are often referred to as “FICO scores”. Each of the three credit repositories – Experian, TransUnion, and Equifax – have their own scoring model, thus each person really has 3 credit scores. Because all these scoring systems are based on the FICO model, the three scores should be fairly similar.

The following is the distribution of FICO scores across the country:

  • Over 800 - 11% of the population

  • 700 – 800 - 49% of the population

  • 600 – 700 - 27% of the population

  • Less than 600 - 13% of the population

Lenders use credit scores to tell them how likely potential borrowers will pay back their loans, and thus use credit scores to determine whether or not to grant credit, and at what interest rate. The higher the score, the lower the risk. And lower risk to the lender generally translates into a lower interest rate.

The importance of the credit score to the lender will vary depending upon the type of credit being sought. For example, credit card companies use credit scores almost exclusively when analyzing an applicant, and will generally not concern themselves with the applicant’s income, employment, or assets. For mortgage loans, credit is very important, but mortgage lenders will also consider income and assets in the qualification of a consumer.

How Credit Scores Are Calculated

Credit scores are calculated from a lot of different data in your credit file. This data can be grouped into five categories, and each of the categories will have varying importance in determining your score, as follows:

 

         Category/Importance                               

       Payment History - 35%

       Amounts Owed - 30%

       Length of Credit History - 15%

       Types of Credit - 10%

       New Credit - 10%

These percentages are based on the importance of the five categories for the general population. For particular groups - for example, people who have not been using credit long - the importance of these categories may be somewhat different.

Payment History includes the following items:

  • Payment information on specific types of accounts 
  • Presence of derogatory items - bankruptcy, judgments, collection items, and/or delinquency 
  • Severity of delinquency (how long past due)
  • Amount past due
  • Time since (recency of) any derogatory credit
  • Number of past due items
  • Number of accounts paid as agreed

        Amounts Owed takes into consideration these data elements:

  • Amount owing on accounts
  • Amount owing on specific types of accounts
  • Lack of a specific type of balance, in some cases
  • Number of accounts with balances
  • Proportion of credit lines used (proportion of balances to total credit limits on certain types of revolving accounts)
  • Proportion of installment loan amounts still owing (proportion of balance to original loan amount on certain types of installment loans)

Length of Credit History includes such factors as the time since accounts were opened and the time since last account activity.

  New Credit is

  • Number of recently opened accounts, and proportion of accounts that are recently opened, by type of account
  • Number of recent credit inquiries
  • Time since recent account opening(s), by type of account

Types of Credit is the number of (presence, prevalence, and recent information on) various types of accounts.

It is important to remember that a credit score takes into consideration all these categories of information, not just one or two. No one piece of information or factor alone will determine your score. Also, the importance of any factor depends on the overall information in your credit report. For some people, a given factor may be more important than for someone else with a different credit history. In addition, as the information in your credit report changes, so does the importance of any factor in determining your score. 

It impossible to say exactly how important any single factor is in determining your score - even the levels of importance shown here are for the general population, and will be different for different credit profiles. What's important is the mix of information, which varies from person to person, and for any one person over time.

Improving Your Credit Score

As you start the process of improving your credit scores you must remember that the importance of these five factors depends on the overall information in your credit report. For some people, a given factor may be more important than for someone else with a different credit history. Thus the steps you need to take to improve your credit score may be totally different than someone else.

Also, improving your credit score has been compared to losing weight – it takes time and there is no quick fix. This is especially true if you have had delinquent accounts.

Even though the improving of one’s credit scores is truly unique to each individual, the following actions would apply to most consumers: 

Payment History

  • Pay your bills on time. Delinquent payments and collections can have a major negative impact on your score.
  • If you have missed payments, get current and stay current. The longer you pay your bills on time, the better your score.
  • Pay collection accounts. While paying off a collection account will not remove it from your credit report, this action will, over time, change the recency of the delinquent credit and thus improve your scores.

Amounts Owed

  • Keep balances low on credit cards and other revolving credit. It is better to have a $4,000 balance with a $10,000 limit than a $4,000 balance with a $5,000 limit.
  • Pay off debt rather than moving it around.  In fact, owing the same amount but having fewer open accounts may lower your score.
  • Do not close unused credit cards as a short-term strategy to raise your score.
  • Do not open a number of new credit cards that you do not need, just to increase your available credit. This approach could backfire and actually lower the score.

  Length of Credit History

  • If you have been managing credit for a short time, do not open a lot of new accounts too rapidly. New accounts will lower your average account age, which will have a larger effect on your score if you do not have a lot of other credit information.
  • Rapid account buildup can look risky if you are a new credit user.

  Types of Credit Use

  • Apply for and open new credit accounts only as needed. Do not open accounts just to have a better credit mix - it probably will not raise your score.
  • Have credit cards, but manage them responsibly. In general, having credit cards and installment loans (and paying timely payments) will raise your score. Someone with no credit cards, for example, tends to be higher risk than someone who has managed credit cards responsibly.
  • Note that closing an account does not make it go away. A closed account will still show up on your credit report, and may be considered in the score.

  New Credit

  • Do your rate shopping for a given loan within a focused period of time. Credit scores distinguish between a search for a single loan and a search for many new credit lines, in part by the length of time over which inquiries occur.
  • Re-establish your credit history if you have had problems. Opening new accounts responsibly and paying them off on time will raise your score in the long term.
  • It is OK to request and check your own credit report. This won't affect your score, as long as you order your credit report directly from the credit reporting agency or through an organization authorized to provide credit reports to consumers.

Credit Scores and Mortgage Loans

The use of credit scores for mortgage loans is fairly new. Prior to the mid-1990s, mortgage lenders rarely used credit scores. In 1993, the Federal Home Loan Mortgage Corporation (Freddie Mac) was the first to incorporate credit scores into their mortgage loan underwriting process. Almost all mortgage lenders now use credit scores in some fashion. 

While each mortgage lender uses credit scores differently, the following is generally the way most mortgage lenders rate an individual’s credit based on credit scores:

  • Over 720: Excellent credit

  • 700-720: Good credit

  • 680-700: Above average credit

  • 660-680: Average credit

  • 620-660: Below average credit

  • Less than 620: Poor credit

Prior to the acceptance and use of credit scores, credit was just one factor in the mortgage loan qualification process. Other factors that were considered equal in weight to credit were the debt-to-income ratios (the relationship of monthly income to monthly debt payments), employment history, downpayment/equity, and liquid reserves. Through the analysis of the performance of millions of mortgage loans, lenders have learned that an individual’s credit reputation – as evidenced by their credit score  - is the most important factor in determining how consumers will repay their mortgage loans.

As a result of credit scores, the mortgage industry now categorizes mortgage loans into 2 broad categories – “prime” and “sub-prime” mortgage loans. Generally speaking, a borrower with a credit score of less than 620 falls into the sub-prime category. To reflect the risk associated with people with poor credit, sub-prime loans have a higher interest rate than prime loans, and require a larger downpayment/equity position.

The embracement of credit scores by the mortgage industry has resulted in many positive changes for consumers. 

  • In the past, if the debt-to-income ratios were over a certain percentage – 38% - the person could not get a loan regardless of how good the credit. Today, people with excellent credit can be approved for mortgage loans with ratios in excess of 50%.
  • People with excellent credit can now purchase properties with no downpayment and at a good interest rate. Previously a person needed to make a downpayment of at least 5% to obtain a loan.
  • The standard loan approval process involves providing documentation supporting the applicant’s income. Some people are unable (or unwilling) to provide the necessary documentation. In the past, these people were unable to obtain mortgage loans, or would have to pay a very high rate for not documenting their income. Today, people with good/excellent credit can obtain mortgage loans without having to document their income, and at a good interest rate.
  • Before the use of credit scores and creation of the sub-prime loan, a person with poor credit was simply unable to obtain a mortgage loan. In today’s environment, mortgage loans are readily available to people with poor credit.

 

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