Nov. 29, 2010 -- I check my email regularly and try to provide answers here in my column when somebody poses a particularly good question. Here's one that I know confounds a lot of people: credit scores and why your own isn't higher.
QUESTION: A credit reporting firm is currently reporting my credit score as "790," but they are unable to cite any factors as to why it is not higher. My combined cash credit limits --including all of my bank card accounts-- is nearly $300,000. My combined monthly bank card bills average $6,000 resulting in a very high credit to debt ration of 50:1. I always pay all balances in full on or before due dates --never having a revolving balance. During my entire lifetime, I have NEVER been late on a payment or reneged on an obligation. Therefore, I believe my credit score should be much higher, much closer to the 850 maximum. Is their credit score formulation flawed? How could this otherwise be explained? It is further interesting to me how a credit reporting agency can issue an arbitrary score without knowing an individual's net worth or their ratio of assets to liabilities, and cash flow. These are the real constituents of one's credit worthiness.
~Tom D., Pennsylvania
A: In this tricky economy, lots of people would love to have your problem, Tom. A 790 credit score is outstanding! I will tell you that it is better than my own credit score of 785! But I'm not complaining, because here is the simple truth: as long as you have a credit score of 720 or better, you can get any kind of loan you want and get it for the lowest possible interest rate. It's true that720 is a higher threshold than in the real estate bubble days. After the mortgage meltdown of 2008, the threshold for what is considered "excellent" moved up. It used to be that anybody with a score of 680 or above could land a great loan. In fall of 2008, when credit tightened up, lenders started telling me that now only people with scores of 720 – occasionally 740 —and above could qualify for the best loans.So Tom and folks with credit scores like his can relax. Just keep paying your bills on time and you will always have a solid credit score. But I do have some theories as to why somebody like Tom doesn't score over 800. There are five factors that go into your credit score. Tom has the "Payment history" and "Amounts owed" categories covered because he always pays on time and doesn't rack up too much debt in relation to the amount of credit he has been approved for. But it's possible he could be getting dinged in the other three categories, which are mysterious ones only a statistician would think of. Length of credit history. The inventors of the credit score discovered a correlation between people who have been banking for a long time and people who bank responsibly. It shows stability. The FICO model weighs how long you've had your oldest account and also the average age of all your accounts. This is a frustrating one because you can't exactly control your age and we don't want to start issuing credit cards to two-year-olds. Perhaps Tom canceled some of his older credit cards and opened up brand new accounts instead. That will temporarily lower your score.
New credit applications
The key is not to apply for a bunch of credit –especially credit cards-- all at once. That makes it look like you're about to go on some wild shopping spree, you have a gambling problem or you're financing an independent film or something. Fortunately, credit scoring models look at mortgage and car loan applications differently. It's understandable that people will shop around for these large loans and every application you make in a 14 to 45 day time period counts as just one entry.
Mix of credit
This one is not so intuitive, but apparently people are better risks if they have a combination of revolving loans and installment loans. In other words, it's best to have a mixture: a home loan, car loans and credit cards. Mortgage debt is considered "good debt" since a house can be an investment and is backed up by the piece of property. The thinking on auto loans is that at least the lender vets the borrower more carefully than a credit card company does. Credit card loans get the least respect.
As to Tom's question about how credit scores can be accurate if they don't consider your net worth, it is amazing isn't it? But it's true. Credit scoring has been so successful at predicting whether people will pay their bills that our entire banking system is now built around it. But they're not perfect. Credit scoring models give preference to people who have credit, use it, and pay it off on time. Ironically, that means if you're so rich that you pay cash for everything, you won't have a high credit score. Additionally, young people --even the really responsible ones-- may have low credit scores because of the classic Catch 22: you have to have credit to get credit.
The best way to check your credit score is by buying it directly from Fair Isaac, the inventor of the original credit score that is by far the most used. Click here to visit MyFico.com where you can buy just a credit score without a bunch of other services. There is a $20 charge. (Credit reports are free --Get your free reports at www.annualcreditreport.com-- Credit scores are not.) Checking your credit score and then improving it if you need to is an investment that will save you tens of thousands of dollars over your lifetime. Once your score is up over 720, you're set. No need to become a worrier, like Tom.