What Hurts, Helps Credit Rating

Thanks to growing pressure from consumers and regulators, you now can learn more about how your credit score is determined. In the process, you may find that many things you believed would help improve your credit may actually hurt. Credit scores can determine whether you can get a loan or a job and what price you pay for insurance. But credit scorers fought hard to keep both the scores themselves, and the formula for determining them, a secret.

In response to growing public pressure, however, leading credit scorer Fair, Isaac & Co. of San Rafael is shedding light on its credit-scoring procedures. The company has posted on its Web site (http://www.fairisaac.com) the relative weights a variety of factors have on your credit rating. These include timeliness of loan payments, amount you owe, length of loan history, breadth of loan history and whether you're opening new accounts at a rapid clip.

Watts further refined what Fair Isaac considers when calculating credit scores. In the process, he revealed that many long-held beliefs about what improves and hurts your score are dead wrong.

And because credit scores--a three-digit number ranging from 300 to around 900--are used by employers, lenders, landlords and insurers, these myths can hamper your ability to get loans, jobs and housing and can boost your insurance rates.

Here are some of the myths and realities of credit scoring:

Myth: Canceling unused credit cards, thus reducing the amount of available credit, will boost your score.

Reality: Canceling cards could hurt your score for two significant reasons.

One component of your score calculates a ratio based on how much you've borrowed versus how much credit you have available. The lower this ratio, the higher the score. Translation: If you have 10 credit cards with an aggregate credit limit of $10,000, but have an outstanding balance of just $1,000, your ratio is just 0.10, which gives you a relatively high score in this area. On the other hand, if you have borrowed $1,000 on one card with a total credit limit of $1,000, your ratio is 1. That gives you a miserable score, Watts says.

Roughly 30% of your credit score is based on this ratio and five other factors related to the amount you owe today versus the amount you initially borrowed. Having several loans that are paid down well below their initial balances boosts your score.

An additional 15% of your score is based on your "length of experience" with credit. However, that experience is measured only by what remains on your credit file. If you cancel your oldest credit cards--perhaps those high-rate cards you've had since 1975--and keep only the newer, low-rate cards, your long history with credit evaporates. This doesn't happen overnight. Generally, information--good and bad--takes seven years to expunge. But over time, canceling old cards will make you look like a relative credit newbie and lower your score. It's better to keep old cards and simply not use them.

Myth: Your score declines if your borrowing exceeds a particular percentage of your income.

Reality: The FICO program doesn't consider your income--at all. This data is not collected by the program. (It also doesn't collect data on your age, assets, marital status, gender, ethnicity or address.)

However, when a lender considers giving you a loan, it will check your income to determine a debt-to-income ratio. Generally speaking, lenders frown on people who have unsecured debt payments exceeding 20% of take-home pay and mortgage loan payments exceeding 30% of net income. Moreover, if you have substantial "available" but unused credit, such as high credit limits on numerous credit cards, they're less likely to extend another loan, fearing that you could become overextended even if you're not now.

Why does it matter that the credit score doesn't take your income into account, even if lenders do?

Because when you're applying for a major loan such as a mortgage, anyone with a credit score above a certain level is considered a no-brainer for approval. But if you drop below that score by even 10 points, the lender must do considerably more underwriting to give you a loan and in the process will hold you to a higher debt-to-income standard.

Moreover, your score is used for more than just loans. For instance, a version of your FICO score is used in calculating auto insurance rates. That score can have a bigger impact on the premium you pay for auto insurance than your driving record, Watts contends.

"We have found from our research that a person's credit history is more indicative of their propensity to file an insurance claim than their driving record," Watts says. "It has to do with human psychology. If you are a conservative person who pays bills on time, you are more likely to maintain your house and keep your roof intact; you are more likely to maintain your health; and you are more likely to maintain your car and be a cautious driver."

On the other hand, your driving record can be skewed by an accident that you didn't cause, or that was the result of bad weather rather than poor driving, he says.

Myth: There are different FICO scores for different industries.

Reality: The FICO score does not have industry-specific versions. The score is generic. But consumers are categorized.

Here's how it works: Fair Isaac's program does a quick preliminary sweep of a credit file to deposit consumers into one of 10 categories before they are rated. The company is not yet willing to disclose what all of those categories are, but they include people with short credit histories; people with "thin" files--in other words, you may have long experience with credit, but you don't have many different types of loans; people with rich files--long and diverse histories with credit; and those with problem files, pockmarked with negatives such as bankruptcies, foreclosures and accounts that have gone to collection agencies, Watts says.

Once consumers are categorized, the program creates a score that's aimed at ranking consumers in the same category, best to worst, based on their propensity to pay back a debt. Again, the company is not yet prepared to say what factors will make one consumer with a bankruptcy more likely to get credit than another with a similar problem.