Tips on How Do Credit Scores Work
A credit score is a way for lenders to rate the risk they assume when lending you money—or deciding not to. This three-digit number is an analysis of the likelihood that you, the borrower, will repay your debt. Ninety percent of financial institutions utilize the FICO (Fair Isaac Corporation) scale. VantageScore is also used and was developed by the three credit reporting agencies, Experian, TransUnion, and Equifax.
Credit scores are an instrument used to determine financial reliability, fiscal health, creditworthiness – there are a number of ways to say the same thing. Simply stated, a credit score is a quick way for a lender to assess how responsible you have been, to date, with your finances.
When you are in the position to borrow money, it behooves you to have a high credit score. Being approved for a credit card or a loan is wonderful. But don’t settle for approval without shopping for the best terms (lowest interest rates and fees) you can get from the lender.
A credit score is not the only piece of the puzzle used by creditors to assess you. They also look at your overall credit history, and your debt-to-income ratio (how much debt you have compared to your income).
And, by the way, it’s completely possible to have a top-shelf credit score and be deep in debt. If you have multiple credit cards, a mortgage, auto loans, student loans, personal loans… and you pay them all in a timely manner, your credit score will be high. But, again, a credit score is one piece of the puzzle. Borrowers in this scenario will likely face higher interest rates than an individual with a comparably high credit score, sans the debt.
Word to the wise: Do NOT ignore your score. It takes years to build a good credit history.
How Your Credit Score is Computed
While it can seem enigmatic or even arbitrary from the outside, it is anything but. A finite algorithm is used to compute credit scores. Knowing what boosts or hurts your credit history is powerful knowledge and can set you on the right course to help raise your score. Based on information found in your credit reports (Experian, TransUnion, and Equifax), scores are broken down as follows:
|Payment History||35%||Do you pay on time? Pay late? Have you been sent to collections on any accounts?|
|Credit Utilization||30%||What do you owe? Do you pay balances in full? What is the available credit on your accounts? Of your total credit line, aim to use less than 30% of available credit each month to score high here.|
|Credit History Length||15%||How often are you using the credit you have? How long have you had open account/s?|
|Credit Types Used||10%||This has to do with whether or not you have a mix of credit types in your report. One credit type is called revolving credit, such as credit cards. Alternatively, there is installment credit, such as personal/student/auto loans, etc. Try to have both types.|
|New Credit||10%||Are you trying to open new credit? Credit inquiries affect your credit. If you have multiple inquiries, also called “pulls,” this can present a temporary negative effect on your rating.|
|Total||100%||The described elements are weighted according to their importance in the total.|
How Credit is Issued
The three main credit bureaus maintain credit reports and then issue them as permitted by law to lending institutions, insurers, landlords, banks and other creditors. For example, if you apply for a new card, a creditor will request a copy of your credit report from one of the main bureaus. If you receive an approval, the new card called a “tradeline,” will appear on your credit report. Your activity will be updated approximately every 30 days.
Retail stores, banks, credit card companies and others send updates to each of the main credit bureaus on a monthly basis. The way you, the borrower, pay down your debt is reported back to the main bureaus. If you pay late, pay on time, don’t pay at all, or don’t even use the credit card is all noted and sent in and will be recorded on your credit report.
The Fair Credit Reporting Act (FCRA) is a law that originated to ensure that consumers were protected when dealing with the credit bureaus. The law stipulates that the credit bureaus supply correct and complete information to the businesses evaluating your application. Additionally, it states that each of the credit bureaus must provide you with one free copy each year of your credits reports. They do not appear in the mailbox unless you solicit your reports, however.
Where Do You Stand?
- 18% of Americans have good credit.
- 82% of Americans don’t and are vulnerable to high interest rates.
|Very Good Credit||740-799|
|Bad Credit||< 580|
Credit in America
The United States of America with its vast geography and diverse population is also known for its economic disparity. In comparing national credit averages, it is important to keep in mind lower credit in one area compared to another could be due to regional economic conditions, a recent natural disaster, or any number of other factors. In 2017, FICO’s nationwide average score was 695 and VantageScore’s was 673. The Consumer Financial Protection Bureau calls these numbers “prime,” or average.
One of the most diverse categories in assessing credit scores is the comparison between age groups. Trends show that with increased age, credit improves. The youngest age cohort typically has a lack of credit diversity and certainly has a shorter credit history, as they’re just starting their credit journey. Whereas, the 30-39-year-old group—generally speaking—endure large expenditures in this decade. They may have wedding expenses, first mortgages and also have the highest credit card debt. Once into the next decade, scores improve, and so on throughout life.
According to Time Magazine, the following is the breakdown of FICO compiled credit scores per age group as of April 2017:
- 18-29 years old: 652
- 30-39 years old: 671
- 40-49 years old: 685
- 50-59 years old: 709
- Age 60+: 743
The lowest credit scores in 2017 were in southern states; Arkansas (653), Louisiana (650) and Mississippi (642). These states continue to be adversely affected by the 2005 recession. Their economic recovery measured in terms of credit utilization is among the lowest in the nation. Financially sound states were Minnesota (707) and North Dakota (700).
States with greater than 40% of their population considered subprime (borrowers with poor credit history who qualify for high-interest rates), according to the Federal Reserve Bank of New York, were; Alabama, Arkansas, Florida, Georgia, Louisiana, Mississippi, Nevada, New Mexico, Oklahoma, Tennessee and Texas.
High income correlates to higher credit scores. How?
Debt-to-income is not a stand-alone factor in compiling a credit score. However, part of your credit score takes into account the amount of available credit you use monthly. It should be less than 30% of your total available credit. If you have low income, you may depend on credit cards to pay for a portion of your living expenses. Of course, this drives up the percentage of available credit you utilize on a monthly basis.
Second, the line of credit approved by credit card lenders is based on your income. If you have low income resulting in a low line of credit, chances are you will eat it up faster than a huge line of credit for a wealthier individual.
How to Get Your Reports
Credit Reports: Every 12 months you are able to obtain one free, federally mandated copy of your credit report from each of the credit reporting companies. You can order online at annualcreditreport.com or call 1-877-322-8228. On your credit report you will find your name, any previous names, past and present addresses, whether you have filed for bankruptcy, or been sued or arrested.
Credit Score: You can pay to get your credit score at MyFico. CreditKarma and CreditSesame let you view TransUnion and Experian scores free. Many larger banks now put your credit score on your monthly credit card statement, so look and see if your bank participates. If you are paperless, it will be online. The U.S. Government offers a list of free credit counseling services.
Ways to Improve Your Credit
Certainly, monitor your credit reports for errors. Look for data breaches, which are not uncommon in the world we live in. Your identity belongs to you. Do not let someone else use it! If you find an error on your credit report, do not panic. Just deal with it. How? You are responsible for reporting anything erroneous in writing to the company who provided the report. Also, separately inform the creditor in writing that you are disputing the item.
- Keep balances on revolving credit low, or pay in full each month.
- Have diverse credit in your history: installment loans and revolving (credit cards).
- Reduce the amount of debt you owe.
- Pay all bills on time.
- If you are just getting started with credit history, don’t open too many new accounts at once: it looks risky to lenders.
- If you have had credit problems in the past, it is okay. Keep your head up and start again. This time, do it right by making on-time payments and living within your means.
- Is a creditor or lender mistreating you? Contact the Consumer Financial Protection Bureau.
1. What is a Credit Score? Fair Isaac Corporation. Available at https://www.myfico.com/credit-education/credit-scores/
2. Fair Credit Reporting Act. Ftc.Gov. Available at https://www.ftc.gov/enforcement/rules/rulemaking-regulatory-reform-proceedings/fair-credit-reporting-act
3. John S Kiernan (2019). How to Check Your Credit Score for Free, in 2 Minutes. Available at https://wallethub.com/edu/how-to-check-credit-score/25503/
4. What Is a Good Credit Score? Experian Information Solutions, Inc. Available at https://www.experian.com/blogs/ask-experian/credit-education/score-basics/what-is-a-good-credit-score/
5. Brittney Mayer (2018). 300 — 850: The “Credit Score Range” Explained (FICO & VantageScore). Available at https://www.badcredit.org/how-to/credit-score-range/
6. Kali Geldis (2018). 11 Ways to Improve Your Credit Score. Credit.Com, Inc. Available at https://www.credit.com/credit-repair/how-to-improve-credit-score/
7. How to repair my credit and improve my FICO® Scores. Fair Isaac Corporation. Available at https://www.myfico.com/credit-education/improve-your-credit-score
8. Christine DiGangi (2016). 10 Things Everyone Should Know About Credit Scores. Credit.Com, Inc. Available at https://www.credit.com/credit-scores/10-things-everyone-should-know-about-credit-scores/
9. Casey Bond (2017). Everything You Need to Know About Credit Scores. Available at https://creditcards.usnews.com/articles/everything-you-need-to-know-about-credit-scores