As we continue to experience credit challenges in today's market, it's important to be able to educate your clients as much as possible.  And some of the most common misunderstandings out there revolve around credit scores.  So here is information you can pass along to your clients in a concise, easy to understand way!

First, there are three main credit bureaus, Transunion, Equifax, and Experian.  In a mortgage application, we will use the middle score (not an average, but the middle score) of the lowest scored applicant on the application.  Credit scores can vary widely between the bureaus as each of them have different formulas that they use.  So what goes into those numbers?

Your credit score consists of 5 main categories:

Payment History, Amounts Owed, Length of Credit History, New Credit and Types of Credit.  For the average person, the percentages look like this:

Chart courtesy of www.myfico.com 

Your payment history looks at both the positive and negative sides of how you've paid your bills in the past.  For instance, if you have never missed a payment, this 35% of your score will be fantastic.  If you miss a payment, it counts less and less against you the further away that late payment is.  For instance, a late payment this month will drag down your score much more than a late payment two years ago. 

The second biggest category is amounts owed.  This is where people tend to hurt themselves when they don't understand credit scores.  If you have two credit card accounts both with $5,000 limits and on one of them you carry a $4,000 balance, you are using only 40% of your available credit.  That's not bad.  But what happens if you cancel the other account since you're not using it and it doesn't have a balance?  Now you're using 80% of your available credit.  That's a big red flag!!  So keeping your accounts with zero balances open is really a positive thing. 

Doing that also helps with the 3rd largest percentage item, length of credit history.  Think of this category like a bank would.  If you were a bank lending your money, would you want to lend it to someone that has had credit for 25 years or someone that's had one credit card open for 6 months?  Exactly, I'll take the person with the track record please.  That's why this is a critical part of the credit score. 

The 4th category is new credit.  In general, the credit score will dip immediately upon opening up a new account until a track record is proven on the account (typically the score will improve back to 'even' after 2-3 payments on the new account).  This is also a part of the credit score where people can really have a negative impact on their score even though they're putting themselves in a better position.  Let's say you get that attractive $5,000 balance transfer offer in the mail.  And you have a $5,000 balance on a card.  So, you open the new account and transfer the balance.  Well, it's good for you (better terms) but bad for your score!!  Why?  Again, think like the bank.  All they see is that you just opened a new account and bam!, the card is maxed out immediately.  This could be seen as though you're living off your credit cards!  (And even worse, most people cancel out their old account which gives you a double whammy to your score!!)

Finally, the types of credit are also a part of your score.  Lenders (especially when related to a mortgage application) want to see that you've been able to handle different types of credit.  So preferably, there's a mix of credit cards, auto loans, prior mortgages, student loans and sometimes utility accounts to show that you make sure to pay all of your accounts on time. 

Of course, there are also other minor factors that play into the score, but this gives you a basis of understanding you can share with your clients.  Most importantly, you can see from this explanation that it's not just about paying your bills on time.  It takes into account a host of other factors to help arrive at that mysterious number, your credit score!