Don't Be a Fool - Understanding How Credit Works is the Best Way to Higher Credit Scores

alt Anyone who has ever applied for a home mortgage or an auto loan knows that their personal credit score is the single most important factor in determining first if they qualify for a loan and, if so, what type of loan they get and what rate of interest they pay. That's because a credit score calculates the probability that an individual borrower will actually make their payments on time.

Credit scoring was first introduced in 1958 by the Fair Isaac Corporation (FICO), and for more than 35 years, the FICO score was the key indicator used by lenders across the U.S. Then in 1995, Fair Isaac developed business credit scoring to address the growing small business lending market. Most banks now use some form of credit-scoring model to determine commercial loan decisions. The primary source for business credit scores is Paydex from Dun & Bradstreet.

Most banks and investors will use both the FICO score of the business owner and the Paydex score of the business to determine whether you get a loan and on what terms. What is evident, however, is that if you don't understand the credit scoring systems, your scores are likely to be less than you may want or need.

FICO Scores

To come up with a FICO score, Fair Isaac uses 22 different pieces of data collected from the three major credit reporting bureaus - Equifax, Experian and TransUnion. Credit scores range from 300 to 850. People with scores below 600 usually struggle to get credit. Those with scores above 740 receive the best rates on loans.

There are five factors that determine your FICO score:

Your payment history makes up 35 percent of your FICO score. Late payments incurred within the last 6 to 24 months have the greatest negative impact on your credit score. Any late payments over 24 months old have very little impact on your score.
Outstanding balances make up 30 percent of your FICO score. Your credit rating is determined in part by your outstanding debt. Revolving lines of credit, like credit cards, must be kept below a 30 percent utilization rate. Accounts above the 30 percent utilization rate will negatively affect your score. That means that if you have a $10,000 limit on your VISA card, you must keep your total charges under $3,000. Even if you pay off your balance every month, if the balance is above the 30 percent on the day your credit report is pulled, your score will drop precipitously.
The length of time you have had credit makes up 15 percent of your score. Your credit rating is directly linked to the roots of your credit history. The longer your history of good - standing credit is, the higher your credit rating. Don't ever close a credit line with a good history rating. If you have an older credit card you don't use often, keep it, use it periodically and pay it off so it will remain active and in good standing. Conversely, opening new credit cards will lower your score so be very careful before applying for new lines of credit.
The types of credit you have make up 10 percent of your FICO score. Credit bureaus award higher scores to people with at least three revolving accounts. Ideally, the bureaus want you to have three to five major credit cards from American Express, VISA, MasterCard and Discover. Retail cards like Macy's are not favored. If you have too few cards, the bureaus will not have sufficient proof that you can properly manage multiple accounts. Too many cards and the bureaus may think you have too much opportunity to extend yourself.

Also, have at least one installment loan on your credit report that requires payment within 30 days of purchase. Never apply for a loan that delays payment beyond 30 days. It will damage your score.
The number of credit inquires you have makes up 10 percent of your score. Your credit history plays a part in the impact the number of inquiries will have. For most people, one additional credit inquiry will take less than five points off your score. Ten or more inquiries can impact your score. Also, inquiries can have greater impact if you have few accounts and a short credit history. But you are not docked for pulling your own credit reports, which are call "soft" inquiries.

According to financial experts, there are a few other tips that can help your score.

First, get rid of credit cards that have "Universal Default" clauses. Nearly half of all credit card issuers include this clause in the fine print of your credit card application agreement. What this clause states is that your creditor reserves the right to penalize you with an increased interest rate if you pay any of your creditors late. You can accidentally forget to pay another credit card company on time, and the result can be an increase in your credit card interest rates up to 20 or even 30 percent. It also will lower your credit score on the credit card.

Second, pull your credit report at least quarterly not only to check for errors, but also to make sure that your credit card limits are being reported accurately. If a credit limit on one of your credit cards is reported as "0", for instance, any amount of charges you put on the card will place you above the 30 percent utilization rate and will damage your credit score.

Finally, never pay off a credit from a collection agency before you negotiate for a letter of deletion. Paying a bill that has been turned over for collection can actually be more damaging than ignoring it. Each time you make a payment, you restart the time period that the item will remain on your credit report. Rather than making payments, arrange to make payment only when they agree to remove the item from the record.

Business Credit Scores

While the uses of credit scores are similar in consumer and commercial lending, the scores are determined in different ways. While individual scores take a number of factors into consideration, the Paydex system looks at only one thing: whether a business makes payments on time and meets creditors' payment terms.

Paydex scores range from 0 to 100. A score 80 means the business meet creditors' terms and pay on time. Anything above that means they pay bills before they arrive or during the early payment discount periods. A business credit score of 70 means you're paying your bill 15 days late; with a score of 50 you're 30 days late.

To establish a Paydex score, apply for a D-U-N-S number - a nine-digit business identification number - and use it to establish a small line of credit with a company that reports to Dun &Bradstreet. After you've placed several small orders with your personal credit card to establish a record, use your D-U-N-S number to apply for a business line of credit with them.

Establishing a business line of credit is different than the procedure for a business credit card. The application process for a business credit card generally requires owners to pledge their personal assets, so obtaining a card requires owners to have good individual credit.

Once you've established a Paydex account, it's important to keep it active. They want to see continuous good activity. Your score will drop if you don't use it. Also, inquiries made on your credit report will lower your score, so keep that in mind each time you consider applying for new credit.

For more information on business credit scoring or joining the Paydex system, go to www.dnb.com .

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