Sometimes it’s good to get back to basics. Credit score plays a huge role in the real estate business, yet a lot of real estate professionals don’t know much about it. There are five components to credit score:
1. Payment History — 35%
2. Amount Owed — 30%
3. Length of History — 15%
4. New Credit — 10%
5. Type of Credit — 10%
Payment History — 35% of Score
By far the most important component of credit score is payment history, as it accounts for 35% of a consumer’s credit rating. This category quantifies how good a person has been at paying his or her debts. The algorithm uses common sense logic, reasoning, Hey, if this guy pays other people, he’ll probably pay us too. This category is simple. Pay your bills on time, and your score goes up. Pay your bills late, and your score goes down.
The number of accounts is also important. A person who inherited a house, pays cash for cars and doesn’t use credit cards will be known as a “thin file.” Credit score can be lousy due to lack of use of credit — not just because of negative items. The trick is to have just the right amount of credit lines — not too many, not too few. Most experts agree that one mortgage, a couple of auto loans, and three major credit cards would be a healthy mix, providing all those payments are made on time.
The length of time since your last negative item also impacts this category. The previous 24 months of credit history has the most impact on credit score. It’s hard to believe, but a 4-year-old bad debt may not affect your score as much as being 60 days late on your car payment right now. The goal is to put at least 24 months of space between now and your last negative item.
Amount Owed — 30% of Score
“Amount owed” refers to how much of your mortgage or other installment loans are outstanding compared to how much of that debt has been paid off. The credit scoring formulas are secret, so we will never know exactly how they are computed. However, many experts agree that your total debt on revolving accounts should not exceed 30% of your total limits. The balance on any one card should not exceed 50% of that card’s credit limit. If you have 5 charge cards with total limits of $20,000, you don’t want to carry more than $6,000 in balances. If each of those 5 cards has a limit of $4,000, you don’t want any one of those cards to carry a balance exceeding $2,000.
Length of Credit History — 15% of Score
The credit scoring system tracks the “date opened” for every account, so the longer you hold those accounts (and pay them on time), the better. This category also takes into account how long it has been since you used certain accounts. If your only credit card is a VISA that sits in your jewelry box because it’s only there for “emergencies,” you won’t get much credit in this category — even if you have held that account for a decade. Accounts that lie dormant do not help your score in this category as much as those that are used. Simply use the card periodically, and the length of history associated with that card will positively affect your credit score.
New Credit — 10% of Score
“Would you like to save 10% today by opening up a Target credit card?” Your answer should almost always be “No, thank you.” Saying “yes” to such an offer may harm your credit score in three different ways. First, an inquiry will be placed on your credit profile, which negatively affects credit score. Second, opening new lines of credit in itself is potentially harmful to credit score. And lastly, department store credit cards are viewed as cheesy to the credit scoring system. FICO likes VISA, MasterCard and American Express, for example, but it frowns on Gap, Victoria’s Secret and the like. Be hesitant to open new lines of credit.
Type of credit — 10% of Score
Aim for a “healthy” mix of credit. A motorcycle payment, a Sea-Doo payment and five department store credit cards would not be as healthy of a mix of credit as one mortgage, two car payments and a couple of major credit cards.
Wade Young is a Colorado Mortgage Broker.
Solid credit score advice Wade!
Excellent post! Why is it that with all the money that goes into education, we fail to teach our children and grandchildren how credit works?
Great rundown on how a credit score is caluclated! It is beneficial for everyone to learn how it works.
Wade, thanks for the break down, I thought I have alwasy understood creidt andthe scoring system, and we all know that it does have a mind of its own but this will really help me to at least break things down for a borrower.
Awesome post. Gonna link my credit problems page to it and refer my writers to it as well. Thanks for saving me tons of work!
Wade – good post. Look at how the majority (65%) of the score is made up of the first two factors, as it should be.
Neat post. One of the best credit score explanations I’ve seen. Usually you have to pay, or at the very least, register as a free guest, to read this kind of detailed information.
It would be nice if the credit scoring agencies would break down peoples scores into the different sections so people could get a better idea what was bringing them down. Maybe have 5 scores from 0 -850
1. Payment History — 800
2. Amount Owed — 750
3. Length of History — 600
4. New Credit — 700
5. Type of Credit — 700
Then, for instance, someone could see at a glace that length of history was their weak point.
very good explanation of how they do this. Keep up the good work.
What you have to know about credit scores is that you can easily maintain good credit score by using a credit score chart. They are really helpful and easy to use. Also they will give you a good chance of understanding where you stand with your finance.
I recently came across your blog and have been reading along. I thought I would leave my first comment. I don’t know what to
say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.
Betty
http://www.my-foreclosures.info