Our thoughts . . . 11-03-08
THE MYSTERIES OF CREDIT SCORING
Are the credit markets frozen? For big corporations and banks, perhaps they are. For small businesses and individuals on a local level? Not at all; in fact, we have found that professional practice lenders are soliciting new business as much as ever, although they have tightened some guidelines to ensure that their portfolios remain strong.
In previous articles we have addressed some of these, such as the need for liquid reserves available to the buyer, a strong cash-flow for the practice and the possibility of the seller needing to carry a small second mortgage. Another general change we have seen is that most lenders are now requiring a 650 credit score, whereas previously they usually required around a 620 score.So what does that mean exactly? What is a credit score? Books have been written explaining what credit scores are and how to raise them, but here it is in a nutshell: Your credit score is a number that is calculated based on a complex formula that predicts the likelihood that you will repay a loan that is made to you, based on past payment history and the amount of credit available to you.
There are three credit repositories that generate scores, and all three use their own version of a scoring model to generate a numerical credit score for you. Generally, these three numbers are going to be similar to each other unless one of the credit bureaus has a report that contains an error that could cause the score to be lower than the others. The mathematical formulae that these three companies use are kept quite secret from the public, because the credit bureaus think that if people knew how credit scores were calculated, they could "game" the system to increase their scores artificially.
However, much like we know that Colonel Sander’s "secret" recipe of 11 herbs and spices is some basic combination of flour, salt, paprika, pepper, and other generic seasonings, we know the general make-up of the credit scoring models. Even though we don’t have access to the exact algorithm, we know that the credit scoring models take into account the following information:
Items one, three, four and five are self-explanatory; if you have an established mix of credit accounts that have been open for five or ten years or longer, and you pay the bills on time each and every month and abstain from applying for credit you don’t need you will probably have a high credit score.
Item number two is the one that can cause great confusion, and in some cases, credit disaster if it is not fully understood. In general, borrowers who use less than 30% of their available credit will have the highest scores in this category. For example, if you have two credit cards with a total of a $10,000 credit limit and you carry a combined balance of $2,500 from month to month, you are using 25% of your available credit and your scores will reflect that in a positive manner. However, if you owed $9,500 on those two cards, you would be using 95% of your available credit and the scoring system would consider you a large risk. It is not how much you owe, but how much you owe as a proportion of what you are able to borrow. This is where it gets a little silly.
There are two dentists, Dr. Lukas and Dr. Stevens. Dr. Lukas manages his credit closely and closed a couple of old credit cards that he doesn’t really use anymore, leaving him with just one credit card with a limit of $5,000. He owes $4,500 on the card and plans to pay it off over the next six months.
Dr. Stevens has ten credit cards that have an aggregate account limit of $200,000. He owes $59,000 on these cards and he although he makes the minimum monthly payments on time, he struggles to do so.
Who is the better credit risk? Or should I ask, who would you rather loan money to, knowing both of their financial situations? It is likely that Dr. Stevens, although he is drowning in debt, will have a higher credit score than Dr. Lukas! Dr. Lukas unintentionally hurt his credit score by closing his old accounts—remember that the age of your credit accounts make up 10% of your score—and by making his amount of available credit very small. Although Dr. Stevens owes more than 10 times what Dr. Lukas does, because he has such massive amounts of available credit still left, his scores will be higher even though he is on the brink of financial disaster!
In today’s lending environment where banks are focusing so much more on the credit scoring number, you as a potential borrower need to do everything you can to keep your scores up. Keep your old accounts open, even if you don’t use them. Limit the number of credit inquires that you allow other parties to make on your behalf. Make sure you keep your revolving balances at or below 30% of your available credit. And by all means when the bill comes in the mail, pay it on time.
By following these simple guidelines, you will put yourself in a position to receive the best interest rates and programs that lenders offer. By failing to follow them, you might not be eligible for a loan at all!
Steve Wolff, DDS
UMKC Class of 1977