Credit Scores: Everything You Need (or Want) to Know

October 28, 2014

Your credit score – 3 little numbers that a lot of people don’t know much about. In this post we cover the basics of credit scores so you can have some ideas for what behaviors affect the score.

What is it?

The score is a three digit number that predicts the likelihood that you will pay back a loan or credit card. The higher the number, the more “creditworthiness” you have, and the more likely you are to pay off a loan.

Why should I care?

Lenders use your credit score to determine whether they want to lend to you and, if so, at what interest rate. Generally, a higher credit score will get you a lower interest rate because the lender deems you to be a lower risk. A bad score can get your loan denied, or can at least result in a higher interest rate. When it comes to a loan such as a mortgage, a higher interest rate will result in you paying a lot more money over the length of the loan.

Even if you aren’t taking out a loan anytime soon, the score can impact other things that you might be doing. For example, landlords often pull scores to determine whether they will rent you an apartment or house, and it may impact the deposit that they charge you. In addition, some insurance companies use the scores to determine what rates to charge you for auto, home, and other insurance products. In addition, some employers look at your credit score when they are deciding whether to hire you.

FICO vs. Vantage

Prior to the 1980’s, there was not a standardized method for determining credit scores. Instead, lenders each had their own method of determining your creditworthiness. In 1989, a standardized calculation known as the FICO score was first introduced by an analytics company called Fair, Isaac, and Company (hence FICO). The FICO model is used by the vast majority of the three national credit bureaus. I describe in the section below how the FICO scores are calculated. The FICO score ranges from 300 to 850.

In 2006, the three major credit bureaus (Equifax, Experian, and TransUnion) released VantageScore, which is an attempt to compete with the FICO score. The newest version of VantageScore gives you a score between 300 and 850. VantageScore has been marketed as a more accurate score – stating that it looks at and breaks down your credit history at a more granular level than the FICO score does.

For example, the VantageScore separates real estate loans into first mortgage, lines of credit, and home equity loans, instead of classifying all such loans the same. It also breaks down installment loans into student loans, auto loans, personal installment, and standard installment loans. VantageScore says that is captures and models consumer behaviors more accurately, and it offers predictive scoring rather than only a current score. As a result, VantageScore is being marketed to lenders as a more accurate way to score consumers who have a limited credit history. VantageScore is becoming more accepted in the industry, but FICO is still the most widely used model.

How is the FICO score calculated?

The exact formula for calculating a FICO score is secret. FICO has disclosed that the components of the score are as follows:

  • 35% payment history – This looks at whether you have paid past credit accounts on time
  • 30% amounts owed  – This category is a little more complicated. Owing money on credit accounts does not necessarily mean you are a high-risk borrower; however, if you are using a high percentage of your available credit, it could indicate that you are over-extended. So for this portion, your score will take into account the amount owed on all accounts, the amount owed on different types of accounts (i.e. credit cards versus installment loans such as car loans), whether you’re showing an amount owed on certain types of account, how many of your accounts have balances, how much of the total credit line is being used, and how much of installment loan amounts are owed compared with the original loan amount (i.e. if you take out a 5 year car loan and have paid off 3 years through installment payments, that is a good sign).
  • 15% length of credit history – This category looks at how long you have had credit accounts established. Generally a longer history will increase your score.
  • 10% new credit – If you have opened new accounts lately it may lower your score because (according to FICO) research has shown that opening several accounts in a short period of time means you are a higher risk to lenders.
  • 10% types of credit used – This looks at your mix of credit cards, retail accounts, installment loans, and mortgage loans.

When you pull your credit score from the three credit bureaus, you might notice that your score is not the same from each institution. This disparity happens because the three bureaus are using all of the credit history that they have on record for you, and they may not all have the exact same information. As a result, many lenders will average the scores or will take the middle score when they are looking at your credit.

It is somewhat counter-intuitive to think that having no debt might lower your FICO score. But as you can see, having credit and managing it responsibly shows potential lenders that you are not as great a risk as someone who has no history at all. Therefore, if you are looking to establish a credit history, it may be a good idea to use a credit card to make a few small purchases each month, and then pay off the credit card in full and on time each month. The key is ensuring that you do not carry a balance. Alternatively, if you have another loan, such as a student loan or an automobile loan, having an on-time payment history for that type of loan will also help you build up your credit history.

Credit scores and getting a job

As I noted above, potential employers may look at your credit score when they decide whether or not to offer you a job. Whether it’s fair or not, a low score may cause a potential employer to be concerned with how responsible a prospective employee is. If the job you are applying for involves money or finance, then there is even greater concern – if you can’t handle your own money then an employer will not want to trust you with the employer’s money. Some states have enacted restrictions on when an employer can look at your credit score. Most of these laws contain exceptions if you will be working in the financial industry.

Student loans

Student loans are generally treated as installment loans by the credit bureaus. So you can increase your credit score by making your loan payment in full and on time each month. If you find yourself unable to pay your student loan, you should consider deferring the loans because that will not ding your credit score like a default will. According to the FICO analytics blog, having student loan debt will not automatically lower your score, and in many cases, can increase your score if you have a good payment history.

What is a “good” score?

A FICO score of 720 or higher is generally considered a “good” score. Different lenders may have different benchmarks, so keep building you score and don’t despair if you aren’t yet at 720.

How do I check my score?

There are a lot of places online where you can check your score for “free.” The catch is that you have to give your credit card number and the service isn’t free after the first month so you will automatically get charged unless you cancel. You also need to be careful about who you give your social security number to (your SSN is needed to check your score).

Credit Karma appears to be an exception – it is free of charge and you do not have to give a credit card number so you can get charged in the future. You will have to deal with a few advertisements when you log on. If you go to AnnualCreditReport.com then you will have access to your credit report for free. However, you will not have access to your score for free. It is a good idea to monitor your credit report to ensure there is not any fraud, and to ensure that you can identify any problems early on.