Sometimes the things we hear about credit scores end up being like when a story gets exaggerated from person to person. You know, like that time you saw a spider the size of a quarter in your shower, but when you told your friend about it — it was the size of your hand…
A lot of it is misinformation, to begin with, but when presented alongside fear-based sales tactics… the truth becomes pretty skewed.
Today I’m confronting some of the urban legends you may have heard about credit and presenting the truth, the whole truth — and nothing but the truth.
Let’s begin the debunking process by laying all the cards out on the table…
Key terms we need to know:
Credit score – The numerical expression of your creditworthiness that banks use to loan out credit. Banks and credit companies have developed algorithms that use this number to determine how likely you are to repay on a line of credit.
FICO – aka Fair Isaac Corporation. I hear you, “Okay great, who’s Fair Isaac?”
Quick history lesson! (trust me, this is important!) Back in the 1960s, Fair Isaac literally pioneered a revolution by creating credit risk scoring for the financial services industry. His new system allowed businesses to properly analyzing risk on loans, and also expanded consumer’s access to credit. Quite literally, a game-changer. Pretty cool how to see how far “being ahead of the curve” catapulted the Fair Isaac Corporation, as Fair Isaac’s FICO score is widely recognized as the industry standard for lenders!
“Free Credit Report” – This type of report that you can pull from home is provided by a company called Vantage. Their business model tried to compete with FICO by providing transparency to consumers, allowing them to see their credit scores and what was affecting them in (relatively) real-time. However, FICO and Vantage are two separate companies… with two separate algorithms for determining your “credit score”. This is why often times your credit report that you pull does not match your FICO score when applying for a loan!
Hard Credit Pull – A request for credit the releases your official credit score
Soft Credit Pull – This report basically just shows what’s there on your credit report. (ie: payment history, current lines of credit, outstanding balances, etc.)
Alright, now that we are experts in credit terminology let’s get to the good stuff: the truth!
So what makes up your credit score anyways?
30-35% CREDIT HISTORY
This typically has the biggest effect on your overall credit score. How long have you been making on-time payments? The better your payment history the better your score. Makes sense.
30% YOUR AVAILABLE CREDIT
This is how much you owe based on how much is available to borrow. What lenders are looking for is no more than 30% of your available balance to be borrowed at any given time.
15% LENGTH OF TIME
How long have you had a history with lines of credit? Months? Years? A longer exposure to credit (with on-time payments) will help boost your score.
What types of credit loans make up your credit history? (ie: Installment loans, long-term loans, short-term loans, credit card debt, etc.) Many credit users benefit from having a diversified credit profile.
Less than 10% NEW CREDIT AND INQUIRIES
This is the item I swear that gets the most media attention, and it actually has the lowest impact on your overall score. Since a new line of credit doesn’t showcase your good behavior to a potential lender, it’s kind of just a big question mark. Why was this line of credit opened? Will you continue making the payments on time? Since there is some question here, it does mean more risk for the lender — which is why it affects your score negatively.
As far as inquiries go, you will often you’ll hear loan providers, well-meaning friends, or family tell you that if you shop your home loan, your credit score will drop! While this is true, some salespeople will use this more as a scare tactic to prevent you from doing your research. Multiple inquiries (3-5 credit pulls) for the same installment debt will count as one inquiry and will not have an impact on the score, so long as the “shopping” is done within 45 days. Inquiries will show on a credit report for a maximum of two years, and only impact your credit for 1 year. Typically, it will only drop your score if you have 6+ different credit pulls for various types of credit lines as some statistics correlate this many credit applications with a greater risk for bankruptcy.
My advice? When you’re pursuing a home loan, work with a reputable lender who can help you maximize your buying potential. Start shopping for a rate within 30 days of your home purchase, as this should keep everything under the “45-day” umbrella!
I hope you learned something you didn’t already know about your credit! Why? Because it’s YOUR credit! And my goal is to empower you by giving you the knowledge to make smart financial decisions. Are there any other urban legends that you may have heard about credit that you’d like me to address? Let me know in the comments below!