You’ve probably heard of credit scores. You know that banks use them to decide whether or not to give you a loan and what interest rate to charge. But what really is behind the credit score? What’s not in the credit score? Does it really matter? And should the bank even use it? These are the kinds of questions that I asked when I learned about the scores. I’ve been asked these questions a lot over the years as well. I’ve found a lot of inaccurate and downright wrong information on the internet. Well, here are the true answers.
What is a credit score?
Your credit score is an estimated value put on your credit history. The FICO score is the most well know. It goes from 300 to 850. The higher the score the better record you have of paying your bills and not charging up your debt. So if you don’t pay your bills then your score will go down. Banks use this score because it is an easy way to get a general idea of how well you manage your debt and other bills.
What is behind the credit score?
The formula varies a little bit between different companies. The formula for the FICO score consists of 5 basic categories: credit length, types of credit, credit inquiries, payment record and debt utilization.
This is how long, in years, you’ve been using credit. This is why many people say to keep your oldest credit card forever. Really, as long as you have a solid record for 7 years you probably have a long enough record to get and maintain a high score. So don’t keep an account if you don’t like it or it costs too much money. This is also only of medium importance to the credit score.
Types of credit
This looks at the different types of credit that you have. It helps your score if you’ve had several different types of accounts like a mortgage, a credit card and a car payment. It shows that you can handle multiple accounts at once. This is one of the smallest factors in the score so don’t go out of your way to get different types of credit just to raise your score.
This is how many times banks have requested your credit record. Having a lot of requests can lower your score. However, banks know that when you’re shopping around for a loan that you may have several requests. Because of that, several within a month only count as one. The concern here is if you’re applying for a new credit card every month. That will hurt your score. Like types of credit, this has only a small effect on your score.
Your payment record has a very large effect on your credit score. This is how good you are at paying your credit bills on time. Every time you’re late your credit score will go down. The later you are the lower it will take your score. The formula looks at it in 30 day batches. So if you’re more than 30 days late it’ll lower it a bit, 60 a bit more, 90 or 120 days even more. The goal here is to always pay on time. This will have one of the biggest effects on your score. And this is where you can have the biggest impact when you want to raise your score.
Debt utilization is the other big part of your credit score. Here’s how it works. Say you have a credit card with a $1000 credit limit. If you only owe the credit card company $100 then your credit score will be higher than if you owe the credit card company $900. Basically banks want to see that you have credit and don’t use it.
What’s not in the credit score?
You may notice that your credit score doesn’t include your income. It also doesn’t include your net worth. It doesn’t look at how much money you have. It only looks at how much you owe other people. This has led to some interesting situations. People in their prime earning years have found that their credit scores have gone down. This is because your credit score only looks at what you owe. Some people reach their fifties, are making more than they’ve ever made, have large savings accounts because they want to retire, but don’t owe any money. They have paid off their mortgages and their cars and don’t need credit cards much. This results in a low credit score since they won’t have a lot of recent loan payments. Less debt like this means a lower score.
Do credit scores really matter, and should banks even use them?
This is kind of a yes and no situation. Credit scores do matter. They give a good indication of how likely you are to pay your bills. Banks have found that if you haven’t paid your bills in the past then you aren’t likely to pay them in the future. They’ve learned this the hard way over and over. The subprime mortgage crisis is a recent example. The loans were called subprime because the people getting the mortgages had bad credit scores.
But the scores only tell half the story. You can have a bad credit score, but still not be a credit risk. People that pay all their bills, save up for their purchases instead of taking out loans and don’t use credit cards can still be good credit risks even though they’ll have lower scores. That is one word of warning. If you follow the advice on this website, advice like save up for your car instead of taking out a loan, pay your mortgage off early, don’t use a lot of credit cards and always pay off the full balance, you won’t maximize your credit score. But you will be able to buy anything you want.
Banks should look at more than just the score to determine whether or not to give you a loan. That’s why they look at your income. If you want to borrow a lot of money, like to buy a house, they’ll also look at your investments and savings.
The bottom line is that credit scores are not the end all be all that they may appear to be. They are just a gauge on how well a person has paid their debt bills on time in the past. That only tells half of the story since the other half is whether or not they have the money and income to pay their bills in the future.
myfico.com is good source for information on how the FICO score in particular and credit scores in general work.