Credit scores are a little confusing aren’t they?
There are literally thousands of articles and posts about credit scores that tackle topics ranging from how to get your score, how to improve it, which cities have the best credit scores and even how credit scores affect your love life. The opinions differ depending on who you ask and it seems like everyone claims to be an expert. That can be really frustrating if all you want to do is know what your score is and why it matters.
We’ve decided to tackle this huge subject of credit scores by breaking it down into simple parts: how they came about, what they are, how they’re calculated, good scores, bad scores and what it all means for you.
Over the next few minutes, we’ll take an in-depth look at each of these areas and talk with a few experts about how credit scores are calculated and how it affects your life.
Understanding how your credit score is calculated is really important, because once you know the factors influencing your score, you can create a roadmap for your credit future.
Now, before we get into the specifics of how your score is calculated, we think it’s important to head back into history for a moment to understand how we got to the modern scoring system.
The History of Credit Scores
Long ago, before today’s big-name credit bureaus, local business owners and bankers had no way of knowing how creditworthy a customer was. So, let’s say you lived in a small town and you wanted to score a home loan from the bank.
Most likely, the guy at the bank responsible for handing out loans would talk to his buddy at the grocery store across the street to get insider info on your reputation. If you’re going to loan someone money, it’s pretty crucial to know if they’ll pay it back, right?
Eventually, lenders realized it benefitted them to know as much as possible about their customers. So, local merchants created files about their customers. They’d include newspaper clippings about the person (marriage announcements, arrests, etc.) and other information to determine whether or not they wanted to lend money to them.
Instead of each separate company having a file about a person, credit reporting agencies (known as “bureaus”) were created to keep track of all the clients in the area. If a lender had a question about your credibility, she’d call the local bureau to find out.
Over time, those bureaus became national ones known as Experian, TransUnion and Equifax. Just like the old days, they go to lenders and businesses to find out your history with them. Each bureau gives you a credit score based on about 300 factors, a few of which we’ll talk about in a few minutes.
That score is created by a rating system the Fair Isaac Corporation, or FICO, designed for each bureau. Started by an engineer named Fair and a mathematician named Isaac, FICO’s scoring system is a way to determine risk and has helped lenders, bureaus and banks since the 60’s.
What is a Credit Score?
In simple terms, your credit score is what credit card companies, mortgage lenders, insurance providers, etc., use to determine whether or not you’re going to pay your bills on time. The higher the number, the better score (more details later).
Now, if you’ve done the research to know your “score,” you’ve probably noticed that you get a credit score from TransUnion, Equifax, Experian and FICO. Why? Because each organization has their unique way of calculating your score.
In reality, said Rod Griffin, director of public education at Experian and a 19-year veteran with the company, we should say “credit scores” instead of “credit score” because your scores vary depending on which bureau is reporting.
Most consumers put a huge emphasis on their credit scores but, Rod said, the more important factor is your credit history.
Your credit scores are based on a number of factors in your past, some of the more important of which include: how many accounts you’ve opened and closed, when you paid on time and when you were late. It’s like a laundry list of your good and bad habits. So, you can see why knowing your credit history is as important (if not more important) than knowing your credit scores.
“These days, there’s almost a paranoia about credit scores and a lack of attention on what’s driving that number,” Rod said. “It’s important to know your credit scores … but it’s more important to know what’s in your history.”
And this is a great way to go into our next section. We’ve touched on it a bit so far, but we really want to dig into the details about the factors behind your scores.
How is My Credit Score Determined?
Think of your credit score like a recipe for chocolate chip cookies – everyone has their own opinion about what ingredients make the best cookies.
Your grandma likes to sprinkle in some cinnamon. Your mom adds extra chocolate chips. Your significant other is all about walnuts, while the chef you saw on TV says unsalted butter is the key.
But, the truth is, nearly every recipe uses the same ingredients; they just give more attention to certain ones over others.
Let’s apply that to your scores. I checked my credit scores and found that my FICO score was 15 points higher than my Equifax score, which was five points higher than my TransUnion score.
As you can see, there’s some variation here. Each of these agencies has their own recipe for creating a score, but even though the scores vary, they all fall within 20 points of each other. Different ingredients, relatively equal results.
Is there one score that’s more important than another? We believe that your FICO score is the most important, mainly because that’s the score the 25 largest U.S. credit-card issuers, the 25 largest auto lenders and the top 50 U.S. financial institutions use when determining your creditworthiness.
For example, a few months ago I bought a used car. When the dealership ran my credit, they used my FICO score. Mortgage lenders also use this score (we’ll tackle this in a few minutes).
How does FICO generate their score? We turned to their website for the answer. Here’s their methodology:
- Payment History: 35%
- How much you owe in loans, credit card balances, etc: 30%
- How long you’ve had your credit accounts: 15%
- How much new credit you have: 10%
- The variation of credit accounts you have: 10%
As you can see, the most important factors in your FICO credit score are your payment history and your total balance.
“There are really two things a person needs to know about their credit scores,” Rod said. “You have to pay your bill on time, every single time, and you need to keep your balances as low as possible.”
What Rod said matches with what FICO says about their scoring system. If you want to set yourself up for good credit, make a habit of paying your bills on their due date and try to keep your balances as low as possible.
And that leads us into the next section of our guide to credit scores: good credit.
What’s a Good Credit Score and How Do I Get It?
Think of your credit score like the old-school grading system. You got a letter grade – A, B, C, D or F – based on a number score. So, anything between an 80 and an 89 was a B, and anything between a 90 and 100 was an A.
Various websites have their grading systems, so we decided to choose the Credit.org scale because we’ll be using it later to illustrate how your credit affects your daily life:
- Excellent: 740-850
- Good: 680-740
- Acceptable: 620-680
- Subprime: 550-620
- Poor: 300-550
So, depending on who you ask, “good” credit is anything around 680 and above. But let’s not get carried away with numbers. Remember the advice Experian’s Rod Griffin gave us? Focus on your credit history, not your score, because your history reflects your habits and your habits are what truly influence your credit.
What are the Habits of Someone with a Good Credit Score?
We’ve already reviewed this a bit a few minutes ago. Those with good credit scores are the ones who pay their bills on time and keep their balances low.
Let’s break those two factors down a bit. First, payments.
Credit bureaus keep track of your payments from the last seven years, so there’s really no time to relax when it comes to your payments. One “delinquent” payment can stick on your credit report for a long time. We’ll explain delinquencies in the next section.
As for balances, the key is to know your overall credit card limit and how much your current balances are. If your balances are under 30% of your total limit, you’re in good shape, according to popular credit-score website Credit Karma.
For example, if you have an overall balance of $5,000 across five credit cards with a total limit of $25,000, you’re in better shape than if you have a $5,000 balance with a total credit limit of $10,000.
What’s a Bad Credit Score and How Does it Happen?
Your credit is considered “subprime” or “poor” if it falls below 620. This could happen because consumers don’t have any credit history or their history is sparse.
If you’ve got a credit history and a low score, late payments and high balances in proportion to your credit limits are likely to blame.
When it comes to paying late, credit report agencies classify your “delinquencies” in one of four categories: 30 days late, 60 days late, 90 days late and accounts that went to collections.
The first three late categories (30,60,90) are self-explanatory. The fourth, accounts going to collections, happens when your bills are more than 90 days past-due and your lender sends your account out to an agency whose purpose is to track down consumers and make them pay their debts.
Delinquencies and accounts that go to collections can cause serious damage to your credit score (the penalty varies on your individual history), so do everything you can to pay your bill on time.
Also, consider this: the timing of your delinquency affects your score in different ways.
“If a person has one delinquency of 30 days a couple of years ago, the point impact will be different than the person who has a 30-day delinquency a month ago,” Rod said.
And this is where the complexity of credit scores comes into view. There’s no set points-penalty for your credit mistakes. Each score is based on your credit history.
“The scientists who developed the (credit scoring) model have studied millions of histories and behaviors and the risk of each element in your credit history,” Rod said. “It’s a really sophisticated process.”
But not so complex, he said, that you don’t have control over your history and score. And that’s the good news. Even if your credit scores are in the sub-prime or poor range, you can change them.
“Never give up hope; that’s always the key,” Rod said. “Unlike history books, you can change what’s being written … you can change your score over time.”
As our series on consumer credit continues, we’ll cover the ever-important topic of how to build a positive credit history.
But for now, we’re going to take a look at how your credit scores affect your day-to-day life.
How Much of an Impact Do My Credit Scores have on the Big Picture?
Truth is, most of us are concerned about our credit in a temporary sense, like when we want to get a car loan or we apply for a mortgage. In those moments, our scores are really important.
But we tend to lose sight of how our scores can affect our wallets over time, and to get a clear picture of those effects we talked with Melinda Opperman, a senior VP at Springboard Nonprofit Consumer Credit Management, a certified national credit-counseling organization.
As we talked with Melinda about the long-term benefits of good credit, she started discussing the results of a study the company did in 2012 about credit scores and interest rates for mortgages, car loans and credit cards.
How Your Credit Score Can Affect Your Mortgage
Let’s say you’re shopping for a house, Melinda said, and you want to get a 30-year mortgage for $160,000. If your credit score is between 740-850, you’ll get (at the time of the research) a loan at 3.9% interest. You’ll end up paying $89,000 in interest by the end of 30 years.
Now, if your credit score falls in the “good” range (620 – 680), you’re going to pay an extra $8,000 in interest because your rate will be 4.2% instead of 3.9%.
Acceptable credit gets a 4.9% rate, which will cost you $28,000 more than those with excellent credit.
The real shock comes when you look at the subprime rate: 8.6%. The difference between 3.9% may not seem like much compared to 8.6%, but over 30 years you’ll end up paying $229,000 in interest.
Not only is that $140,000 more than someone with excellent credit, it’s also $69,000 more than the purchase price of your home!
But that’s not all, Melinda said. Let’s say you wanted to spend $1,500 per month on your mortgage. A buyer with subprime credit is going to use a big chunk of that $1,500 to pay their high interest rate, while the buyer with excellent credit will be paying much less in interest every month.
Translation: Lenders will factor this into how much you can spend on your home. Better credit means you’ll get more money for a house. Bad credit means you’ll get less money for you house because you have to pay more in interest.
How Your Credit Score Can Affect Your Auto Loan
The same goes for cars as well, Melinda said. The typical auto loan APR for a $25,000 car in 2012 for someone with excellent credit was 5.1%, while rates for subprime credit were 17.9%.
The monthly difference? About $160, which means you’ll be paying $9,600 more over the life of the loan simply because of your credit score.
The Big Cost of Bad Credit
Now, combine this example – $9,600 – with the previous mortgage example where subprime borrows paid $140,000 more than people with excellent credit. That’s a whopping $149,600, which, at today’s going rate with average scholarship and grant amounts, could send both of your kids to Harvard for a four-year degree.
Let’s look at it from the day-to-day perspective. Using the $149,600 estimate above, having subprime credit scores will cost you about $13.60 a day for the next 30 years. That’s a pretty sobering number and a really powerful reminder of how bad credit can affect your life.
Our Conclusions About the Importance of Your Credit Scores
Our research and our discussions with industry professionals has shown us both sides of the coin when it comes to your credit scores.
On the one hand, Experian expert Rod Griffin told us how important it is to follow your credit history rather than obsess over your credit score. On the other hand, Springboard exec Melinda Opperman showed us how your credit scores impact your daily life.
If we could boil down our conclusions in one brief sentence, into would be this:
- pay your bills on time,
- keep your credit card balances low and,
- never forget the impact bad credit can have on your day-to-day circumstances.
Now, if you find yourself in the middle of a really tough time in life and your credit has taken a hit, we want to remind you your score is a history book that can be changed over time. Our findings show that analyzing your credit history and knowing your habits can go a long way in repairing a bad score and preparing you for a low-interest mortgage or car loan.
If you want to keep track of your credit score, I suggest Credit Karma. Their free service allows you to access your TransUnion and Equifax credit scores for free anytime you want. Those scores are updated every two weeks, too.
If you want to keep tabs on your FICO score, you can purchase a membership to the myFICO website. There are three tiers to this membership costing you $19.95, $29.95 and $58.95 a month. But if you’d like your score for free, check with your credit card company Cards like the Chase Slate and Discover it offer free FICO-score access.
In the meantime, we know that student-loan debt is making headlines and that it can impact your credit score. We wrote an article recently about how to handle this debt through a positive attitude, an understanding of debt, exploring loan-forgiveness options and more.
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