The curtain has parted, albeit slightly, on the mystery of how your credit rating is calculated. Find out what these common credit problems can do to your standing.

By Liz Pulliam Weston

One of the questions I’m asked most often about credit scores is exactly how much certain actions affect people’s scores.

Until now, the best I could do was say, “It depends.” That’s because the company that created the leading credit score, the FICO, has been wary about releasing specifics.

Fortunately, that just changed. At my request and for the first time, the company (also known as FICO) has released details about how specific actions, from maxing out a credit card to filing for bankruptcy, can affect people with different credit scores.

I asked the company to compute the results of those actions for two examples: a person with a 780 score, which is an excellent score on the 300-to-850 FICO scale, and someone with a 680 score. The results:

The results are given in a range because FICO is still a little nervous about revealing too much about its proprietary scoring. But the range is fairly tight, and we can clearly see the disparate impacts of the different actions.

A guide, not a guarantee

Before we go further, I have to make this clear: Your mileage may vary.

People with the same credit score can have very different credit profiles: more or fewer accounts, a different mix of accounts, a longer or shorter credit history, use of more or less of their available credit, etc.

Because of those differences, the same action — maxing out a card, say — can have different effects on people with the same score, depending on the details of their individual credit profiles.

For the sake of this exercise, FICO assumed both people had several active major credit cards as well as a mortgage, a car loan and student loans.

The person with the 780 score:

• Has at least 10 credit accounts in total and a 15-year credit history.
• Uses 15% to 25% of her credit card limits.
• Has no late payments on her credit reports.
• Has no collection accounts or other major negatives.

The person with the 680 score:

• Has six credit accounts and an eight-year credit history.
• Uses 40% to 50% of her credit card limits.
• Was 90 days late on an account two years ago.
• Was 30 days late on another account one year ago.

Here’s what you need to know about each action and the effect it had:

Maxing out a credit card

Using 100% of your limit on any credit card puts you at risk of over-limit fees. It also takes a bite out of your credit score.

Our person with the 680 score might lose 10 to 30 points from this one action, while the 780 scorer could shed 25 to 45 points.

The difference points up an important fact: The higher your score, the more points you tend to lose from “bad” actions. That’s because the scoring formula is sensitive to any sign you’re getting in over your head. Maxing out a credit card is considered one of those signs.

You also should know that it typically doesn’t matter to the formula if you carry a balance or pay off that maxed-out card as soon as you get your statement. What’s usually reported to the credit bureaus is the balance on your last statement. Even if you pay the debt in full before the due date, the maxed-out card will hurt your score.

Skipping a payment

Mailing a payment a few days late normally won’t hurt your score, although you may incur late fees and trigger higher interest rates. The big hurt comes when you miss a payment cycle entirely.

A 30-day-late report would shave 60 to 80 points from our lower-scoring person and 90 to 110 points from our higher scorer. In other words, one lapse of attention could plunge the 680-scorer into subprime credit territory, and our 780-scorer could find credit much harder to get and more expensive.

This is why it’s so important to set up automatic payments to ensure your bills get paid on time, all the time. With credit cards, you can set up automatic payments that take the minimum payment out of your checking account to ward against a late payment. You can always make a second payment that reduces your debt or pays it off entirely. You can sign up for automatic payments on the Web site of your card issuer.

Settling a credit card debt

All the advertisements about “settling your debt for pennies on the dollar” make debt settlement sound like a great solution. But failing to pay what you owe a creditor will take a serious toll on your score.

The 680 scorer would lose 45 to 65 points with this maneuver, while the 780 scorer would shed 105 to 125 points.

Our scenario assumed that our borrowers would miss one payment before settling the debt with their credit card companies. In reality, debt settlement negotiations can drag on much longer, with each missed payment taking another chunk out of your score.

Settling a debt with a collection agency would hurt less, probably much less, because the FICO formula is set up to weigh more heavily what the original creditor says about you than what a collection agency reports. But if our borrowers were settling with a collection agency instead, their scores would be lower to begin with, because they would have collection accounts on their records.

Also, you should know that the amount of debt your creditor “forgives” in a debt settlement solution is typically added to your taxable income. So you may save some money by settling a debt, but you’ll give some of it back to Uncle Sam in higher taxes.

Losing a property to foreclosure

Foreclosure deals a severe blow to your credit score: 85 to 105 points for our person with the 680 score and 140 to 160 points for the one with the 780 score.

Foreclosures have implications for your future ability to get a mortgage as well. Although your score may start to improve as soon as the house is gone, mortgage lenders may not be willing to extend you another home loan until two to four years have elapsed.

In an attempt to protect their credit, many people attempt short sales, selling their houses for less than what’s owed, with the lenders’ permission. Unfortunately, these transactions, even if successful, are often reported as settlements. And a settlement, as you’ve seen, is pretty bad for credit scores. To lenders, a short sale isn’t quite as bad as a foreclosure, though, and it may be easier to get another mortgage once you’ve rebuilt your credit.

Filing for bankruptcy

FICO spokesman Craig Watts once called bankruptcy the nuclear bomb of credit actions. Filing for bankruptcy would shave 130 to 150 points from the 680 score and 220 to 240 points from the 780 score.

This is different from the other black marks, where the higher scorer was still left with better numbers than the lower scorer. In this case, both would wind up near the bottom of the credit barrel. Getting new credit, particularly in the current credit-crunch environment, would be extremely tough.

Sometimes, of course, bankruptcy is the best of bad options. But if you can’t pay your bills, you should at least explore the other possibilities: forbearance, credit counseling or even debt settlement.

Finally, if you have any of these five black marks on your record, remember two things: The impact on your score may differ from what’s shown above, and regardless of how many points you lost, you can rebuild your FICO score over time.

You can start by using a free FICO score estimator, such as this one at Bankrate.com, or MSN Money’s credit score estimator, which similarly models a score on Experian’s 330-to-830 range, to see where you stand.

Or you can sign up for free credit scores from sites such as Quizzle, Credit.com and Credit Karma, which use the actual information on file about you with the credit bureaus. But the scores you get still may not be the ones lenders actually see.

Or you can buy your Equifax or TransUnion FICO score from MyFICO.com. (Experian no longer sells FICO scores to consumers, although it continues to sell the scores to lenders.) With paid scores, you’ll get specific advice about how to improve your numbers. In general, when you’re trying to build a credit score, you should:

• Pay your bills on time, all the time.
• Reduce your credit utilization; below 30% is good, below 10% is better.
• Have a mix of credit on your reports, including installment loans (mortgages, auto loans and personal loans) and revolving accounts (credit cards and lines of credit).
• Refrain from closing accounts.
• Apply for new credit sparingly.

The first time homebuyer’s tax credit has been helpful to a lot of people, saving them thousands of dollars toward the purchase of a new home, but they’re not the only tax credits that got a boost this year.  Here’s a few other that might apply to you.

“Residential Energy Property Credit”

• Have you made any improvements to the energy efficiency of your home?  If so you might qualify for this expanded tax credit.  You can claim up top 30% of the purchase price of qualifying home improvements, up to $1,500.  Certain improvements avoid this $1,500 limit as well, things like wind turbines, which will give you a 30% tax credit with no maximum.
• Be sure you check with the manufacturer of the materials used for your home improvement projects to make sure they qualify.

“American Opportunity Tax Credit”

• You might have already heard of the “Hope Credit”.  Well it’s been renamed and expanded.  This credit allows you to deduct the first $2,000 of college tuition and course materials, then 25% of the next $2,000, maxing out at $2,500—up from the $1,800 limit imposed by the Hope Credit.  In addition, the credit can now be applied to all 4 years of undergraduate study instead of just the Freshmen and Sophomore years.  The qualifying income level has also seen a substantial increase—from $46,000 to $80,000.
• Oh, and as a bonus, 40% of this tax credit is refundable even if you have no tax liability.

Unemployment

• Lost your job in 2009?  Well the good news is the first $2,400 of unemployment benefits are tax exempt.

Automobile Credits

The Cash for Clunkers program might be over, but there are still several other deductions for vehicles purchased in 2009 that you might qualify for.

• New cars purchased between February 17^th, 2009, and December 31^st may be able to deduct state and local sales taxes for the first $49,500 of the vehicle’s purchase price.  If you make over $125,000 as an individual, or $250,000 as a couple you might not qualify though.
• Purchasing a hybrid or plug-in electric vehicle?  There’s tax incentives for those as well.  Tax credits ranging from $2,500 to $15,000 are available this year.  Those credits are topping out at $7,500 next year, so it might be the right time to take advantage of a holiday sale.

For more information, consult the IRS website.

Treasury Secretary Timothy F. Geithner, speaking at a small-business financing forum at the Treasury Department, called on banks to “get back to the business of lending.”

The Treasury Department released a report earlier this week showing that many of the banks that received government aid in the form of stimulus money earlier this year continue to tighten credit. Loan originations in September fell 6 percent at Bank of America and 14 percent at Wells Fargo compared with the August.

Geithner went on to state that when banks rein in their lending it is the small businesses that are hurt the most since they rely on banks for 90% of their lending, versus large corporations that only get 30% of their loans from banks. “Banks bear some responsibility for the extent of the damage caused by the crisis, you carry a substantial obligation to help our communities get back on their feet.” he told the banking representatives.

If you’re counting on your tax return in 2010 for a vacation or to pay off some bills, you might be one of the 15.4 million taxpayers in for a shock when you discover that your refund will be lower than expected, or even worse, you might end up owing money to the IRS.

The Making Work Pay tax credit, part of the $787 billion economic stimulus package was passed earlier this year, reduced the amount of income tax withheld from taxpayer’s paychecks by up to $400 for individuals or $800 for couples.  The idea was that people with more money would, get this, buy more.

The problem though, announced in a report on Monday, was that the Federal Tax Tables used to determine the correct withholdings failed to take into account situations like taxpayers with two jobs, families where both spouses work, or taxpayers with Social Security income still in the workplace (the people who probably need their full refund the most).

The Inspector General of the Treasury Department in charge of tax administration estimated that over 10% of 2009 filers would owe additional taxes due to the complex and convoluted Making Work Pay credit.  To make matters worse, 65,000 of those people might also face penalties from the IRS for underpaying their taxes.

If you’re worried that you might be one of the Americans affected by this, visit the IRS withholding calculator.

“Debt consolidation.” It has such an alluring ring to it. It creates this fantasy that you can wrap up all your debts into one attractive, low interest package, and everything will be hunky dory with your debt. Sadly, the easy quick fixes are often rather bad for you, financially and credit worthiness-wise.
This glorious idea of an easy fix to being thousands of dollars in debt has been fertile soil (fertile with manure) for an entire industry with fabulous claims of lower monthly payments, low interest rates, and zero hassle.

You know what they say about something being too good to be true though…

So before you jump feet first into debt consolidation, be sure you’re aware of a few things.

• Debt consolidation companies are not nonprofit organizations, they won’t improve your credit, and they won’t do anything you can’t do yourself. Here’s the deal, from an industry insider: you gather all your paperwork and send it to them, they tell you how much to pay them each month, then they’re supposed to negotiate lower payments and interest with your creditors and make the payments for you. The reality is they are notorious for paying your bills late, destroying your credit, they take 10-20% of what you pay them each month for “administrative costs” (it’s not profit, they’re a nonprofit organization, remember), and they once again can’t get better rates than you can by spending some time on the phone with your creditors. Some of the worst of them will even purposely let your debts charge off so they can negotiate a better settlement on your debts once they’re turned over to a collection company, allowing them to take a portion of the money they “save” you. Believe me, with the hit your credit will take by doing that, and the resulting higher interest rates and fees you’ll have on everything after that due to your abysmal credit, you’re not saving anything.
• So what if you’re not going with a debt consolidation company, but are instead getting a debt consolidation loan? Well, that is a much better option, but it’s still not a good option. First of all, chances are good you’ve got some dings on your credit already if you’re looking for a consolidation loan, so the chances of you getting a loan are pretty slim, and if you do get the loan, your interest rate isn’t going to be better than the cards you’re paying off. So you get the convenience of one payment, but no monetary savings, and that’s what this is supposed to be about, saving money, not just convenience. So don’t believe the promises of easy money, it’s just a lure to get you in the door like a wide mouth bass.
• What about flipping your debt from card to card chasing the no interest balance transfers? Well, it’s bad for your credit, the banks will catch on and cancel the cards, it’s illegal, and there is the little thing of our failing economy and the fact that those zero percent interest cards just aren’t available anymore. This solution is so… 2007. Reality caught up to this plan about a year ago.

So what should you do?

• Get a home equity loan. This will have a low interest rate and the interest will be tax deductible. You’ll have the up-front costs of origination fees, insurance, and an appraisal. Warning though, this isn’t as easy as it once was before the mortgage crisis, but if you’re lucky enough to still have equity after the freefall of housing prices, this is an excellent option.
• Negotiate with your creditors on your own. Remember the credit card industry is “losing” tons of money right now because the impending enforcement of the credit card reform act, so they’re probably going to be more willing to bend to keep the paying customers they still have. This gives you leverage. They want you paying, and paying them, not defaulting or taking your business to another bank.
• Refinance your home, cashing out your equity. This is different from a home equity loan and will give you lower monthly payments because you’ll probably get a longer loan term than a standard equity loan. Keep in mind though; this is going to cost you more in the long run because you’re extending the length of your mortgage without lowering the price of the home. If you can get your credit cards debts paid off though, and then apply all or a portion of what you were paying the credit cards companies toward your mortgage, you can minimize or overcome the damage though.
• If you have somehow weathered this without destroying your credit already, a personal loan from a credit union might be an option. You’ll get interest rates in the 10-15% range most likely, but that’s still better than the 24.99-29.99% you’ll be paying on credit cards these days.
• If the situation is truly dire, you might also want to consult with an attorney. It’s sad, but true, that is some situations bankruptcy might be your best option. I strongly advise seeking legal advice before going down this route though.
• Last, but certainly not least, there’s the hardest, yet easiest option. Living within your means. Paying off your debts can be accomplished by putting more money toward them each month. That might mean cutting back on eating out, getting rid of the 300 channels of cable since you probably only watch 3 of them anyway, maybe carpooling to save gas, get a second job, etc. Make a personal budget, find where you can cut back, and put that money toward the bills. This doesn’t require loans or lawyers or anything else because it easy, but living within your means can be so hard. It takes self control and determination, but the rewards are great.

President Obama today signed into law the bill extending the homebuyers tax credit through May 1st, 2010– a 6 month extension of the tax credit.

The law provides an $8,000 tax credit for first-time homebuyers, and $6,500 for homebuyers who have owned their current home for at least 5 years. Contracts must be in place by May 1st, 2010 to qualify.

Part 2 of 2

How to protect yourself.

• Keep in mind the interest rate increases won’t affect you if you’re not carrying large balances.  Going from 9.99% to 14.99% isn’t going to really impact your wallet if you’re already living within your means rather than living on credit.
  • Be aware of the fine print on your credit cards.  If you know that the new card with the 0% introductory rate for the first 12 months is going to instantly jump to 24.99% if you’re even a day late during that time frame, you’ll probably be a little more careful about making sure the payment is sent on time.
  • Pick cards with lower long term rates rather than teaser rates that expire and then go up.  The longer you have a card the better it is for your credit score, so you want cards that will still be useful to you 2 or 3 years down the road.
  • Read the mail you get from your credit card issuers.  I too have been guilty in the past of just finding the payment due and ignoring the rest of the information stuffed in the envelope, and I’ve been burned by it.  The banks are notorious for slipping in information about rate changes or changes in your terms of service.  Stay informed, that way you’ll be able to change your spending habits before the card goes to 99.99% next month.
  • Cash advances…  just don’t do it.  The interest charged on cash advances is always significantly higher than the rate charged on regular purchases, and to add insult to injury, when you pay your bill each month the credit card companies are going to apply your payment to your normal purchases, not the higher interest cash advance balance, first.
  • This one may be obvious, but PAY ON TIME.  Don’t count on the postal service to get the payment to the bank in a timely manner, send the payment early to be safe.  Remember that until the new laws are being enforced you’re still subject to universal default, so that one late payment could cause the interest rates to go up on all your cards.
  • Along with the obvious pay on time, there’s also stay under your credit limit.  Over limit fees and the increased interest rates are only getting worse and worse, so do your best to avoid them completely.
  • Pay in full to avoid interest.  Credit cards should be used as a convenience, not a replacement for income, so if you’re spending within your means this should be easy to do.  If you’re not living within your means, it’s time to draw up a reasonable budget and figure out what it’s going to take to get your finances in check.
  • If you find yourself using your cards more than you should just to make ends meet, don’t be afraid to ask for help.  Feel free to give our experts a call at 1-888-WHY-FICO.  We can give you the unbiased advice based on our experience that will help you get on track.

Part 1 of 2

I’ve spoken a lot recently about what credit card issuers are doing before the Credit Card Reform Act goes into effect next February. They’re justifying their practices by saying that their revenues are suffering with the ever increasing unemployment and default rates. Sadly their solution is to penalize the paying customers. Here’s a list of specific things to watch out for in handy “10 things to watch out for” format.

• Increasing interest rates. The phrase of the day with the card issuers seems to be “any time any reason” price changes. This isn’t just happening to sub-prime customers either. One of the major banks just raised the interest rate on their low risk prime cards to 29.99%. Interest rates like this have been ridiculous in the past even on sub-prime cards. Rates for sub-prime cards are even worse.

• Penalty rates are going up. Those are the rates that are put in place if you’re late, go over your limit, etc.

• “Unprofitable” accounts are being shut down or getting their limits reduced. In other words, people that pay their cards off each month, denying the card issuers interest and penalty fees, are being closed down. The issuers want to keep the people that carry balances and are late here and there.

• Cash advance and balance transfer fees are skyrocketing to all time highs. The days of no cost, 0% interest balance transfers are long gone, and those “convenience” checks are going to significantly increase the real cost of your purchases.

• Annual fees are being added and increased. Last year less than 20% of credit cards had annual fees, but it’s predicted that by February nearly all credit cards from the big banks will have them. The cards that already had annual fees are seeing them doubled, tripled, even quadrupled.

• Fixed rates are being changed to variable rates. In the past with fixed rates meant that if the prime interest rate went up your rates remained the same, decreasing the profits of the banks, but now if the historically low prime interest rate goes up (which it will since it can’t really get any lower), your rate will go up. If prime is 3% and your rate is prime +24.99%, and prime goes to 6% your rate goes to 27.99% instead of staying at 24.99%. Oh, and the best part, there’s no provision for the rates to go back down. So if prime goes back to 3%, your interest rate doesn’t go back to 24.99%.

• The banks are changing the terms of their special fees to make them all inclusive. For example, banks charge a special fee for “international transactions” in other forms of currency, but they’re changing the terms so those fees apply even when the transaction is still in American greenbacks.

• They’re making rewards an endangered species. Cash back rewards are being lowered or eliminated while things like airline miles are getting tougher restrictions making it harder, if not impossible, for people to use them.

• The banks are getting creative and creating new fees in addition to the old ones. Not using your card? Here’s an inactivity fee. Not using it enough? Have a low activity fee.

• The banks are closing cards with no notice. That’s means you might not even know until you go to use the card and your transaction is embarrassingly declined.

I’ll follow this up tomorrow with some suggestions on how to protect yourself.

With the meteoric rise in credit card interest rates and the plummeting credit limits I often wonder why more people don’t turn to credit unions for their credit needs. There was a time when going through the big banks for credit cards made a lot of sense—back when they’d offer no interest on balance transfers for 12 months or more, or when their incentive programs were actually a savings compared to their rates. Those days are long gone though as the big banks offer less and less attractive rates and incentives by the day.

The advantage to credit unions is that they are, technically, nonprofits run by their members. This means they can offer interest rates and fee schedules far below those offered by the big banks (you know, the for profit ones). Many might contend that credit unions have membership limitations, such as you have to work for a certain company or live within a certain geographical area. In my experience, and I’m speaking as someone who has dealt exclusively with credit unions since I opened my first passbook savings account over 2 decades ago, the membership limitations they have always contain loopholes. If you go in and tell them you want to open an account, they’ll find a way. They’ve earned my loyalty over the years, and I’m not speaking of any one particular credit union because I have opened accounts at 6 different ones due to relocations, because they have universally offered me better interest rates on car loans, home loans, checking accounts, lines of credit, and credit cards. In addition they have just plain treated me better, like a valued customer and not just a number.

I found a chart in a recent Pew Report that shows clearly the differences in rates between the big banks and your average credit union. Look it over and keep them in mind if you’re looking to minimize the amount you pay in interest, fees, and penalties.