Credit is one of the most critical components in our life, yet the least regulated, and even less understood. More and more, less understood because how you manage your debt affects your credit. Today, credit is measured by a FICO score. It is a snapshot of an individual's credit at any time.
FICO is a very statistically significant predicative indicator of how well you will repay debt. FICO is an anagram for Fair Issac Company. It is essentially an algorithm for the forty-two variables in your credit report. Depending on what version the repositories use, Equifax (version 96), Transunion (version 98), and Experion (FICO 2 '98), you will get a different score. The scores range from approximately 300 to 900 points. The higher the score the lower the risk of default. Below 600 the odds are 8-1 you will be 90+ days late on your mortgage payment. Above 800 and the odds are 1299-1 you will be late.
Scores are based on five main types of credit information. Past payment performance, such as late payment, collections, judgments and bankruptcies, past due amount, and tax liens, account for approximately 35 percent of the weight of the score. Credit utilization or the amount of outstanding debt, weighs in at approximately 30 percent of a consumer's score. The length of a consumer's credit history (how long accounts have been open) accounts for approximately 15% of the score. Inquiries or applications for new credit equal approximately 10 percent of the score. The type of credit (revolving versus finance company accounts etc.) used equals 10 percent. With all these seemingly rigid rules how do you "manage" your credit score?
Well, aside from paying your bills on time, managing your debt correctly is key. The balances on outstanding revolving debt should not exceed 30 percent of the consumer's available credit limit on a particular credit card. High outstanding balances can have a major negative impact on the score, as they represent higher risk than accounts with lower credit utilization. By paying down, but not closing the account the consumer will improve the percentage of current balances to the potential high credit balance. Paying off revolving debt before installment debt will have a more significant impact on raising the borrower's score. Please note, however, arbitrarily consolidating credit balances and closing accounts often will have a negative impact on the score as it skews the picture of a consumer's credit utilization. For instance, your consumer has five credit cards each having a $5,000 high credit limit and four of those cards each have a $1,000 outstanding balance owing. You are using approximately 16% of available credit. Now, you consolidate all of the cards to just one card and close the other cards. Credit surfing for a card with a lower APR? Sounds like a good idea until you do the math and the score goes down. Why would the score go down? You have just done something that artificially skews the percentage of credit utilization from 16 to 80 percent, which obviously represents a higher risk than a consumer using less than 30 percent of available credit.
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