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Shah: What is a credit score and how can you improve yours?
Navin Shah

Your credit score represents your credit history.  It is a number grade that reflects how well you have managed financial obligations such as loans and lines of credit.  

It is used to decide if you are approved or denied for credit; if you pay a higher or lower interest rate for credit; and if companies want to offer you certain products or benefits, such as reduced car insurance premiums.  

So let’s look at how your credit score is determined and how you can improve it.  

What Is A Credit Score?

A credit score is a three-digit number generated by a computer program.  It is based on an analysis of information in your credit history and it is designed to predict risk – namely, how likely are you to pay your credit obligations during the next 24 months.  

There are several credit-scoring companies, but one dominates the marketplace and is used by about 90 percent of financial institutions in their credit decision-making.  It’s called the FICO score, named for the company that produces it:  the Fair Isaac Corporation.

It is not unusual for a consumer to have three different FICO scores – one from each of the three major credit bureaus:  Equifax, Experian, and TransUnion.  Why?  Because each of these companies has its own computer model, or formula, for evaluating credit history.  When different importance is given to different aspects of your credit behavior, the result is a different credit score.

FICO scores range from 300 to 850 – the higher the number, the lower the risk to the lender that you will default on any credit extended to you.   

• 750 or higher means you are considered an excellent candidate for credit

• 700 to 749 = good

• 650 to 699 = fair

• 600 to 649 = poor

• Below 600 = bad    

Most scores fall between 600 and 750.        

As an example, here’s how your credit score influences you when buying a house.  A loan from the Federal Housing Administration requires a minimum credit score of 500, while most lenders require a score of 620 to 640 to qualify for a conventional mortgage. 

How To Impact Your Credit Score  

If you want to raise your credit score, it’s essential to understand the factors that do and don’t make up your credit score.  First, let’s dismiss the things that never affect a credit score:  age, race, marital status, income, and employment. 

The five elements that do determine your credit score – and the relative importance of each item -- are:

1. Payment history – 35 percent of your score is based on whether you pay your loans and credit accounts on time.  For example, how many accounts do you have that are past due, how many days late are the payments, and what is the dollar amount of the past due payments.  

Other elements considered in this category are whether you have ever declared bankruptcy, ever been ordered by a court to pay accounts, or ever had accounts sent to a collection bureau.  Bankruptcy has perhaps the single most harmful impact on your credit score, so use every available option to avoid taking this action – bankruptcy should be your last resort, not your first resource.  

To maintain a high credit score, pay all your bills on time including your landlord, utility company, and cable provider.  Also clear up any accounts that are late or in collection.  Your best option is to pay every bill off completely, starting with those charging you the highest monthly interest.  

Your second-best option is to pay down as many bills as much as possible.  Paying down and paying off will result in two important benefits – first, a higher credit score and second, lower amounts paid in interest charges.

2. Amounts owed – 30 percent of your score comes from the number of accounts on which you owe; the dollar amount you owe on each one; and your credit utilization – namely, the total dollar amount of the credit you are using on all your accounts compared to the total dollar amount of credit you have been approved to receive on all your accounts.

Your “debt to credit” ratio is an important measure in evaluating your credit worthiness because it points to how responsible you are in using money – do you consistently spend all the credit for which you are eligible or do you keep unused credit available for emergencies and special purchases?

Be aware of the difference between two ratios:  (1) the “debt to credit” ratio is used to determine your credit score because it shows the amount of debt you have incurred compared to the amount of credit you are approved to receive, while (2) the “debt to income” ratio is typically used by lenders when evaluating you for a loan or mortgage because it shows the amount of your debt payments each month compared to your available monthly income.        

The preferred level for the “debt to credit” ratio is 30 percent or less – which demonstrates that you are using only about 30 percent of the credit for which you have been approved.  

So being “maxed out” on a credit card means your credit utilization is high and that will lower your credit score – and if you are “maxed out” on multiple cards means you are using even more of your approved credit, so your credit score will be lowered even further.

To reduce your “debt to credit” ratio and improve your credit score, apply for a higher line of credit, but do not use the full higher amount.

Another strategy is to apply for an additional credit card, then split your spending between the cards -- but do not use the full amount of approved credit on either account.  This improves your credit score because you have a lower “credit utilization” on two cards, instead of a higher utilization on one card.

One caution: if you use this multi-credit card strategy, never have more than three credit cards among which to balance your spending.  The more cards, the harder your challenge in managing them all properly.    

Your best option:  eliminate or reduce credit card balances.  But do not close any accounts with approved credit that you are not using – because not using approved credit is a good thing for your credit score.

3. Length of credit history – 15 percent of your credit score is determined by the average age of open accounts and the number of years of information in your credit history.  

It’s usually better for your credit score to have long-time credit accounts and more credit history – typically five years or longer – because even if you have had an occasional credit mistake, it becomes less damaging in the context of a more established, more complete credit report.      

4. Type of credit used – 10 percent of your credit score is based on the mix of the credit you are using such as credit cards, personal loans, lines of credit from retail stores, car loans, and home mortgage.  

Your goal should be to avoid relying excessively on any one of these types of credit – a balance demonstrates that you are a more responsible, more aware borrower.

5. New credit – 10 percent of your credit score reflects the number of new accounts for which you have recently applied.

Opening too many accounts makes it appear as if you are desperate for credit and that is a red flag for evaluators, so limit your credit applications.

Remember that your credit history is the key to your credit score, so it’s essential to check your credit report for accuracy.  Yet according to the Federal Trade Commission, one in five consumers found an error in their credit report.

Under federal law, you are entitled to receive one free credit report per year from each of the three credit bureaus – Equifax, Experian, and TransUnion.  Things to confirm include your personal information, as well as your payment history on each one.

Things to question or correct include accounts you don’t recognize or applications for credit that you didn’t make; collections being reported after the statute of reporting limitations, which is 7.5 years from the date of first delinquency, according to the federal Fair Credit Reporting Act; an account or bill that is supposed to be paid by an ex-spouse; and data that is more than 15 years old.  

Possible causes for errors include your identity being stolen and the thief abusing your credit, or your credit report containing information about someone with the same name.

The credit report you receive from any of the three credit bureaus does not include your credit score.  To see your credit score, you can purchase it from a credit score provider or you can use one of the sources available free online, notably the FICO score estimator at www.myfico.com

In our credit-based society, your past credit behavior helps to shape your future credit opportunities.  Key to this is your credit score.  While you should not obsess about your credit score, you should be aware of it -- and you can definitely work at improving it.

Navin Shah is Chairman of Royal Hotel Investments, which owns and operates two hotels in Covington and one in Conyers.  He is also Vice Chairman of Embassy National Bank, a community bank in Lawrenceville that he helped establish in 2007 and has become one of the leading SBA “Preferred Lenders” in the southeast.  He can be reached by e-mail at 1kingshah@gmail.com