Financial Makeover: Credit History Woes
March 18, 2002 -- John is trying to get a home mortgage, but he has some credit issues.
About four years ago, John had three credit cards charged off and sent to a collection agency. Although the collection agencies have not bothered him for a few years, these unpaid accounts remain on his credit report.
Since then, he's had three auto loans and few credit cards for which he has always paid on time. But with a credit score barely in the 600 range, he is still paying extreme interest rates on any loans he gets. Now John wants to know what benefit he gets in settling with the collection agencies for these past accounts and how can he raise his score.
Before making any decisions, John and his wife Joanne should take a good, hard look at their Fair Isaac and Company credit bureau score, also known as a FICO score.
This scoring system, which attempts to predict the level of risk involved with lending someone money, is used by many lenders to evaluate credit worthiness. Commonly, the higher the FICO score, the better the credit.
Most consumers' FICO scores are between 300 and 850, with the median score being 725. With a score in the low 600's, John and Joanne may have difficulty obtaining a loan or getting a loan with above average interest rates because of the risk lenders associate with their score. Preferably, a FICO score should be above 650 to avoid being considered a higher risk for default.
Getting the Facts About FICO Scores
Because these scores are the most widely used and recognized credit rating available, John and Joanne need to truly understand their results.
A FICO score takes into account the following factors:
Credit history Total credit Length of credit history Number of accounts Current debt status — Are you taking on more debt?
A good credit history is the key to a solid FICO score. Primarily, lenders are looking to see if John and Joanne have consistently paid creditors on time and how many accounts have shown late payments. Any outstanding debt — including debt forwarded to a collection agency — will show up on their credit history. This may have a significant and negative impact on their FICO score.
Total credit is another primary concern for lenders. They will look at the total amount owed on all accounts and how many different types of accounts John and Joanne currently have. With this information, lenders will try to evaluate whether or not there is a chance they may become overextended.
These first two areas — credit history and total credit — represent 65 percent of the overall FICO score. The other 35 percent is based on how long credit accounts have been established, how long since various accounts have been used, and how many new accounts have been opened. Lenders will also review the mix of credit types, such as credit cards, retail cards, installment loans, finance companies, and mortgage loans.
Improving Your Score
How can John and Joanne improve their FICO score? After they receive their score, John and Joanne should review the four reason codes that explain their results. Because the first code provided represents the factor with the most negative impact, this is a good place for John and Joanne to start the process of improving their credit.
With their credit history in hand, John and Joanne can also address any existing credit discrepancies and verify that accounts listed on their credit report are accounts they own. If any fraudulent accounts exist, they can work with the credit bureau to potentially remove these accounts from their report.
It is also important to note that lenders use the FICO score as a component in how they set the interest rates they will charge for loans. Therefore, if John and Joanne improve their FICO score, they could reduce their interest rates and be eligible for better loans in the future.
Finally, it is good to review a current credit report at least once per year. For anyone interested in making a large purchase, such as a home or car, taking the time to review your credit is even more critical.
For more information about FICO scores, go to www.myfico.com, or click on the web link on this page.
Hopefully, this first step will help John and Joanne reach their long-term financial goals.
Need to get your finances in order? Apply for a makeover
Brian Reamer is a fee-only financial consultant with SVA Planners in Madison, Wis., the Registered Investment Advisory affiliate of Suby, Von Haden & Associates. He is a member of the American Association of Individual Investors and the Financial Planning Association, an industry affiliate of the National Association of Personal Financial Advisors (NAPFA).