A happy consequence of this Great Recession is that Americans are widely expected to be better consumers.
That means we'll only take on loans that we can afford, pay off credit-card debt at the end of each month and sock money away. It also means our credit scores will reach what the industry calls super prime, the top score achievable.
Or will they? Turns out our scores are not just a reflection of our ability, or lack thereof, to pay on time, but they tell a story of how we run our lives. If there's a blip in that story, say a 30-day late payment, the red flags pop up and all those years of paying dutifully can fall flat quickly.
Much attention has been focused on credit scores during this recession as consumers have struggled to keep up with their mortgage payments and revolving debt. Many consumers — even those who have long had outstanding credit ratings — have complained that their scores have fallen as credit-card companies slashed limits and closed inactive cards.
But people shouldn't worry so much about their scores, according to experts. "It's less about the score than it is about the information that's contained in the report," said Steve Katz, senior director of consumer education for TransUnion. "The score is only a reflection of what's in the report."
The most important information in your credit report is your bill-paying history. It bears repeating: Pay your bills on time every single month. A whopping 35 percent of your FICO credit score is tied to that payment history.
Another 30 percent of your score is based on your outstanding debt. Lenders expect you to use credit cards but to do so prudently. If you have three credit cards with a total of $30,000 in available credit, they will look at how much of that you're using. That's called your utilization rate. Don't max those cards out. In fact, don't even come close to it.
Figuring out your utilization rate is easy math. Add up all your outstanding balances and divide by your total credit limit, which should produce a number less than 1. If it hits 1, you're maxed out.
Most credit experts, including the credit bureaus, will advise you to keep your credit utilization under 30 percent of the total limit.
But here's a secret: Make sure you do it for each card. If you exceed that threshold on one card — say you use 70 percent of that limit but only 10 percent on another card and nothing on a third card — you're under 30 percent of the total limit, but you'll still get dinged for using so much of the limit on the first card.
How much of your limit you use in any given month can turn the tide on your card. If, for example, you max out your American Express card every month but pay it in full, you can still get slammed for hitting your limit. The credit card companies don't report if you've paid off your card; only how much you spent.
"Whether you pay in full or not is not relevant," said Maxine Sweet, vice president of public education at Experian. "If I charge $5,000 this month, the credit history is not going to know if that $5,000 is part of a longer-term bill or not.
"From a scoring standpoint, what's important is: How does my balance of $5,000 compare to my total credit limit?" she said.
Also, some 15 percent of your score is based on your credit history, which doesn't bode well for college graduates just getting on the bandwagon. But if you've been managing your credit well for a couple decades or more, chances are your numbers are pretty lofty.
But remember this: The higher you climb, the further and faster you fall. If you've been doing a stellar job of managing your credit for 20 or 30 years and one month you miss a payment — say, you landed in the hospital with a bad leg break — not only do the red flags go up but the warning sirens go off at full blast. You automatically get put into a much riskier credit category than the neighbor who tends to be a bit late on his monthly payments.
Seems unfair, you say? It's because you're exhibiting uncharacteristic behavior. The system reads that as something is wrong, so wrong that you now might not be able to pay your car loan and the department-store credit card on time.
Craig Watts, public affairs director at FICO, which produces credit scores, described it metaphorically as this: You're the perfect angel of a child during all of grade school and junior high, but then you get to high school and discover partying is not the bad thing your parents said it was. You become so good at it that your angelic history is now mud.
"Your reputation is suddenly skewed heavily to the left," Watts said. "It will take time to restore that pristine reputation. The same thing happens with credit risk and credit score."
The lesson here: Your credit score is your credit reputation.
Here's another thing you probably didn't know: Many banks rely on a proprietary statistic known as the odds-to-score ratio that has more to do with people like you than you alone. It tells lenders what the likelihood is of a 90-day delinquency based on what your score is.
For example, a FICO score of 780 tells a lender that for all the consumers in his marketplace with a score of 780, one out of every 400 will become 90 days late in the next two years, meaning your odds-to-score ratio is 400-to-1. The ratios fall in tandem with the scores.
Your credit scores are also affected, though less so, by your pursuit of new credit. And they are a catch-all of your history.
"Everything in your credit history will have an impact," Sweet said. "A credit score will have many factors and considers every element in the credit history."
When you actively seek new or more credit, your rating gets what's called a "hard inquiry" that pares a few points off your score. When the banks check your credit — most of them do it every 30 days — that's considered a "soft inquiry" and won't affect your rating. Same is true for mailers with pre-approved credit lines.
"Don't apply for too much credit in a short period of time," Katz said. "You start to look credit-hungry, and each one of those applications triggers an inquiry. Three or four in a short period of time start to add up."
The type of history you have also shows up in your scores. Banks typically like to see that you have a good track record with revolving credit and installment loans.
"A good mix of credit can be useful to your score, but not so useful that you should open a credit card to get it," Watts cautioned.
Given all this, it might be hard to swallow that credit scores are actually a good thing for consumers. They're discriminatory for sure, but on risk, not on race, age or gender.
"It's the kind of tool that the courts and government have favored because by design it doesn't discriminate in an unpalatable manner," Watts said.
Finally, should you be checking your credit score regularly? The answer is: It depends. There are services you can sign up for that will track even the tiniest of changes to your score, for a fee.
TransUnion's Katz said everyone should know what their score is at all times. "Your accounts are being updated by your creditors every 30 days," he said. "You should know what they contain because it can change."
But Experian's Sweet, who has a regular check on her score, doesn't think it's necessary to be obsessive about it.
"People are chasing their score too much," she said, adding that consumers should spend more time understanding how their credit actions affect their scores. "You have to be educated enough to know what is in your credit report and how it is scored."
FICO's Watts said you should simply be financially fit. "Rather than micro-manage your FICO score, it's way easier to adopt careful management habits," he said.
"If you do that and your score is high, like the upper 700s, you don't have to worry about dings if you close an account and open another one. Who cares?" he said. "Don't worry about the little stuff."
And don't forget the good news: credit scores are salvageable.
"The worse the situation, the longer it's going to be to recover," Watts said. "A bankruptcy or foreclosure will take several years to fix. But the nice thing is your score can recover," he said.
"Bankers have come to respect the fact that people do learn new rules, and that many can go through difficult times and become good borrowers again."
Jennifer Waters, RISMEDIA, May 18, 2010