Yesterday, I wrote about Credit Reports and Child ID Theft and since then several people have asked me to clarify exactly where their credit scores come from and how to build good credit.  So here goes…

The first step one might take is to obtain a current credit report tri-merged with scores from all three major credit reporting bureaus: Equifax, Experian & TransUnion.  Don’t worry; your score is not affected when you check your own credit report.   However, given recent mortgage market and interest rate trends you may want to consider having your trusted Mortgage Planner pull your credit and conduct an analysis for you.  Most mortgage loan officers will do this for free and who knows, maybe you will also be able to save some money with a refinance of your current loan!  Otherwise, ordering your credit report may cost you around $35 or using a credit monitoring service could be as high as $25-50 per month.

I’ve found that most consumers do not know how their credit score is figured out.  It is not the most difficult thing in the world of finance, but what makes it a little hard to understand is that it can constantly change every month based on your debts, payments and credit activity.

Your credit score is based on 5 primary factors:

The type of credit that you have makes up about 10% of your credit score. The bureaus look at is how many accounts you might have and whether they are installment based or revolving.  Having too little or too much could hurt your credit score.

Your payment history represents the majority or 35% or your score. Creditors want to see how well you pay your bills each month. Your Credit Score is affected by how many bills have been paid late and how many were sent out for collection, charged-off or are in judgment.

The next biggest factor or 30% of your score is based on your current debt. How much you owe on your home, on your car, on your credit cards, etc. The ratio of current debt to available credit limit is very important and can affect your ability to obtain future credit offers such as a mortgage refinance.  I generally recommend that consumers keep the debt-to-limit ratio below 25% for each account … and more-over, the debt-to-income ratio well below 40%.

The next 15% of your credit score is based on the length of time you’ve had credit.  The longer your accounts have been open, the longer your creditors will have to judge how you do making your payments.  They view your past payment history as a pretty good indicator of how you will do going forward.  A good tip is to open them early in life and then maintain them in good standing over time.  Or in other words don’t close an account just because you haven’t used it in a while.

Finally, the last 10% of your credit score is determined by the number of inquiries on your credit report. If you apply for a lot of credit cards, department store cards or loans, these finance companies will check your credit report and show up as inquiries. Credit inquires hurt your credit scores because they signal that you may have financial trouble or that you are planning on adding new liabilities and more debt. The more recent these inquiries, especially within the last 90 days, the more they can damage your credit score.

Inquiries are often referred to as either “soft or hard” and sometimes as “firm.”  A Firm Credit Offer or Hard inquiry can possibly lower your score by as much as 4 to 8 points.  One strategy that should be employed is to OPT OUT of pre-screened credit and insurance offers.  I’ll address this issue in my next blog.

In the end, know that good credit equals good credibility in the eyes of those whom you do business with.  Finance companies are not the only ones checking credit reports these days.  It has become commonplace for employers and insurance carriers to also check credit reports.  So be mindful of your good credit standing, teach this lesson to your children and bring it up as a topic of conversation during your next meeting with your trusted Financial Advisor.

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