Deciphering Your Credit Score
Every part of the decision making process when determining whether to extend credit to a borrower revolves around their personal credit score. Deciding whether to extend credit is not the only decision that is impacted by this financial fact of a consumer’s life. The lower the credit score, the higher the risk factor, which translates to higher interest rates and insurance premiums.
Personal credit scores are complicated, and our current system is stacked against the consumer. It can take years of well-disciplined borrowing to establish a good score and that score can be dramatically reduced from one unfortunate incident in the life of a consumer.
Personal credit scores typically range from 350-850 with a good score usually starting at 750 and a marginal score starting at 700. Most people are not aware of what a difference a few points can make for their everyday lives. To give you an idea of what I am talking about let’s assume that our sample consumer is a homeowner. If his or her FICO score drops to 650 instead of being in the marginal range at 700, it will have a significant impact on their monthly and annual financial picture. A consumer with a FICO score of 650 or below can expect to pay higher insurance premiums and higher interest rates on their home, car or other credit accounts. On average they will pay a combined total of $758 more per month on these items than a consumer with a FICO score of 700. That is an annual expense of $9,096.
In trying to understand this complicated representation of our credit worthiness, let’s consider the different ingredients that make up a consumer’s personal credit score. There are 5 main components to a consumer’s FICO score: Payment History, Available or Unused Credit, Length of Credit History, the number of Inquiries that have been made in a given time frame and the Credit Mix or the types of credit.
Payment history is pretty straight forward – have you made your payments in a timely manner? Have you been late and if so, how often do late payments happen?
Available or Unused Credit can be deceiving. A FICO score factors in how much of your available credit have you used and what percentage is still available.
Length of Credit History plays an important role because it gives a picture of how long you have managed or mismanaged your credit. A consumer with a longer credit history and a good payment history will be considered a better credit risk.
The number of Inquiries in a given period of time gives a picture of the how active you have been in your request for credit. This can also indicate if someone has been illegally using your personal information to try to open credit in your name.
Credit Mix is an indicator of the types of credit accounts you have open or have had open in the past. Revolving credit accounts are different from fixed-payment accounts because you can continually add to revolving credit accounts as long as you stay below your set credit limit or maximum.
So what part does each of the components of a credit report play in determining whether a consumer is a good credit risk or a poor credit risk?
Payment history 35%
Available Credit 30%
Length of credit history 15%
Inquiries 10%
Credit Mix 10%
These percentages come into play especially when a consumer is on the edge of a decision for approval or being declined. Suffice it to say that it is important to keep a close watch on your credit report and score through consistent monitoring.
Doug Smith is a 40 year consulting veteran in the small business and franchising arena and spends his time helping entrepreneurs understand the implications of lending and helping them secure the right lending product mix for their business or franchise project. He is the founder of Biz Finance Solutions – www.bizfinancesolutions.com. Besides providing both traditional and non-traditional approaches to business finance, he helps new and existing business owners establish business credit solely in the name of their business and helps those whose credit score has suffered in the current economic climate get on the right path for credit repair and improving their credit score.