“If you don’t take good care of your credit, then your credit won’t take good care of you.” – Tyler Gregory
In the last piece of “Let’s Talk Finance”, All About Credit Cards, we delved into the basics of credit cards, the different types of them and the many benefits they offer. We also talked about the differences between credit and debit cards and how to use credit cards judiciously for effective personal financial management.
Whenever there’s talk of making transactions via a credit card or involving any sort of credit, there’s an inevitable trailing question of credit scores. In this segment we’ll explore the definition, importance and calculation of credit score and the bearing it has on personal finance as well as other money related decisions one has to make on a regular basis.
Fact: Around 26 million Americans don’t have a credit score.
What is a Credit Score?
There is a stark lack of literacy when it comes to credit scores. In fact, a lot of people are so unaware about the concept that they only come face to face with it when they try to make a huge purchase, take out a loan or buy a house/property.
A credit score is essentially a three-digit number. This number decides if a person is worthy of getting any line of credit, mortgage or a credit card for that matter and the interest rate at which they will get the said credit.
One look at the credit score and the lenders or financial institutions will have a complete picture of the kind of credit-taker you are and what the credit risk you pose is. The riskier you seem to the lender, the lower your chances of getting credit are. And even if you do manage to get approval for the credit, it may cost you more or less depending on how high or low your credit scores are.
Every individual has their own credit score. If you’re looking to co-sign a loan then both the co-signers’ scores will be looked into before the interest rate is decided on.
The scores generally range from 300-850. The higher your scores, the better the terms of credit would be.
Fact: Credit reports and credit scores are not the same.
Credit Scoring Systems
Your credit score is calculated via a scoring system that takes into account several aspects of your finances. Out of hundreds of scoring systems that exist in the world today, two majorly known credit scoring systems across the globe are- FICO® and VantageScore®.
The more well-known of the two is FICO®. This scoring system was developed by Fair Isaac Corporation (hence the name) in 1989. This particular scoring system is used by the three principal credit bureaus- Equifax®, Experian® and TransUnion®.
Lenders and other financial institutions analyze and report information in different ways. The three bureaus report, update and store consumers’ credit histories in their own way. Hence each scoring system gives out a statistically different credit score.
Different lenders have different items on their lists to check out before approving a line of credit for an individual. Where you stand in terms of getting the credit you desire depends upon which credit bureau your lender refers to for getting your credit scores.
Fact: Credit scoring systems may change from country to country.
FICO® Vs VantageScore®
By now it is clear that a credit score is an evaluation of your credit risk at any given point in time. And that it helps lenders and financial institutions determine if or not you are worth loaning you a line of credit.
Both FICO and VantageScore credit scores are widely used across the globe. They have one of the most important things in common. In both these score ranges, a higher score is better. Meaning, higher your score the more likely you are to be approved for a line of credit.
There is a minimum scoring criteria for you to even be eligible for a credit score. To have a credit score, your credit report must be in line with the minimum criteria of a scoring model.
The Similarities and Differences
For you to qualify for a FICO score, your credit report must reflect a tradeline that goes back at least 6 months. And at least one tradeline on the report must have had some activity in the last 6 months. Qualifying for a VantageScore is relatively easier as all you need is to have at least one tradeline. The age of the account isn’t a factor.
Both FICO and VantageScore credit scores have the same range of 300-850. However, lenders could interpret these scores differently. A good credit score can mean different things to different lenders and can vary from brand to brand of the score systems.
For example, XYZ bank’s eligibility for being approved for a loan may be a minimum FICO score of 740. But for another credit issuer a VantageScore of 660 could be high enough to qualify.
As different bureaus churn information differently, FICO generates a single bureau-specific score for each one of the three credit bureaus- Equifax®, Experian® and TransUnion®, using information only from their bureau. Hence, it is not one score that comes out, but three separate scores. Whereas, VantageScore is a single “tri-bureau” score and generates a score by combining information from all the three credit bureaus.
The table below shows a general categorization of how FICO and VantageScore credit scores could be ranked.
Fact: 90% of the lenders use the FICO® score to make decisions.
What Goes Into Calculating A Credit Score?
Regardless of the brand of the scoring system, the ingredients that go into a credit score are similar. Credit scores are ultimately calculated by the same set of 5 factors which could make your credit score rise or fall.
Everything that is in a credit report has a direct impact on the calculation of your credit score. Information outside doesn’t impact your score directly.
The factors that are weighed while calculating your credit scores are:
This is a record of how timely you have been paying back your credit debts. This includes payments made through credit cards, other retail accounts, loans and their installments, mortgages or any other line of credit. Public documents and reports like bankruptcies, foreclosures, suits, etc. are also looked into and counted. The more on-time you are in paying back, the better your credit score has the chance of getting. The later your payments or dues get, the worse your credit score could get.
This is the analysis of how much in debt you are and if you can or cannot manage to pay back what you owe the lenders. High outstanding balances or being “maxed out” on your credit cards can significantly affect your credit scores in a negative way. Experts suggest keeping track of the credit card limit and not to exceed 30%. Paying installments on time is a huge plus. Even if you have a good amount yet to be paid, every single installment that is paid on time counts.
Type of Credit in Use
This includes the different types of credit you have taken so far. Credit cards, retail accounts, installment loans, mortgages, etc. are all part of that mix. What is essentially being tracked through this is what different types of credit you have and how well you use and manage them. For example, you wouldn’t want to make humongous payments using your credit card because that could lower your credit score tremendously.
This is the indication of any new debt you wish to take or have. If you do not have a long history of taking credit, opening up different credit accounts could be a risky business. Every time you apply for a new line of credit, the application is considered an “Inquiry” or in the more jargonic sense, a “Hard hit”. Multiple hard hits would affect your score negatively.
Length of Credit History
This simply refers to how far back your credit taking goes. This is a very important aspect of calculating your credit score because the longer you have displayed good credit management for the better your score would be. And it is a direct indicator of you being a responsible credit taker. Your repayment could be tracked over the period of your history which would help lenders make up their mind about lending you more credit.
Fact: Nearly 1 in 3 U.S. consumers have subprime credit.
Common Credit Score Myths
- “My income affects my credit score!”
As discussed above, credit score is calculated by taking into account factors mentioned in your credit report. And your income is not one of them. Hence, your credit score has nothing to do with your income. All that matters is a healthy credit history.
- “Closing old accounts can improve my credit score!”
It’s a common misbelief that opening up more credit accounts hurts their credit scores. And they thus try to close their older accounts. Closing an older account can shorten your credit history which in turn could affect your credit score adversely. Because having a long and healthy credit history is a definite plus.
- “My credit score is the sole factor for getting a loan approved.”
Your credit score definitely is a very essential element in getting great loan terms and better credit cards but there are a lot of other factors that weigh into the decision of a lender to loan you money. Including but not limited to, the kind of job you have, your age etc.
Facts and Figures About Credit Score
There comes a point in almost every average human’s life where they get involved in some kind of credit taking. And a good credit score is one of the most important things in terms of getting the desired line of credit. Surprisingly, not many people are aware about their credit score or even the most basic of things related to it.
Roughly, only 60% of the people know what their credit score is. And around 44% adult Americans haven’t viewed their credit score in the last 12 months. 9.68% of the U.S. adult population is “credit invisible”, meaning they have no credit history of any kind.
As of 2021, the average FICO score is 716. The average credit score rose by a total of 5 points as compared to the previous year. 22% of Americans have no FICO scores. And only a whopping 1.6% of them have a perfect FICO score of 850.
A FICO score of 670 or more is considered a good credit score. According to an article published in the CNBC which was based on the findings of early 2020, the average credit score for men and women was at a tied score of 705.
In A Nutshell
Credit management is the most essential part of effective financial management.
A bad credit score could haunt you forever hence managing your credit is one of the topmost things you must keep a track of. Even the smallest of unpaid balances can cause a dent in your scores. But on the other hand, a good score can help you save a lot of money. A higher score could ensure better interest rates which would mean paying less.
Wisely managing credit helps you get higher credit scores. And high credit scores mean you will get better terms for the line of credit you desire and better opportunities in terms of mortgages or loans. Paying bills on time and the judicious use of credit is as good as getting extra dollars.