Why is your credit score so important? Isn’t debt something you should avoid? Many personal financial experts will advise you to avoid debt to the extent reasonably possible. And you would be smart to heed that advice.
Too much debt can be dangerous and can lead to financial ruin. Certain kinds of debt are also more troublesome and harmful than others. For example, consumer debt for items which are consumed or depreciate in value over time should be kept to a minimum.
Sometimes Debt Financing Is Necessary For Certain Transactions
There are certain times, however, where debt is beneficial and necessary. It can allow us to make worthwhile purchases of assets which are necessary and/or appreciate over time. Such purchases often would otherwise not be possible without the use of debt.
The prime example is purchasing a new home. If everyone tried to accumulate enough money for an all cash purchase before buying, home ownership would only be a dream for most of us. Responsibly obtaining an affordable mortgage in order to purchase your residence at a properly negotiated price can be a wise move.
You may also wish to borrow money to buy a rental property, another investment, or to start or purchase a business. These may also be smart moves as long as you buy at a good price and have a responsible and realistic cash flow plan as to how you will service the debt.
Your Credit Score Can Affect Your Borrowing Costs, But Other Areas As Well
In order to be able to borrow money, and to do so on attractive terms, you need to have a requisite credit score. Credit score is not the only factor that lenders use in deciding if they will lend to you, or what the terms will be.
Other factors such as your income, as well as employment status and history, are also very important. But credit score is a key factor when applying for a loan. The better your credit score, the better the deal will be for you.
Your credit score does not come into play only when you are borrowing money to purchase something. For example, if you try to lease an apartment or a car, your credit score will usually play a big part in the type of deal you get, if any. Credit reports and scores are also necessary when applying for credit cards. Employers may also look at your credit report, but not your score.
A poor credit score can result in higher borrowing costs, fees, and/or down payments, or worse yet, a denial of your application.
What is A Credit Score?
A credit score is a number credit bureaus or other organizations compute, which indicates to creditors how risky it would be to lend you money.
Most lenders usually report monthly to the three main credit bureaus which keep track of individuals’ credit histories. These bureaus are TransUnion, Equifax, and Experian. As such, these are the primary providers of credit reports which lenders in the United States use.
Your credit score is determined from the information contained in these credit reports. This information can and does change over time.
For the most part, each credit bureau’s credit report for a specific individual should be very similar. However, differences may exist among the different bureaus. Also, it is possible for one report to contain an error while another doesn’t.
FICO Credit Scores
Credit scores can be based on many different models. However, the ones most commonly used by lenders in the United States are called FICO scores. The name comes from the company formerly known as Fair Isaac Corporation, which creates the algorithms on which they are based.
There are several FICO score variations which lenders may use. For example, a credit card company can use one FICO score, while an auto lender may use a different variation. Home mortgage lenders can use yet another. All scores are based on similar factors.
Each variation is computed using different algorithms which are modified to put more weight on criteria deemed more important to lenders in certain industries. FICO says it also updates it’s models over time to keep up with changing consumer behaviors. According to FICO, the most widely used score today is the base “FICO Score 8.”
Non-FICO or “Educational” Credit Scores
There are also other proprietary models created by the credit bureaus and other companies which calculate non-FICO credit scores. Such credit scores are referred to as “educational” credit scores.
They are primarily intended to help or “educate” the customer to understand roughly where their creditworthiness stands. Although they may resemble the FICO scores, they are based on different formulas. Lenders do not generally use these scores.
How Is My Credit Score Calculated?
The exact formulas used by FICO are not known to the public. However, FICO provides some guidelines in helping you to understand what affects your score. Although there are different variations, the key factors for the general population (according to FICO) are discussed below.
Note that the indicated weightings are averages for the general population. Each individual may have different weightings based on their credit history and the information contained in their credit report.
The most important factor is payment history. It gets an average weight of 35% from FICO. You obviously want to pay your bills on time. Lenders want to see that you are responsible and capable of making timely payments on your credit obligations. Late payments will reduce your credit score.
However, it is possible to improve a low score resulting from a late payment history. Making timely payments consistently over time will gradually raise your score.
This category gets a weighting of 30%. The absolute amount you owe is not as important as the amount you owe relative to your available credit.
Let’s assume that you have available credit of $20,000, and you have debt balances totaling $5,000. You are currently using up 25% of your available credit. Now let’s say your friend has only $4,000 of debt balances, but their available credit is only $5,000. Your friend is using 80% of their available credit.
Despite a lower absolute debt balance, the friend’s credit score would be more negatively impacted due to the fact that they are using a higher percentage of available credit.
Note that even if you pay off your credit card balances monthly, for example, high monthly usage as a percentage of the available credit can also reduce your score. So the “credit utilization” ratio is very important.
The types of accounts (i.e. credit cards) on which you owe and the number of accounts which have balances can also affect your score. Having outstanding balances on many accounts may indicate a higher risk of future default.
Length of Credit History
An average weighting of 15% is assigned to length of credit history by FICO. Typically, a long (and good) credit history will increase your credit score. However, it is possible to have a high credit score even with a shorter history. A long history indicates to lenders that you have experience in handling credit.
Factors considered include the age of your oldest and newest credit accounts. The age of specific individual accounts, and the average age of all your accounts are also important.
Different types of accounts include credit cards, mortgage loans, retail accounts, and installment loans. Having a good history with different account types shows lenders you can handle different types of credit obligations.
However, having too many accounts (relative to your overall credit profile) can be a negative. So once you have a sufficient credit history, don’t open credit accounts that you don’t need.
Keep in mind that even if you close an account, its history will still be reported on your credit report, and it will still affect your credit score. Closed accounts in good standing can show up on your credit report for up to ten years. Delinquent closed accounts can be on your report for seven years from the date of the original date of delinquency.
Credit mix gets an average weighting of 10% from FICO.
Opening too many accounts within a short time frame is seen as risky by lenders. It also lowers the average age of your accounts. This is especially true if you don’t have a long credit history.
Despite their relatively small impact on your score, too many credit inquiries by creditors can also reduce your credit score. Inquiries remain on your credit report for two years but only those in the past twelve months are used in computing your FICO credit score.
However, only checks related to credit risk are counted. Some types of credit checks are disregarded. For example, checking your own credit through a credit bureau or other organization such as FICO will not hurt your credit score. Neither will “promotional” or “administrative” requests from lenders. The same holds true for inquiries from employers.
Promotional inquiries are when a lender checks your credit in order to make you a “pre-approved” credit offer. An administrative request is when a lender checks your credit as part of a review of your credit account.
Multiple inquiries from credit card applications, especially within a short time frame can have more of a negative impact. However, credit checks from auto or mortgage lenders done within a short time frame (i.e. 30 days) may be treated as one inquiry. As such, they may not affect your score much if at all. This is done to allow customers to “rate shop.”
On average, new credit gets a 10% weight in calculating your FICO score.
What Does My Credit Score Mean?
The base FICO scores (FICO Score 8) range from 300 to 850. Industry-specific FICO scores range from 250-900. Following is a discussion of base FICO score range categories.
The highest category is when your score is 800 or more. This type of score is considered “exceptional” and is much greater than the national average. About 1% of individuals with such a score are expected to fall behind on their payments.
The next category range is 740 to 799. A score within this range is considered very good or above average. Those in this range have a delinquency risk of about 2%, and will also likely be able to get attractive loan terms.
The “median” range is between 670 and 739. Approximately 8% of such borrowers may become delinquent. As such, although deemed “acceptable”, a score in this range may not allow you to get the best available credit terms.
The range of 580 to 669 is deemed “fair” and falls below the national average. Individuals with scores in this range will likely pay more for borrowing money if they are approved. About 28% of such individuals may fail to make timely payments on their obligations.
Scores of 579 and under are considered “poor”, with a risk that almost 61% of such borrowers will become delinquent. In addition to higher interest rates, such individuals must usually pay additional fees and/or make higher deposits with the creditor to reduce their chances of having their applications rejected.
Certain Public Records Can Appear On Your Credit Report And Affect Your Score
A bankruptcy filing is the worst one. A Chapter 7 bankruptcy (no debt repayment) remains on your credit report for 10 years. A Chapter 13 bankruptcy (partial debt repayment) will show up for seven years.
Tax liens may also show up on your report. Unpaid tax liens will remain for up to 10 years from their original filing date. Paid tax liens can appear for up to seven years after they’re released. You can attempt to get a federal tax lien withdrawn by using IRS Form 12277. This form allows you to request a withdrawal.
Monetary (civil) judgments resulting from a lawsuit can also make their way onto your credit report. They can appear there for up to seven years. However, you may sometimes be able to convince a credit bureau to remove a judgment sooner if you have paid it. A paid judgment will be less detrimental than an unpaid one.
As part of the National Consumer Assistance Plan (NCAP), new standards went into effect July 1, 2017 which will require only tax liens and judgments that have attached minimum identifying information such as social security numbers or dates of birth to be reported. This will affect a significant number of judgments, and some tax liens.
Other Key Points To Consider About Your Credit Report And Score
- In order to generate a FICO score, you generally must have at least one account open at least six months, and at least one report on an account (i.e., from a lender) to a credit bureau within the past six months.
- For married couples, joint accounts will appear on both reports. So it is important to be aware of your spouse’s credit behavior.
- You can get a free credit report from each of the three major credit bureaus once every twelve months from annualcreditreport.com. It is a good idea to check these reports once a year, especially for errors or any signs of identity theft. However, a credit score will not be provided along with the report.
- If you find errors on your credit report, you should contact the credit bureau which compiled it.
Your credit score will usually play a significant role in a lender’s decision to loan you money. Not to mention the terms of the loan. The higher your credit score the better. Credit score is also important when leasing a car or an apartment. So check your credit periodically to make sure you will not be in for a big surprise when you need it most.