Ask DWM: What do I need to know about (and do with) my credit scores?

CreditScoreRangesAnswer: Great question. Banks severely tightened their lending standards after the subprime mortgage crisis, making your credit score more critical than before, even for high net worth individuals. When lenders are determining whether to extend credit and at what interest rate, one of the most important factors they look at is your credit score.

Actually, you don’t have one score, but several. You have a Fair Isaac Corp. (“FICO”) score from Equifax, Experian and TransUnion. Each is a score on a particular day of how much of your available credit you have used, payment history, length of credit history, types of credit, and new accounts and inquiries. They vary slightly because some creditors don’t report to all of the credit bureaus, and some bureaus may have errors on your report. The balance of how these factors affect your score depends on your length of credit history and other factors, and their impact on your score changes as your credit profile changes over time.

Before extending you credit, a lender will not only consider how much credit you have available to you, but also how much (as a percentage) of that credit you are currently using, as this could be an indicator that you are experiencing financial difficulty. For example, if you have a $50k total credit card limit (spread over several cards), and are carrying a total of $20k in balances (40% utilization rate), it will have a negative effect. This is true even if you use your credit cards to earn reward points and pay off the balance in full each month. You want to keep your utilization ratio below 30%, and people with the best scores generally use less than 10% of their available credit at any given time. Of course, lenders take into consideration how much credit is already available to you, whether you are utilizing it or not, because they want to make sure you would be able to afford all your payments if you did choose to use more credit. So, it’s a balancing act.

Avoid late payments. One late payment can hurt your score for more than a year. If you’re out of town or just flat out miss making the payment on time, call the credit card company and ask them to waive penalties and most importantly, not report this infraction to the credit bureau. Consider signing up for automatic payments to prevent this situation. Credit cards and most other loans offer the option of having the minimum payment deducted, and if you wish to pay more or pay early, you may still do so.

The length of your credit history gives a lender an idea of your behavior over time. This includes how long you have had credit, how old your oldest account is, and how long it has been since you used certain accounts.

“Types of credit” generally makes up a small part of your score. This may include installment loans, retail accounts, credit cards, and mortgage loans. Lenders like to use this to gauge how you handle installment vs revolving credit for example.

Credit inquiries hurt your score. When you shop for a mortgage or a car or education loan, those inquiries count slightly against your score. However, multiple inquiries about your credit within a few weeks, typically count only as one “demerit”. Additionally, opening several accounts in a short period generally signals a greater risk to creditors.

Once a year, you can get a free credit report by going to www.annualcreditreport.com. You may order a report from all three bureaus at once, or order one from a different bureau every four months to keep a more diligent eye on your credit throughout the year. Be sure to dispute any errors you find. This will provide details of what’s in your credit file but not your score. If you are planning to apply for new credit in the next year, you should check your score and take steps to improve it if needed. Generally scores over 740 receive the best mortgage rates. (Scores range from 300-850). There are several ways to keep an eye on your score over a period of time. Discover credit cards provide a score for free on your monthly statement, or you can check it any time you log in. You can also get a free FICO report on several websites like Credit Karma, but the score on the free one may not necessarily be the score a potential lender would receive. The same goes for buying your score directly from the bureaus. (There are actually 56 different versions of your FICO score, depending on which software and industry-specific versions the lender is using- auto, mortgage, credit card, etc.) A general version FICO report for one bureau costs $19.95, or $59.85 for all three, and includes ratings for different factors that are helping or hindering your score.

We encourage you to take a look to see where you stand and take steps to maintain great credit scores. Like your other assets, they need to be maximized and protected.