Improve Credit Scores

Five Scoring Elements Dissected (Cont'd)

Credit History

Weighted at 15 percent, credit history is no small thing. For a FICO score to be calculated, your credit report must contain at least one account that has been open for six months or more and at least one account that has been updated in the past six months. The older your credit accounts, the better your score.

1. FICO scoring takes into account both the oldest credit account and the average age of all open accounts, so it makes sense to keep accounts that are in good standing open (unless they are of the subpar variety; see "Types of Credit" below). Closing accounts not only lowers your score by reducing open account history, but it may also affect the "amounts owed" portion of the pie by lowering the total credit available so that remaining balances weigh more in terms of a percentage of the total available credit. If you've already closed some very old accounts, some creditors will permit you to open them back up (under the same account number). Reopening an account that's far older than anything currently open or reopening a couple of old accounts may be worth a try if doing so will increase the average age of all open accounts. Just bear in mind that before reopening your accounts creditors will perform an inquiry, which will put a small downward pressure on your FICO score. Yet the benefit of adding an aged account should override this, especially for those with a sparse or short credit history.

2. Recent activity helps your score, so use your accounts. If you have several revolving accounts, rotate using them every couple of months or so while keeping the balances below 40 percent of the cap or paying them off in full every month.

Are you beginning to see how one of the five scoring elements can affect one or more of the other four?

Types of Credit

The types of credit and creditors account for 10 percent of your credit score. The best scenario is to have a mix of secured and unsecured credit and installment and revolving accounts. Secured credit is simply when collateral is used, such as a house or car, while unsecured credit is when no collateral is used, and the credit extended is guaranteed with a simple signature or promise. The ideal mix appears to be a couple of credit cards and a mortgage or an installment loan on a car.

The quality of the lender also matters. There are captive and general lenders. Auto manufacturers are captive lenders-they loan money on their product only; the FICO scoring model treats them the same as a bank, which is good. Credit from auto manufacturing companies such as Toyota Motor Credit and General Motors is fine. But be wary of outside dealer financing; it's often from a finance company. Finance companies, unlike banks, are general lenders; they loan money on anything and are to be avoided because they will hurt your FICO score.

FICO's scoring algorithm attempts to detect if a consumer is making poor credit decisions-that is, getting poor credit terms such as paying a higher interest rate. It's assumed, with some merit, that consumers who use general lenders are making bad credit decisions, and thus any lender that has "Banc" or "Finance" in its name will lower your credit score.

Appliance and electronics stores are always offering "90 days same as cash," or "no payments for two years." That type of credit is almost always provided by outside finance companies and is harmful to a FICO score. The exceptions are department stores such as Sears and Macy's, which provide branded credit cards using Citibank and Chase Manhattan, respectively.

New Credit

Though it's weighted at only 10 percent, obtaining new credit impacts a score far more than most people realize.

1. Anytime you apply for credit of any kind, the potential lender performs an inquiry. These compound, with each successive one taking more points off your score. Inquiries have a greater impact on those with a shorter credit history and/or fewer accounts because FICO assumes that the newer you are to credit, the more likely you are to overindulge. FICO also claims that those with six or more inquiries in a two-year span are eight times more likely to declare bankruptcy than those with no inquiries (this claim was made prior to the Bankruptcy Reform Bill of 2005 taking effect). Many department stores try to lure you into applying for a credit card in exchange for 10 percent or more off your purchase. Don't do it! Don't apply for any credit unless you absolutely need it!

2. (Exceptions would be the rebuilding of credit, explained later, and those needing to establish credit for the first time.)

3. Some inquiries don't count against your FICO score, including those you perform yourself and those coded PRM (permissible purpose), which include preapproved credit offers, those considered to be "routine account reviews" by existing creditors, and employment-related inquiries. Further, "rate shopping" (going to multiple lenders in search of the best rate on a car or home loan) will only count as a single inquiry if the multiple inquiries were made in the same 14-day period (though each inquiry will still show up on the report). In addition, the FICO score will ignore all inquiries made in the 30 days prior to scoring, so it will be completely unaffected by rate shopping.

4. In 2001, FICO developed a new scoring model called Nexgen. It is supposed to be a more accurate predictor of consumer behavior, but few lenders have adopted it because of the cost involved in fielding the new software. Moreover, lenders are reluctant to adopt something that Fannie Mae and Freddie Mac (explained later in this chapter) have yet to endorse; it took them six years to endorse FICO's original scoring model. Nexgen does a few things better, like permitting 45-day rate shopping verses 14. This is excellent, as it allows those in search of a home or auto to take up to six weeks as opposed to two when deciding on what lender to do business with and not be penalized for multiple inquiries during that period.

5. Each time you actually obtain new credit, it will affect your FICO score, most likely in a negative way. The more new accounts you have relative to the total number of accounts reported, the worse the effect on your score. New credit will be most detrimental to someone with a shorter credit history. If you've had past credit problems, getting new credit will harm your score in the short term, but it will help you in the long run if you get the right type of credit and pay on time. In the best-case scenario, someone who has a stellar record and hasn't applied for new credit in many years (say 10 or 15) can actually boost his or her score by opening up a new account.

6. Unsecured new credit will do more harm than secured new credit. Be cognizant of this, and obtain unsecured credit judiciously.

7. FICO scores both secured and unsecured cards the same way.

When you receive credit card offers, bear in mind that only "preapproved" is preapproved. "Preselected," "prequalified," or similar terms do not mean approved. Even some preapproved offers have additional conditions; read the fine print. Applying for these cards will generate an inquiry that counts against your credit score. Further, auto dealers are notorious for performing inquiries without approval. Don't give them your SSN unless you fully intend to buy a car and are certain to get approval. (You can be certain when you have good credit and your debt-to-income ratio is within their acceptable range.)

People often ask if auto insurers may perform an inquiry on a credit report. They may, unless state law specifically precludes it.² Inquiries will be covered in detail in Chapter 10.


2. Many states have adopted laws that regulate the practice, such as the score not being the sole determinant, as well as disclosure rules. See the National Association of Mutual Insurance Commissioners Web site (www.namic.org) for more information.