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Complexities of credit scoring

Most consumers have at least heard of credit scoring. However few really understand it and how it can impact them, or how it works. For those who make a valiant effort (and sometimes spend a lot of money) trying to track and understand their scores, it can be a frustrating experience.

As such I am doing a two-part column this week and next on the basics of understanding credit scoring. This week I will discuss what a credit score is and in general terms how it works. Next week I will discuss the numerous versions of credit scores you as a consumer can purchase to find out where you stand, and why some are totally worthless and some are vital to your financial planning.

For the uninitiated a credit score is a number (generally between 350-850) that indicates your credit worthiness in relation to the rest of the people in the U.S. A computer model evaluates all your credit data and compares you to a statistical sample of consumers that have both succeeded in paying all their bills on time and those who have not. The result is a measure of the likelihood you will or won’t default on future obligations. For most credit extensions, a score of 620 would be at the low end and 720 would generally get you whatever you want.

Some of the areas that scoring models look at include the length of time you have had credit, the number and types of accounts you have had (such as mortgages, bank cards, installment loans, student loans and department store cards). The longer you have had accounts open, the better. The average consumer has had their oldest account open for about 13 years.

The exact ideal mix of types of credit you have used is not known publicly, and may well vary. However, in general if you have had several department store cards (which are often fairly easy to get) and never had a mortgage or a bank card (which are harder to get) you may not score well.

The scoring model also looks at your total credit limits on revolving debt and your usage of that amount. If you owe over 40 percent of your limits, it’s likely your score will get dinged.

Another item the model looks at is the number of inquiries you have had in the last 12 months. If you have been applying for a new credit card every month, your score will likely get hit again. Research shows that people who are living within their means (and thus are better credit risks) don’t need new credit cards every month. People who aren’t living within their means tend to pay MasterCard with Visa and need more credit. Statistically, most consumers apply for credit once a year and open a new account about every 13 months.

Also, if you have had any late payments it can impact your score. Only 32 percent of U.S. consumers missed a payment in the last 12 months. Late payments on a mortgage are particularly painful to get over in terms of getting your score back up. One 30-day late mortgage payment could knock 50 or more points off your hard-earned score overnight. A 30-day late on a car loan is probably less severe, but you will be impacted. Over time the impact of these situations is offset if you pay everything else on time, but even several years later it can affect your score.

If you ever get a letter from a collection agency you had best pay attention to it. Even if it’s unjust don’t ignore it. Generally collection agencies will give you a short period in which to settle up before they put it on your credit report. However once it’s on there it will impact your score for seven long years even though you may pay it off eventually. Once it is paid it will show as a “paid collection,” which is less of an impact than an “open collection” but still something you don’t need.

The impacts of a low credit score are far more sweeping than you might think. Even if you have no plans to buy a home for several years you will be affected in other ways. Credit reports and scores are used for far more than mortgages.

Most notably, they determine what credit card offers you may be eligible for. Those low rates and balance transfers are not open to everyone, and the higher your credit score the better.

Other areas where the credit score has an influence are employment and rental housing. Employers look at a credit report to gauge if an employee will be able to live within their means given the salary being offered. Someone who has a pile of debt is more likely to be stressed out about their personal finances more than someone who isn’t, and more likely to be unhappy with the salary they are making if it’s not adequate to pay their bills. Also, if the position involves being trusted with large amounts of money, someone who is in debt is going to be more likely to fall prey to temptation to steal than someone who isn’t.

Landlords want to know if you have a record of paying your bills on time as well, as that likely indicates your ability and willingness to pay your rent on time.

Another industry that uses credit reports is the insurance industry. Although I’m not sure I believe it, they claim that people with low credit scores tend to be worse insurance risks. The industry claims that people with credit problems tend to be more distracted and stressed than those without and thus are more prone to health problems or accidents.

Now that you know a bit about how credit scoring works, I will address next week how the selling and marketing of credit scoring works; the different types of credit scores out there for sale and which ones are worth spending your money on and which are not.

Chris Neuswanger can be reached at Macro Financial Group in Avon at 970-748-0342 or via e-mail at chris.n@macrofinancial.com. He welcomes mortgage-related inquiries from readers.


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