Demystifying your credit scores

From MSN.com, 8/10/2011 1:44 PM ET
|By CardRatings.com

Understanding how your scores are determined can help you find the credit card that best suits your needs. Consider these 8 possibilities.

Credit card issuers make fast decisions, bolstered by credit scores that boil down the last decade of your financial history into a three-digit number. A difference of a few points can upgrade your credit card rewards program or eliminate a balance transfer fee. However, few of us take the time to understand where our credit scores come from and how they affect our selection of credit card offers.

Who Determines Your Credit Scores?

Until recently, only FICO issued authentic credit scores. When you apply for a loan or a line of credit, your potential lender collects information on your credit history from one or more of the three major credit-reporting agencies (TransUnion, Experian and Equifax) and plugs it into FICO’s proprietary algorithms, or a variation sponsored by the lender’s preferred credit bureau.

The FICO system weights your credit history based on the information available, usually just the sources to which a particular bank subscribes. Because banks may subscribe to as many as four different credit-scoring systems, credit report accuracy across multiple bureaus has become essential for effective personal finance management.

How is your FICO score calculated?

According to FICO, five elements make up your credit score:

  • Payment history (35%)
  • Your credit utilization, or how much of your credit you’re actually using (30%)
  • Length of your credit history (15%)
  • Recently issued credit (10%)
  • Types of credit used (10%)

Experian launched its VantageScore algorithm as an alternative to FICO, with a few tweaks to the traditional model that emphasize available credit and your overall debt load. TransUnion and Equifax use their own versions of credit scoring, and all three credit bureaus assign “letter grades” to consumer credit profiles. (Know your score? Take this quiz to get an estimate.)

How do Banks Rank Credit Scores?

Finding the best credit card often means having to know where your credit scores fall on the spectrum of typical consumers. Over the past few years, lenders have ratcheted expectations skyward. Before the financial crisis of 2008, many banks considered a 680 FICO score “good.” Today, it’s just “fair.” Research from FICO, Experian and Informa Research reveals how banks look at credit scores today:

  • Excellent: 760-850 on FICO, 900-990 on VantageScore or an “A” letter grade.
  • Good: 700-759 on FICO, 800-899 on VantageScore or a “B” letter grade.
  • Fair: 620-699 on FICO, 700-799 on VantageScore or a “C” letter grade.
  • Poor: Below 620 on FICO, below 700 on VantageScore or a “D” or “F” letter grade.

You may also have heard a bank representative or a mortgage broker note that you’ve got a “thin credit file.” That just means your limited credit history makes it hard for a credit card issuer to figure out whether you’re a good risk. Building a track record with a student credit card or secured credit card usually improves your score over time.

Best-Rated Cards for Each Credit Score Range

The best-rated credit cards in each category reveal how lenders view each group of consumers. As risk increases, so do finance charges and fees. Bank managers often rely on the aspirational nature of credit card brands, hoping that you’ll settle for a deal in the category just below your current score range. To help you get started, here are eight popular credit cards (two in each category) that have a reputation for fairness based on acceptance, finance charges and rewards. (Find a better credit card.)

Excellent Credit

The best credit card companies save their most impressive offers for consumers with high FICO scores. Banks assume you’ll pay your bills on time, rarely run through more than half of your available credit and rack up lots of big-ticket purchases that earn them some tidy fees from merchants.

  • Capital One VentureOne Rewards Credit Card. This souped-up version of the popular Venture card carries no annual fee and a crazy balance transfer offer with no transfer fee.
  • Chase Freedom Visa. Its television ads only slightly exaggerate reality: Chase practically falls over itself trying to give free money to cardholders with excellent credit. This all-purpose card boasts a strong balance transfer offer, plus special cash bonuses and rebate opportunities throughout your first year. If you travel frequently, you might get even more value from a Chase Sapphire Card.

The best credit card offers for excellent credit change often, especially when banks try to poach each other’s high-value clients at the end of each quarter.

Good Credit

Under recently revised credit-scoring algorithms, most consumers fall into the “good” category. That doesn’t have to mean giving up on special perks and rebates, though.

  • Citi Forward Card. The best credit card to apply for in this category rewards customers who pay bills on time with reduction in the annual percentage rate of up to 2%.
  • True Earnings Card from Costco and American Express. If you’re already shopping at Costco, you’re probably pretty sharp with your money. One of the best cash-back credit cards on the market, True Earnings doubles as your Costco membership card. It converts up to 3% of your purchases into vouchers redeemable at the nationwide discount warehouse club.

Now that banks have mostly recovered from the credit crunch, expect to see offers and terms for “good” customer accounts improve.

Fair credit

The best credit cards for fair credit often take into account items that don’t appear on your credit report, like rent payments and some utility bills.

  • Capital One No Hassle Cash Rewards. Capital One doesn’t reserve its best cash-back credit card deals for globetrotters and executives. Even with fair credit, you can apply for a version of the issuer’s popular No Hassle cards that lets you earn up to 2% cash back on purchases.
  • Discover Student More Card. Geared toward young adults with thin credit files, Discover’s card offers a 0% teaser APR and an attractive cash-back reward program.

The best credit-card issuers help customers with fair credit “graduate” to better deals as their credit scores improve.

Poor Credit

Before the Credit CARD Act, a handful of banks earned criticism for predatory lending practices applied to consumers with bad credit. Some issuers offered subprime cards that promised small credit limits, then immediately charged hundreds of dollars in service charges. “Fee harvester” accounts preyed on consumers so desperate to improve their credit scores, they felt obliged to shell out significant monthly payments for credit cards they could barely use. (How long will it take you to pay off your cards? Find out with MSN Money’s calculator.)

But that was then, and this is now. If you’re looking to rebuild your credit with a low-cost card you can actually use, check out these two offerings:

  • Orchard Bank Classic MasterCard. The best credit card for those with bad credit, this MasterCard offers a second chance for consumers who’ve had bad luck or learned some tough lessons. This card offers reasonable terms and fees for cardholders committed to making on-time payments.
  • Public Savings Bank Open Sky Secured Visa Credit Card. Sometimes, it takes a little more to convince banks that you’re ready to handle a line of credit. Public Savings Bank lets you borrow against a secured savings account, up to $3,000. With fair rates and fees, compared with other secured credit cards, Open Sky can help you build the 18- to 24-month track record you’ll need to qualify for traditional credit cards.

The best credit card to have at any given time is the card that gives you the highest possible value for your money. Remember to balance your desire to build a strong credit score with the real costs associated with each credit card you add to your wallet. Keep your spending in check, and use online banking tools to track your purchases and rewards. Review your credit score regularly to make sure your plan is having the intended result.

This article was reported by Joe Taylor Jr. for CardRatings.com.

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