The three numbers that can affect where you live and where you work: your credit score.
This post covers what a credit score really is, what affects them, and why they’re so important. I know it’s not the most fun topic, but it’s something that can affect everything from whether you get approved for a credit card or an apartment, and can cost you a lot of money if it’s low, so I want to make sure we all have at least some basic knowledge of why taking care of our credit score is an important part of making money moves.
Just like a lot of other money related topics, it is crazy to me that credit scores are something that have such a huge impact both on and from the financial decisions we make in our lives, yet it’s something that we’re not usually educated on! I definitely never learned about credit scores in school, and while I had a general idea of what could affect my score and knew having a good credit score was important, it wasn’t until I did research for this episode that I learned about what really goes into calculating your credit score.
Let’s start with what exactly a credit score is.
Put simply, a credit score is a number that lenders use to determine the reliability of the lendee, and whether this person will repay the loan or credit card on time. The higher your credit score is, the less of a risk you are. Your credit score is calculated based on your credit report, which basically is a collection of your past activity – your credit history.
Some lenders do their own risk assessments using their own in-house, customized models, but the majority of companies will request a credit score from one or all of the three major credit bureaus: Equifax, Experian, and TransUnion. Then, when the lender requests your credit score, the credit bureau calculates the credit score based on your credit report. This means that it’s not a permanent score, like a grade you get on homework, but something that is calculated each time.
However, because creditors don’t always report everything to all three bureaus, your credit report and therefore your credit score could also change depending on the credit bureau that’s providing the credit score.
Now, why is having a good credit score so important?
Like I said, your credit score is how lenders determine how reliable you are. This means that if you’re applying for a loan, for example, you’re more likely to get approved for a loan and get a lower interest rate if you have a good credit score because the company trusts that you will be able to pay them back. A lower credit score means that you’re a higher risk, so the company may not want to lend you money at all, or will only lend you money at a high interest rate.
If you have bad or mediocre credit, not only could you miss out on a loan or a credit card, but it could also mean that it costs you more. A lot more! Based on interest rates gathered by Informa Research services, someone with an okay credit score would pay $65,000 more on a $200,000 mortgage than someone with a very good credit score. Or, on a 5 year, $30,000 car loan, a borrower with lower scores could pay over $5,000 more. Having bad credit can get really expensive!
Not only that, but your credit score can affect areas of your life outside of receiving credit. Landlords might check your credit report before deciding to rent an apartment to you, and potential employers – if given permission – may also check your credit report during the hiring process. Insurance companies and telephone and utility companies can also use the information in your credit report to decide whether they will offer you their services and what rate you’ll pay if they do.
In addition to determining if you’ll get approved for a credit card, auto loan, or mortgage and how much you’d have to pay on these loans, your credit score can affect where you’ll live and where you’ll work. This is why having good credit is so very important!
So how exactly is this super valuable score calculated? Who decided what this algorithm would be?
I won’t go into the full history of credit scoring, but an issue many companies faced not too long ago was a lack of a standardized scoring system or algorithm. This meant that it was hard to interpret and compare reports to each other. In 1956, an engineer named Bill Fair and a mathematician named Earl Isaac created a company called Fair, Isaac, and Company to make standardized and impartial credit scoring systems to help address this issue. They developed and began selling their algorithms within a couple years.
Then, in the 60’s, Atlanta’s Retail Credit Company – which was founded back in 1899 – decided to computerize its records. The problem was, their information was extremely detailed and they had data not just on Americans’ credit and capital, but about their social, political, and sexual lives as well. As you can imagine, people were not happy about this. In addition to some congressional hearings, this is also part of what led to the Fair Credit Reporting Act in 1970. This legislation required credit bureaus to delete negative information after a period of time, delete information about race, sexuality, and disability, and also allow people access to their credit reports
Atlanta’s Retail Credit Company survived the congressional hearings and continued on the path to computerizing reports, changing their name in 1975 to Equifax. The two other big consumer credit bureaus, TransUnion and Experian, also joined this quest to computerized reports and more importantly, create a standardized model that would make understanding and comparing reports easier. They started working with Fair, Isaac, and Company, and in 1989, the FICO Score was introduced. That algorithm is still very similar to what’s used today.
Now, there are still many different scoring models and as I mentioned earlier, some companies do have their own custom models, but two of the most common models used are the FICO Score and VantageScore. In addition, both FICO and VantageScore models are updated regularly, so your credit score could change based on the specific version or model being used and different industries now use different models, whether it’s a previous year’s model or an industry specific model, which means that the credit score that gets sent to the lender can also change based on whether you’re getting, for example, a credit card or a car. Currently, the FICO Score 8 is the most commonly used model and while they do have a newer model, FICO Score 9, it’s not as widely used yet. Both FICO and the newer VantageScore models use a scale from 300 to 850, with the higher number meaning a better credit score. For FICO, a good credit score is 670 or above, while bad credit is below 580. We want to aim for at least a “very good” score, which is over 740. I won’t get into which models every industry uses, but you can go to myFICO.com to get all of your credit scores from all three bureaus and industry-specific scores like auto, mortgage, and credit card for around $20.
Now, let’s talk about what types of things affect your credit score. For your FICO score, your payment history on loans and credit cards, and the total debt and amount owed is the most important. But, the length of your credit history and the types of accounts you have (called credit mix) is also a factor. For your VantageScore, payment history, credit utilization (or the percent of credit limit you’re using), and the age and type of credit are the most important, while your total balances and debt and recent credit behavior and inquiries can also affect your score.
Things like the length of your credit history are, of course, a little harder to change, since we can’t go back in time! But there are things that are in your control that you can do to either keep your credit score high, or work on improving it.
Credit score models, such as FICO and VantageScore, are updated regularly and different industries use different models! This means that your credit score can change based on whether you’re getting, for example, a credit card or a car.
One is credit utilization – something I’ve talked about before. In order to not negatively impact your credit score, you should keep credit utilization below 30%. This means that if you have a credit limit of $1000 on your credit card, you shouldn’t spend more than $300. If you’re able to, you should also pay off your balance in full so that you have less debt, which will increase your score. Once your balance has been paid off in full for at least three months, you can request a credit limit increase, which would also help with your credit utilization.
Timely payments are also important. If you can, set up autopay so you don’t have to worry about ever making a late payment. Or, some people like to pay their bills as soon as they get them, even if it’s not due yet, so they don’t have to worry about it. A late payment can stay on your credit report for seven years!
You should also avoid closing credit card accounts. Once you have a high score, you can think about closing an account or two without impacting your score too much, but keeping the accounts open – especially for a card with a higher limit – will help increase your credit score by improving your credit utilization. However, this does not mean that you should immediately apply for a new credit card! Applying for a credit card will result in a hard inquiry. A hard inquiry, also called a hard pull, is when a creditor – like a credit card company – has requested to look at your credit file. These hard inquiries stay on your credit report for a couple years, and do negatively impact your credit for a few months. This is because having a lot of hard inquiries in a short time could be interpreted as you seeking a lot of loans and credit cards that you might not be able to pay back. Of course, if you really do need a new credit card or are in a position with good credit and the money to apply for a credit card that better fits your needs, then that small hit on your score is totally worth it!
On the other hand, a soft inquiry is when you check your own credit, or when a lender or credit card company checks your credit to pre-approve you for an offer. These soft inquiries do not impact your credit score, so don’t worry about checking your credit score! You’re entitled to a free copy of your credit report once a year from all three credit bureaus at annualcreditreport.com. Currently, because of COVID-19, you’re able to request this report up to once a week through April 2021. When you request these reports, you should absolutely check to make sure there aren’t any inaccuracies. If you find errors, you can dispute them and get them corrected so that it will stop impacting your credit. Make sure to go over your report thoroughly, because every little bit counts!
One more thing I want to add – you might already use a service like Credit Karma or Mint.com to check your credit score. But, like I mentioned before, different lenders and industries use different credit scoring models and not all credit bureaus have the same information, so while these services can provide a general idea of your creditworthiness, be aware that it might not be the exact same score that gets pulled when you actually apply for a loan or credit card. This is why it’s important to check your full credit report from all three credit bureaus on a regular basis and before making any big moves like an auto loan or mortgage.
If you pay your utility bills and rent on time, you can also ask your landlord and utility companies to report your positive payment history to the credit bureaus. This information isn’t typically included on a credit report – except, of course, if you don’t pay and the amount gets sent to a collection agency. If you don’t have a credit card or don’t have a long credit history, this could be one way to help include positive information into your credit report.
The easiest way to have good credit is to not damage it. Like I mentioned with the late payment, some of these negative actions can remain on your credit report for years. That’s why building credit or rebuilding your credit is something that takes time. There is no quick fix! But, by taking small but important steps like paying down your debt and making payments on time, you can start improving your credit score because, as we talked about at the beginning, your credit score can impact many areas of your life and bad credit can be really expensive. I know this was a lot of dense information, but I hope that you at least understand why having a good credit score is so important. Every little bit helps when you’re building a better credit score or maintaining your high score, and it impacts every single money move we make!
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