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Credit Scores

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Your credit score is a measure of the likelihood that you will pay your debt as agreed. The lower your credit score, the more likely you are to default on your debt. Borrowers with higher credit scores represent a lower risk to the lender.

Most lenders rely on your credit score to determine eligibility for private student loans. Your credit score can also affect the cost of your debt, with lower interest rates and fees reserved for borrowers with better credit scores. This is in contrast to federal education loans, which generally do not depend on your credit score.

What is a Credit Score?

A credit score is an objective measure of credit risk. It summarizes the information from your credit history into a single number. This forms a basis for comparing borrowers. Borrowers with higher credit scores are more likely to pay their debts on time and as agreed. The most popular credit score is the FICO score developed by Fair Isaac Corporation. (The name 'FICO' is derived from the initials of the company name.)

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FICO scores range from 300 to 850, with 850 being the best possible FICO score. Some credit reporting agencies are experimenting with a broader range of scores. A credit score less than 650 is considered "subprime".

Generally, the FICO score depends on the following factors:

Score ComponentWeight
Payment History35%
Amounts Owed30%
Length of Credit History15%
New Credit10%
Types of Credit Used10%

The recency, frequency and severity of credit activity also has an impact.

How do Federal Student Loans use Credit Scores?

The Stafford, Perkins and PLUS loans do not depend on your credit score. The Stafford and Perkins loans are available entirely without regard to your credit history. The PLUS loan, however, requires that the borrower not have an adverse credit history. (Undergraduate borrowers whose parents are denied a PLUS loan will be eligible for increased unsubsidized Stafford loan limits.)

An adverse credit history is defined as being more than 90 days late on any debt or having any Title IV debt (including a debt due to grant overpayment) within the past five years subjected to default determination, bankruptcy discharge, foreclosure, repossession, tax lien, wage garnishment, or write-off. It does not otherwise involve your credit score.

How do Private Student Loans use Credit Scores?

Education lenders generally use the FICO score in combination with other factors to determine eligibility for private student loans. The other criteria typically involve binary (yes/no) decisions, such as debt-to-income ratio and recent bankruptcies.

In most cases you will not be able to obtain a private student loan if you have a FICO score below about 630-650. Typically, more than two-thirds (85% to 95% by loan volume) of private student loan borrowers have credit scores of 650 or higher. 21% to 25% of borrowers have FICO scores of 760 or higher. (These figures are for private student loans only. The national distribution of FICO scores for all forms of credit is different.) The average FICO score is around 710.

A small portion of private education debt does not depend on credit scores. This includes loans like MyRichUncle's Preprime product that use alternate criteria, such as major, GPA, college reputation and year in school to assess credit risk. Another example is so-called "opportunity loans", in which a lender provides a school with funding it can lend to students without regard to traditional credit critera (e.g., about 10% of the loan volume from loans funded with traditional criteria is available in the opportunity pool).

Most education lenders break their interest rates and fees into five tiers, based on the borrower's credit score. About 20% of the borrowers get the best rate, followed by 35%, 20%, 10% and 15%. Each tier has an interest rate that is 1% or 2% higher than the previous tier. This means that borrowers with the worst credit scores can have interest rates that are 5% to 6% higher than the interest rates charged to borrowers with excellent credit. The fees are also higher by as much as 9%, although some lenders roll higher fees into the interest rates. This means that borrowers with bad credit scores may have monthly payments that are 20% to 40% higher and pay two-thirds to 100% more interest over the lifetime of the loan as borrowers with excellent credit scores. That's as much as double the interest! (Most education lenders do not use the rates paid by the best credit customers to subsidize the rates paid by the worst credit customers, as they tend to advertise their best rates.)

The following table illustrates the mapping from FICO scores to no-fee interest rates for a nonprofit state loan agency during the 2007-08 academic year. (Most lenders do not disclose their FICO score tiering nor the mapping from tiers to interest rates.)

FICO Score Interest Rate
770 or higher LIBOR + 2.3%
740 to 769 LIBOR + 2.75%
690 to 739 LIBOR + 3.95%
660 to 689 LIBOR + 6.45%

Notice how the interest rate increases by 0.45% when the FICO score drops below 770, but then jumps by an additional 1.2% when the FICO score drops below 740 and by an additional 2.5% when the FICO score drops below 690.

Borrowers with lower FICO scores will also be subjected to lower loan limits. The proceeds may also be restricted to being spent on school charges. Lenders do this to limit their risk.

If you have a bad credit score, a cosigner with a good credit score can make you eligible for a private student loan. Even if you have a good credit score, a cosigner with a better credit score can potentially reduce the interest rate and fees you'll have to pay on the loan. This is because most lenders use the better of the two credit scores to determine eligibility and the cost of credit.

Another method of getting a better interest rate is to agree to make payments on the loan while you are in school. Many lenders give better rates for borrowers to begin repayment immediately or make interest-only payments during the in-school period.

If you are denied a private student loan, ask the lender about their appeals process. Sometimes they will make an exception if an unusual circumstance lead to the denial, especially if the negative event is not likely to occur again. Appeals will also be accepted if the denial was the result of inaccurate information on your credit report that was subsequently corrected.

The bottom line is that having a bad credit score can significantly affect your ability to borrow from private student loan programs and the cost of that debt. Abusing credit cards while you are in school, for example, can affect the interest rates and fees charged on your next private student loan. Maintaining a good credit score, on the other hand, can save you thousands of dollars in interest on your private student loans.

How do Loan Applications affect Credit Scores?

Every loan application or "inquiry" has the potential to reduce your credit score. According to Fair Isaacs, the company that produces the FICO score used by most education lenders, one "inquiry" will generally result in a 5 point reduction in the FICO score. However, since people with six or more inquiries are eight times more likely to declare bankruptcy than people with no inquiries, it is best to keep the number of inquiries small. Also, if your credit history is short or involves very few accounts, an inquiry is likely to have a bigger impact.

On the other hand, the credit reporting agencies do account for "shopping around" behavior for auto loans and mortgages, but not for education loans. When you apply for a mortgage or auto loan, they ignore any current inquiries within the 30 day period prior to scoring and treat any past inquiries within a short period of time (e.g., 14 or 45 days, depending on the version of the FICO score) as a single inquiry. This compensates for the impact of shopping around. They do not say whether applying for different types of loans (e.g., credit card, mortgage, student loan) counts as separate inquiries even if they are within the shopping around window, but that is likely the case. So the best advice is to apply for all your mortgages and auto loans within a short time period (e.g., a week or two) and to not apply for too many loans.

Warning: Fair Isaacs says that while they conflate inquiries for auto loans and mortgages, they do not yet have enough historical credit data to do this for private student loans. This is partly because private student loans are relatively new and partly because lenders have not been distinguishing private student loans from other forms of unsecured credit. In the mid-1990s, total private student loan volume was about $1 billion, and few borrowers applied for more than one loan. So you still need to limit the total number of private student loan applications and to apply for the loans in a short time span. More than five inquiries is likely to reduce your credit score enough to have an impact on the interest rates and fees for subsequent applications. More than eight inquiries will definitely have an impact on the interest rates and fees. FinAid recommends limiting your private loan applications to one bank, one non-bank specialty lender and the nonprofit state loan agencies in your home state and the state where your college is located.

Credit Reporting Agencies & Marketing Mail

All Title IV lenders report your education loans to the major credit reporting agencies, including Equifax, Experian and TransUnion. A good payment history on your student loans will help you qualify for other forms of credit, such as mortgages. However, the credit reporting agencies will sell your contact information to other education lenders that wish to consolidate your loans. If you do not wish to be inundated with consolidation loan marketing materials, you should opt out by visiting OptOutPrescreen.com. You will be able to opt out for five years via an online process. (To opt out permanently, you will have to submit a form by USPS mail. The form is available on the web site.)

Free Credit Reports

You are entitled to a free copy of your credit report from each of the three major credit reporting agencies once a year. You can obtain these free credit reports from www.annualcreditreport.com. Call 1-877-FACT-ACT (1-877-322-8228) for more information.

Beware of sites with similar names that may charge you a fee for your credit reports or additional services.

FinAid recommends spacing out the free credit reports throughout the year, getting a report from just one of the credit reporting agencies each time, so that you're getting one report every four months.

You should check your credit report at least once a year, especially before any major credit applications such as obtaining a mortgage, auto loan or student loan.

The free credit reports do not necessarily include your credit score.

If you want to buy a copy of your credit reports, including your credit score, you can get it from each credit reporting agency directly. The major credit reporting agencies are:

You can also buy copies of your credit reports and FICO scores from Fair Isaacs at myFICO.com.

There will be slight variations in your FICO score at each credit reporting agency because your credit history at each agency is slightly different.

Improving Your Credit Score

There are no quick fixes to improving your credit score. Disputing all of the negative information in your credit report will not improve your score. If there is inaccurate information, you should certainly dispute it so that it can be corrected. But otherwise, don't dispute the information in the report indiscriminitively. Negative but accurate information will not be removed.

It is very easy to ruin a credit score, but it takes a long time to improve a bad credit score.

Here are a few good tips for improving your credit score:

  • Pay your bills on time and continue paying your bills on time. The number of accounts that are current and the length of time for which they are paid on time has a big impact on your credit score.
  • Paying off an account with negative information does not remove that information from your credit history. Only time can reduce the impact of the negative information, as older credit history doesn't count as much as more recent information. It is better to keep the account active, but to make regular payments as per the credit agreement. This provides positive information to help compensate for the negative information.
  • Do not close accounts that are current, even if you are no longer using them. The length of your credit history in an account has a positive impact, as does the number of accounts that show no late payments. It is more important to have accounts with positive history than to have no history because you have no accounts.
  • Minimize your use of revolving credit, such as credit cards and department store cards. Keep the balances low, and preferably pay off the balance in full at the end of the month. Installment loans (auto loans and mortgages) are a better form of debt.
  • Pay down installment loans, as the ratio of the current balance to the original balance is a measure of your ability to repay debt.
  • Don't max out your credit cards. If you use too much of your available credit, it can be a sign that you're overextended.
  • Avoid opening new accounts that you do not need. Opening too many accounts and the time since you last opened an account can affect your credit score.
  • Do not file for bankruptcy. A bankruptcy will affect your credit for 7 to 10 years.
  • When looking for a new installment loan, confine your inquiries to a short period of time. Generally, inquiries for a single type of financing within a 14 day period are considered to be a single event. [This shopping-around rule does not apply to private student loans. Each loan application is treated as a separate inquiry and can hurt your credit score.]

Requesting a copy of your credit report will not affect your credit score, nor will unsolicited inquiries from other companies. The credit score focuses on consumer-initiated inquiries that involve seeking and obtaining new credit.

An End to Piggybacking

Fair Isaac, the company behind the FICO credit score, announced on June 5, 2007 that it would no longer allow authorized users to inherit the credit history of the account. These changes will be implemented by the various credit reporting agencies in fall 2007 and spring and summer 2008. This was intended to eliminate a form of mortgage fraud known as piggybacking where someone with a good credit score would add a mortgage applicant as an authorized user on their credit card account for a fee, yielding a mortgage approval with a good interest rate.

But the change also has the effect of preventing parents from giving children a good credit score by adding them as authorized users on one of their credit cards. (It is unclear whether one will still be able to provide this kind of benefit by adding the child as a joint account holder.) The net impact of this is fewer students will be able to qualify for private student loans on their own, and will need to apply with a cosigner.

For more information, see Fair Isaac Moves to Protect Lenders from Fraudulent Manipulation of Authorized User Credit Card Accounts.

Credit Score Trivia

For interesting factoids about credit scores, visit www.nationalscoreindex.com. For example, the state with the best average credit score is South Dakota, at 711, while the state with the worst average credit score is Texas at 649. The US National Average is 676.

 

 
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