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General Credit Information (II) – What are the 5 Parts to a Credit Score?
Using the Components of a Credit Score to Improve Credit Post-Bankruptcy
WITHIN THE FICO® SCORE. A FICO® Score can be broken down into five areas. Though this does not divulge the actual mathematical formula for calculating a score, it certainly provides consumers with enough information to understand what improves or destroys a credit score. This is important. Why? Because consumers can save time and energy by just understanding the basics of credit and credit scoring, versus spending hours researching information that is predominately unavailable.
THE FIVE AREAS OF A CREDIT SCORE. A credit score uses the 4 areas of information discussed above, and merges it into 5 general scoring categories. These categories include 1) New Credit (10%), 2) Types of Credit (10%), 3) Payment History (35%), 4) Length of Credit History (15%), and 5) Proportion of Balance (30%) (information from www.myfico.com). These percentages are averages and will vary depending upon the specific situation of each consumer. The key to improving credit is knowing how to score high in each area. The following pages include a breakdown of each scoring area and tips for improvement.
SECTION 1: New Credit (10%). This aspect of credit captures recent requests for new credit. The score considers how many new accounts have been opened and during what duration of time. Individuals that have multiple credit inquires in a very short period of time may not be as adversely affected for “shopping” for a loan or interest rate. However, individuals that routinely apply for new credit may experience an overall dip in their credit score.
New Credit can be measure from inquires, which serve as fingerprints after a lender has touched someone’s credit. Inquiries remains on a credit report for 2 years, however the FICO® Score only considers inquires within the last 12 months.
There are two types of inquires. A “soft” inquiry is a lender reviewing a credit to solicit business, such as through a credit card “pre-approval” letter. Also, a soft inquiry includes an individual reviewing their own report. This does not count against the score. A “hard” is a request for credit and does count against the score. A credit score temporarily dips with recent hard inquires (credit requests) and newly opened accounts.
Bankruptcy TIP. You have to break a couple of eggs to make an omelet. After the bankruptcy is concluded, get some immediate new trade lines. I’d recommend Vantage West Credit Union or Pyramid Credit Union (assuming they were not a creditor in a client’s case). Both offer “secured” credit cards and I don’t believe they pull a credit reports or care about a previous bankruptcy. Best of all, they will report to all three credit bureaus. That said, any new trade lines will help re-establish credit.
SECTION 2: Types of Credit (10%). There are several types of credit with some more obvious than others. Credit cards are “open ended” tradelines, which means the balance can fluctuate up or down, depending upon payments or charges. There are also installment tradelines, which are “closed ended” tradelines, whereby consumers typically bought merchandise on credit, such as jewelry, furniture, or electronics. Other types of credit include signature (personal) loans, automobile loans, mortgages, and home equity lines of credit (HELOC). Diversity of credit is great for the credit score.
Bankruptcy TIP. Clients should get a couple of SMALL credit cards and close-ended accounts. This is not to be confused with creating new debt issues, but rather responsibly adding some new trade lines to one’s credit report.
SECTION 3: Length of Credit (15%). A longer credit history can increase a FICO® Score. Remember, trade lines report when the account was opened and the FICO® Score determines the average age of all trade lines, coupled with the oldest trade lines. Both factors are important. This portion of a credit score also considers how recently a particular account may have been used.
There are two common methods to take advantage of credit length. First, savvy parents often advise their children to open a couple of credit cards when the turn 18. This gives them the opportunity to learn about responsible credit card usage under parent supervision and to start scoring points for their length of history. Second, individuals can add their names to family member’s trade lines to get these accounts to report on their credit.
Bankruptcy TIP. If a client needs access to a credit card (such as for travel or work), often a client’s name can be added to someone else’s account. This inadvertently allows someone to borrow or import a trade line. My understanding is that credit bureaus do not like this, because it is a very powerful tool to drastically increase a credit score.
Section 4: Proportion of Balances (30%). This aspect of a credit report is very important. It is a calculation of how much money an individual owes, versus their available balance. The amount owed is considered in total of all accounts and also in consideration of each account.
The point of credit is to estimate the creditworthiness of an individual and associated risk. That said, there tends to be only one reason why an individual is overextended on credit cards—financial problems. Beyond open ended cards, installment balances can also have an adverse effect if recently acquired (see “TIP” for more info).
Shuffling debt among credit cards via balance transfers does not help a credit score, since the total debt to total account ratio remains unchanged. However, raising credit limits does change the ratio. Also, debt consolidation eliminates available balances and can adversely affect a score. Finally, the amount owed is reported monthly by most creditors, so paying it off each month may not help a score if the payment is received after the balance was reported.
Bankruptcy TIP. This is easy. The mere filing of bankruptcy and eliminating debts drastically improves a client’s debt-to-limit rations. With establishing new trade lines (as discussed above), keep balances very low or paid off.
SECTION 5: Payment History (35%). Payment history is the most important part of a credit report and the most influential factor in determining the credit score. The credit scores considers recently missed payments, the frequency of missed payments, and the end disposition, such as bankruptcy or settlement. Late payments remain on a credit report for 2 years, but have a diminishing impact on the credit score of over time.
Payment history also includes collection accounts and public records, such as judgments, tax liens, bankruptcy, etc. These records can remain on a credit for 7 -10 years, however, they have an immediate diminishing impact on a credit score and are negligible at best after a year. This is probably the biggest misconception with filing bankruptcy, i.e. a credit is ruined for 7 to 10 years.
TIP. Stay current on any new debt.
Summary. Clients can easily regain a 700 plus credit score post-bankruptcy by reviewing their credit and taking a couple of affirmative steps to re-establish themselves. I would recommend uploading a bankruptcy discharge order to all three credit bureaus and then review their credit reports after a couple of months. Yes, give the trade lines several months to update their reporting. If the trade lines are reporting inaccurately, let our office know and we’ll review it (free of charge of course). We can help assist with disputing any inaccurate reporting. I’d also use this as an opportunity to get Credit Karma and spend some time reviewing the information contained within your report.
Next, I’d recommend getting several new trade lines, keep the balances low and payments on-time. With Credit Karma or visiting other sites to retrieve your credit reports, a client can comfortably watch their credit scores quickly climb. Having the information at your fingertips and monitoring your credit is easier than you think. Best of luck!