How Do You Rate? The Three C’s of Credit
When I was in elementary school, I remember a teacher giving us a weeklong project that was designed to get us to eat a balanced diet from the five food groups. Each day, we were told to eat a certain number of servings from each group and report our diet back to the teacher at the end of the project. I loved that project! I remember eating ice-cream bars for my dairy servings and fat-laden bacon and hot dogs for the meat groups. The project was supposed to teach us how to eat a healthy diet, but the specific information about what really made a good diet wasn’t too helpful.
Well, there’s a similar set of guidelines about credit that have been given out for years. It’s called the “Three C’s” of good credit. The Three C’s of credit evaluation are: character, capacity, and collateral. They are frequently used as the guidelines creditors use to decide when to grant credit.
Character (or “creditworthiness”) refers to how responsible you are about paying your bills. If a lender doesn’t know you, he or she might review your credit report to see how well you have handled credit in the past.
Capacity is your ability to pay a loan based on your money-management skills, income, and financial position.
Collateral is security for the lender if you don’t pay back the loan. Collateral can be the car for which you are taking out a loan, stock certificates, a savings account, your house, or other assets.
The problem with the Three C’s method of credit evaluation is that it’s just too vague. Many loans today are impersonal—the loan officer signing off on the loan may never even talk to the borrower. How can a lender judge your character if you are simply a name on a. piece of paper? Just because you have paid your bills in the past doesn’t mean you will be able or willing to pay them in the future. And what about capacity? You may have enough income to pay the bills today, but what happens if you get sick and face huge medical bills, or what if you get ten credit cards and run them up to the limit tomorrow?
Most people have an idea about how much credit they can handle and what type of credit habits they have. What they really need to know are the specific factors bankers think are important in deciding when to issue loans. Let’s get into the nitty-gritty of credit evaluation and try to figure out why one person can get a walletful of cards while another can’t get a single loan.
What’s in a Score?
Information in your credit report will typically most heavily influence your credit score, though information from your application may also be included in some scoring models. Here are the main components of a credit score, as FICO breaks them down:
Payment History: This usually makes up about one-third of your credit score. Here, lenders look at whether you have paid your bills on time. It includes whether you have past late payments, judgments, bankruptcies, or other negative remarks. Lenders look at both how often you were late as well as how late you were—in other words, were you ninety days late or just thirty days late? They also look at how recent your delinquencies were. Recent late payments can be a particular red flag to lenders: a thirty-day late payment just last month can be more detrimental than a ninety-day late payment several years ago, for example.
Amounts Owed: This makes up another third or so of your score. Having debt isn’t a score killer, lenders just want to make sure you don’t have too much debt. They’ll look at how much debt you have, what types of accounts carry balances, and how many accounts have balances. They’ll also likely look at how much debt you have on credit cards and installment accounts (like car loans) and whether you’ve paid those installment balances down or are just at the beginning of the loan.
Because of the way your credit report is compiled, lenders generally won’t know if you pay your bills in full each month. So, for example, if you charge your daughter’s tuition this month to take advantage of frequent-flier miles and end up with a $5,000 bill that you pay off, that $5,000 balance may be treated as debt you currently owe.
Other Factors: Other factors will play a less important role in your score, but still contribute to it. These include:
Inquiries: As I mentioned before, every time you apply for credit (and sometimes for insurance or a job), your credit report may be accessed. Inquiries don’t indicate whether you were approved, just that your report was reviewed. Generally it’s a good idea to keep inquiries below four to six in a six-month period.
When you check your own credit report, or when your report is screened for a preapproved credit offer (listed as “promotional” on your report), those inquiries are not shown to anyone but you, and won’t count against you. Also, if you are home or car shopping, FICO uses special rules to try to ensure that multiple car loan or mortgage inquiries don’t count against you.
Under FICO’s rules, all mortgage-related inquiries and, separately, all auto-related inquiries within the past thirty days are ignored. Going back prior to that thirty-day period, all mortgage-related inquiries and, separately, all auto-related inquiries within a fourteen-day stretch are treated as a single inquiry. The primary reason for this special treatment is to avoid penalizing consumers for shopping for the best mortgage or auto loan (and likely has to do with the rise in Internet loan-shopping sites). The warning about this policy is that it only applies to FICO-developed credit scores and only if the inquiry can be specifically identified as a mortgage- or auto-related inquiry.
Length of Your Credit History: A long, stable credit history is good, so scoring systems usually look at how old your oldest account is, as well as how old your accounts are on average. Sometimes this factor includes only open accounts, but may include both open and closed accounts.
Another related factor is the types of credit you are using. Having a mix of several different types of credit (a major credit card, retail car, and auto loan, for example) is helpful because it gives the lender more information from which to evaluate your credit.
New Credit: Most scoring systems do look at how many new accounts you have and how many have balances. Running up balances on a few new credit cards can negatively affect your score.
Age can be considered in a scoring system, but with the caveat that lenders cannot discriminate against anyone who is age sixty-two or older. Anyone who is between the ages of eighteen (the age at which one can legally enter into a contract) and sixty-one, however, may find that age is a factor that is considered.
What’s Your Score?
Credit scores were tightly under wraps for years. That changed in 2001 when some companies starting showing credit scores. The truth, however, is that seeing your score can leave you more confused than before.
When scores are created, the factors involved interact with each other. It’s not as if you automatically get ten points for having three credit cards and five points for having six. Instead, the factors are interdependent, making it much more difficult to single out what influenced your score. The same ratio of debt to available credit limits, for example, could have more of an effect on someone with a “thin file” (shorter credit history) than someone with a “thick file”—or vice versa, depending on what the data show. If you hear someone saying that an inquiry automatically means ten points off your score, realize that it’s simply not possible to make those kinds of blanket statements.
Checking your credit report once a year or before a major transaction is always a good idea. You’ll want to make sure that all information on the report is accurate and up-to-date. Checking your credit score is also a good idea. Keep in mind, however, that your score may vary from source to source. In mortgage transactions, for example, it’s not uncommon for a lender to get scores from all three major repositories and use the middle or lowest of the three.