Credit scores are an important aspect of your financial life and unfortunately, there is quite a bit of confusion about what credit scores are, how they work and who uses them. There’s also a ton of shaming involved with credit that is unjustified. In this two-part series, we will clear up some confusion about credit scores and help you improve your scores.
What is a Credit Score?
A credit score is a three-digit number (typically from 300-850) calculated to assess an individual’s credit-worthiness. Said another way, a credit score is based on multiple factors which allow a lender to determine how risky it may be to lend to an individual. The lower the credit score, the riskier (theoretically) to lend.
Remember when you were a kid and you lent your friend a few dollars for lunch or you let them borrow one of your video games. You may actually still remember some of your “ex-friends” that didn’t pay you back or return your possessions! What if you had a way to determine the likelihood of your friend paying you back or returning your item in advance based on their history of borrowing from others in the past? THAT’S the goal of credit scores and while it is flawed, it is important to understand how you are being measured.
There are many companies involved in the business of measuring credit-worthiness. The most widely known and used score in the U.S. is called a FICO Score and there are three major credit bureaus which the majority of lenders access to obtain individual FICO credit scores. TransUnion, Equifax, and Experian are the three major credit bureaus that hold your credit data and calculate your credit score.
Why is a Credit Score Important?
Clearly, credit scores are important for financial lenders because it helps them make decisions on whether or not to lend money and how much to charge. However, even if you are debt free and don’t borrow money, your credit score can still impact you. Increasingly more companies are using credit scores to make decisions including landlords for renting apartments, home and auto insurance companies, and utilities such as cell phone and cable companies.
The ranges on the credit score allow lenders charge you more (i.e. higher interest rates) for the same products. Of course, these ranges can vary by lender, but here’s an example:
- 720 – 850: Excellent ‘A’ Credit – This score range typically qualifies the best rates on mortgages, credit cards, and car loans.
- 680 – 719: Good ‘B’ Credit – This score range will qualify for different types of credit, but may not always get the advertised or premium rates
- 630 – 679: Fair ‘C’ Credit – This score range may or may not qualify for different types of credit and will have higher interest rates.
- Under 629: Poor ‘F’ Credit – This score range will typically not qualify for different types of credit and may require a cosigner or collateral (i.e. a secured deposit). This is also referred to as ‘subprime’ credit.
For a benchmark, the average credit score in the U.S. is about 690. What is important to understand is not to personalize or internalize your credit score. You are not wonderful and successful if you have an 800 score and you are not a failure if you have a sub 600 score. It is simply a point-in-time metric of your past interactions with credit and fortunately, you have some level of control to significantly impact that score over time which we will discuss in Part 2.
What Credit Scores Do NOT Consider
As mentioned, credit scores are flawed. They can be based on inaccurate or even fraudulent data and there are also important factors that are not taken into consideration. Credit reports (different from credit scores) list the details of financial accounts upon which the credit score is based. Personally, I have found errors on my credit report simply because I share a name with my father. In a separate instance, my father discovered identity theft when checking his credit report and found a $20,000 loan for dentistry school taken out in his name that he had no connection to. These errors are YOUR responsibility to correct which is why you should check your credit score and credit reports regularly.
Credit scores neither take income nor savings into account and credit scores are not a complete measure of how well you are doing financially. Many refer to the credit score as a ‘debt management score’ because it simply measures how well you borrowed money and paid it back. Net Worth is a much better measure of financial success. For example, two individuals (Person A & B) could have the same credit history and the same credit score even though person A makes $1 million in income per year and has $1 million in savings and Person B makes $30,000 per year and has $0 in savings. As a lender, I would likely prefer to lend to Person A, but the scores will show the exact same number. Keep in mind lenders can ask about income and savings before lending, but it is not a factor in your credit score. Also, for those coming out of high school or college that do not have a credit card and have not borrowed money in the past, they may not even have a credit score. So if you diligently manage your finances with cash and don’t rely on credit, you may find that you do not have a credit score.
What are the Elements of a Credit Score?
Let’s talk about what is actually included in the credit score and in Part 2 we’ll discuss tips on how to improve that score. There are five elements in the calculation of a credit score and they have different weights of importance.
- Payment History (35% of the total score) – This element measures whether you have paid your past accounts on time (e.g credit cards, retail store cards, car loans, mortgage loans, student loans)
- Amounts Owed/Credit Utilization (30% of the total score) – This element measures the total amount of debt owed on all of your accounts. It looks at different types of debt like installment accounts with a fixed payment schedule (e.g. car, mortgage) as well as revolving accounts (i.e. credit cards). For installment accounts, it looks at the remaining balance versus the total amount borrowed, so if you have a $10,000 balance on your car loan and you originally borrowed $20,000, it would show that you still owe 50% of the balance of the loan. For revolving accounts, a credit utilization ratio is used to determine the percentage of your overall credit limit is being used. For example, if you have three credit cards with a total credit limit of $10,000 and you owe a total of $2,000, your credit utilization ratio would be 20%.
- Length of Credit History (15% of the total score) – This element measures the time since your credit accounts have been established. The longer the credit history, the better. It will consider an average length of your credit accounts.
Tip: This is why you should reconsider before closing or canceling your oldest credit card accounts, even if you no longer use them.
- New Credit (10% of the total score) – This element measures the number of recent credit inquiries in the prior 12 months. The idea is if you are signing up for several credit cards in a short span of time, it increases the risk to lenders. In other words, people who open up several accounts in a short span of time typically plan to use them and use them heavily.
- Credit Mix (10% of the total score) – This element simply measures the different types of credit accounts you have. This is biased toward having credit cards, but also includes installment loans like car loans or mortgages as well as retail card accounts.
Where Do I Find My Credit Score?
Finally, let’s talk about where to get both our credit scores and reports. For the official FICO scores and credit reports, you can purchase them from FICO for a one-time purchase of $60 or different monthly plans. A better option, in our view, is to use FREE sites like Mint, Credit Karma, or Credit Sesame that are not the ‘official’ FICO score but do a decent job getting a close approximation. You can use one or all three and it will not affect your credit score. They can also provide you with the details of your credit report which you can view and check for erroneous information.
So we have demystified the credit score, discussed why it’s important and the elements considered and not considered. Again, your credit score is not a measure of personal value or personal success much like a GPA is not a measure of intelligence, but rather the combination of course grades. Also much like a GPA, your credit score is much easier to bring down than it is to pull up, so we have to be diligent about our finances. The purpose isn’t to have an 850 score, but to monitor your score and know how you can improve it to save money if you borrow in the future.