Financial Planning Tips: Credit Score Explained

Financial Planning Tips: What is a Credit Score and How is It Calculated?

credit-score-financial-planning-tipsYour credit score is a three-digit number derived from detailed information from your credit history that summarizes your credit risk—in other words, it helps lenders analyze how likely you are to pay back your credit obligations as agreed upon. For financial planning purposes, understanding what your credit score is, how it is calculated, and how you can improve it are essential. After all, your credit score can have a massive impact on financial planning, your financial options, and current and future financial livelihood.

The most commonly used credit scores are FICO credit scores, which are the credit scores created by the Fair Isaac Corporation. In the U.S., FICO credit scores are used in over 90 percent of lending decisions, assisting lenders with making billions of credit-related decisions each year.[1] Your base FICO scores ranges from 300 to 850 and the higher your score, the better off you’ll be as it indicates to lenders that you are lower risk. There is neither a certain score that indicates whether a person will be a “good” or “bad” customer nor is there any specific, industry-standard “cutoff score” used by lenders; however, individuals with a credit score of 740 or higher will typically be entitled to the best interest rates.

How to establish a credit history?

At age 18, most people first become eligible to apply for credit. But contrary to popular myth, you don’t magically get a credit score and credit report just because you are 18. To the contrary, we all start out with no credit score at all, since credit scores are based on the information on our major credit reports and these reports are not even created until you have had credit (i.e., a loan or a credit card) for at least six months. According to FICO, in order to receive a valid FICO credit score, your credit report must have:[2]

  • At least one account that has been opened for a minimum of six months,
  • At least one account that has been reported to the credit bureau within the past six months, and
  • There is no indication of “deceased” on your credit report. While you may be alive, this can be an issue if you share a joint account with someone who died. You may have to close the joint account before your credit report and score can be generated.

How is your credit score calculated?
credit-score-financial-planningYour FICO credit score is calculated using a scoring model that incorporates many different pieces of credit data on your credit report. However, there are five main categories of information that your FICO score considers and each of these five categories of credit score components have different relative weights (expressed as percentages)[3]:

  • Payment history (35 percent): FICO scores consider how you’ve paid your bills and past credit accounts in the past. Have you ever been late or missed a payment? How recently? How often? How much was owed? On how many different accounts? FICO will also consider public record and collection items; negative factors include: bankruptcies, foreclosures, lawsuits, wage attachments, liens, and judgments.
  • Amount of debt (30 percent): FICO scores consider: total amount owed across all accounts; amount owed on specific types of accounts; the number of accounts with a balance; credit utilization ration (how much of your available credit you’re using) on revolving accounts; and remaining amount owed on installment loans.
  • Length of credit history (15 percent): FICO scores consider: the age of your oldest account; your average account age; and the age of specific types of accounts (i.e., credit cards, auto loans, and etc.).
  • New credit (10 percent): FICO scores consider: the number of new accounts; how long it has been since you opened a new account; how many recent requests for credit you’ve made; and whether or not you are rate shopping for a single loan.
  • Credit mix (10 percent): FICO Scores consider: the different types of credit accounts being used or reported, including credit cards, retail accounts, installment loans, and mortgage loans. How many total different types of accounts do you have? Do you have a good credit mix that relies on multiple types of credit depending on the purpose of the credit (i.e., not using a credit card to buy a boat)?

The three major credit bureaus and understanding credit score differences among the bureaus

You have a FICO credit scores at each of the three major national credit bureaus: Equifax, Experian, and TransUnion. Your FICO credit score may be different at each of these three bureaus, sometimes varying by as much as 50 points. This variance among the credit bureaus can happen for a few reasons including:

  • The credit scores are pulled from different dates. Your credit score can change at any time. As such, if each bureau pulled your credit score at a different date, you could wind up with different scores at each bureau.
  • The credit score was calculated using a different scoring model. Even if your credit score was calculated using the same scoring model, each bureau may store information or calculate your score in a slightly different manner thus leading to a variance in your score among the three credit bureaus.
  • Each credit bureau may not have the same information regarding your credit history. The information on your credit report is supplied by lenders, collection agencies, and court records. Since each bureau sometimes receives information on you from a slightly different network or lenders or receives such information on a different recording time table, your credit score may vary among the three bureaus accordingly.

Your credit score is not static

Your credit score is not set in stone—it will fluctuate up and down depending on your financial behavior. If you are unhappy with your current credit score, the good news is that it is possible to raise your credit score. However, somewhat analogous to losing weight, reaching your goal will take persistence, consistency, and time. While raising your credit score after a poor mark on your credit report or building credit for the first time will take patience and discipline, the financial advantages you can reap from having a good credit score will make the effort well worth your while.

Your credit score and credit history is a significant topic in financial planning that can’t be adequately covered in just one blog post. Accordingly, check back on the Summit blog soon for more financial planning tips regarding your credit as well as blog posts on the importance of having good credit, ways to destroy your credit score, ways to increase your credit score, common credit report errors, and how to dispute errors on your credit report.

For more information on Summit Brokerage Services and our independent financial advisors, visit www.joinsummit.com or contact us at (800) 354-5528.

 

About Summit Brokerage Services, Inc.

Summit Brokerage Services is part of Cetera Financial Group. Summit Brokerage provides a broad range of securities brokerage and investment services to primarily individual investors. Summit Brokerage also sells insurance products, predominantly fixed and variable annuities and life insurance through its subsidiary, SBS Insurance Agency of Florida. Summit Brokerage also provides asset management services through its investment advisor, Summit Financial Group, Inc.

 

About Cetera Financial Group

Cetera Financial Group® (“Cetera”) is a leading network of independent retail broker-dealers empowering the delivery of objective financial advice to individuals, families and company retirement plans across the country through trusted financial advisors and financial institutions.  Cetera is the second-largest independent financial advisor network in the nation by number of advisors, as well as a leading provider of retail services to the investment programs of banks and credit unions.

Through its multiple distinct firms, Cetera offers independent and institutions-based advisors the benefits of a large, established broker-dealer and registered investment adviser, while serving advisors and institutions in a way that is customized to their needs and aspirations.  Advisor support resources offered through Cetera include award-winning wealth management and advisory platforms, comprehensive broker-dealer and registered investment adviser services, practice management support and innovative technology.  For more information, visit www.ceterafinancialgroup.com.

*”Cetera Financial Group” refers to the network of retail independent broker-dealers encompassing, among others, Cetera Advisors, Cetera Advisor Networks, Cetera Financial Institutions, Cetera Financial Specialists, First Allied Securities, Girard Securities, The Legend Group and Summit Brokerage Services.

 

 

[1] CEB TowerGroup analyst report, May 2015. © 2015 The Corporate Executive Board Company.

[2] http://www.myfico.com/CreditEducation/questions/requirement-for-fico-score.aspx

[3] https://www.myfico.com/Downloads/Files/myFICO_UYFS_Booklet.pdf

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