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How your FICO credit score is calculated: New credit

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This is the fourth of a five-part series examining what goes in to creating your FICO credit score -- the three-digit number that helps determine how much you can borrow and on what terms. Each part of the series will take an in-depth look at one of the five basic components of the credit scoring model. Today: new credit.  

If you're not careful, taking on too much new credit too quickly can hurt your FICO credit score.

However, adding some "new credit" to an old, troubled account may actually help your score.


Confused? Welcome to the complex world of the FICO credit score.

That score is used by lenders to decide whether to extend credit to a potential borrower and at what terms. In calculating the score, FICO looks at, among other things, loan applications and new debts that were added to a credit report in the last six to 12 months. It isn't the biggest factor, but the appearance of "new credit" does influence a consumer's FICO score. In FICO's view, it makes a borrower riskier, and thus will typically have a short-term damaging effect on their FICO score.  

But there's more to new credit than that: Like other FICO score factors, "new credit" has some complications. That's why experts say borrowers should focus on understanding -- rather than fearing -- new credit.

"It's definitely something to think about," says Natalie Pankow, a credit adviser with the Jewish Vocational Service employment and training services agency in Chicago. "But the fear I see isn't matched with the reality of how it's tied to your score."

Where new credit fits in
Because of the score's widespread use, what matters to FICO should also matter to you. And what matters to FICO are five separate factors:

1.       Your payment history.
2.       How much total debt you have.
3.       How long you've had credit.
4.       How much new credit you have.
5.       What types of credit you have.

"New credit" makes up about 10 percent of a consumer's FICO score, which ranges between 300 (poor credit) and 850 (excellent credit). 

While building a long history of responsible borrowing will eventually lead to a high FICO credit score, getting a new loan or even just applying for a loan can hurt your score. FICO says its research has shown that borrowers who have recently taken on new debt are more likely to become delinquent or miss loan repayments than borrowers who have not opened new accounts.As a result, FICO's scoring model treats new accounts as a negative for your FICO score. 

How negative? It depends on the length and breadth of your credit history. However, the scoring impact of opening one new account should be the same for any type of loan, whether it's a car loan, a credit card or something else.

What "new credit" is made of
Within its "new credit" category, FICO considers the following factors:      

  • How many accounts have been opened in the past six to 12 months, as well as the proportion of accounts that are new, by account type.
  • How many credit inquiries have been made recently.
  • How long it's been since the opening of any new accounts, by account type.
  • How long it's been since any credit inquiries.
  • The re-appearance on a credit report of positive credit information for an account that had earlier payment problems. 

As the above bullet points show, the first decline in a FICO score happens before a new account is even opened. Once you apply for a loan, it results in what's called a "hard" credit inquiry, in which a bank checks your credit history to decide if it should approve the loan. (That's different from a "soft" inquiry, such as when you check your own credit report) Only hard inquiries negatively impact a borrower's score.

Just how much damage does a hard inquiry do? For most people, it amounts to a loss of fewer than five points. But it can vary. "For example, inquiries can have a greater impact for someone with a short credit history and few accounts than for someone with a long history and wide range of credit experience," says Barry Paperno, consumer operations manager at myFICO.com.

Multiple credit inquiries over a short time frame -- such as applying for five credit cards within a week -- can multiply the score damage. However, with other types of new credit, FICO recognizes that borrowers typically shop around. That's why inquiries from multiple mortgage, auto and student loan applications won't hurt your score for 30 days. Once a month has passed, the FICO scoring model treats multiple inquiries for one of those loan types as a single inquiry, provided the applications all took place within a relatively short window of time, such as 45 days. That consolidation of inquiries helps limit the FICO score damage that would otherwise be caused by multiple credit checks, each counted individually.    

For other types of accounts, it isn't only the inquiry that hurts: Some new accounts hit a borrower's score more than once. Paperno explains that for credit cards and charge cards, the initial inquiry can lower a FICO score and, once approved, the actual appearance of the account on a credit report can hurt it again.

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Why that double penalty? Both items are "predictive of future risk, as it indicates the consumer is seeking new credit. The same can also be said about the appearance of a new account without an inquiry on the credit report," Paperno says. "The FICO scoring formula is designed to assess risk by considering all information on the credit report, even if multiple pieces of information are pointing to the same action by the consumer."

'Born again' new credit
To make things a little more complicated, in FICO's eyes, new credit isn't all bad: Recent "catch-up" payments for older delinquent accounts are treated as new credit and are positive for your score, while the careful use of new loan accounts can help reduce the scoring impact from any past borrowing mistakes.

Under FICO's formula, the "re-establishment" of positive credit information -- which takes place when a borrower becomes current on previously past-due accounts -- is viewed positively. Over time, as the months pass and the borrower makes additional on-time payments, the borrower's FICO score will continue to heal from past mistakes.

However, since some older delinquent accounts may have already been closed, it's not always possible to get current on those troubled accounts. In those situations, FICO says simply adding new accounts -- and always paying them on time -- can help to rejuvenate the borrower's FICO score, since they demonstrate the borrower is now acting more responsibly. "Then, as these practices continue over time, the score will continue to increase," Paperno says.   

Furthermore, although the initial hard inquiry may cause a score dip, a responsible borrower can expect to regain any lost points within a few months. In fact, JVS's Pankow has counseled some borrowers who saw their FICO scores "improve tremendously" within six months to a year after adding new lines of credit. "If you add a positive credit line, it's definitely going to help you out" in the longer term, she says.

Carefully add new credit
FICO encourages borrowers to only open loan accounts they actually need. Credit counselors agree that taking on too many new accounts can cause problems. That's why they advise borrowers against recklessly applying for new credit cards. "I don't want them to open a ton at once because I'm concerned about how they can manage them," says Pankow. More accounts can mean more debts to handle and due dates to remember, which increases the possibility of getting into trouble and potentially missing payments.

But the fear of taking on new credit can be overblown. "I see a lot of clients who are afraid to apply for loans or credit because of fears it will pull down their score," says Pankow.

Since new credit accounts for just 10 percent of a borrower's FICO score, however, and a careful application process can limit the scoring damage, Pankow encourages borrowers to focus on improving other aspects of their behavior rather than worrying about opening new accounts.  

"You should be more concerned with how big your balances are and making payments on time," she says.

See related: How your FICO score is determined: Payment history, How your FICO credit score is calculated: How much you oweHow your FICO credit score is calculated: Length of credit history, How your FICO credit score is calculated: Types of credit used, The FICO 5: Breaking down the elements of the FICO score

 

Published: August 17, 2011



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