3 Keys to Understanding Credit Scores
What is a credit score?
A credit score is a three digit figure that is intended to measure the likelihood an individual will repay debt and credit obligations. It was created to simplify the process of obtaining credit. The score provides a standard, objective measure that can easily compare borrowers. Before credit scores, the lending due diligence was labor intensive, which led to less clear standards and more difficulty in obtaining credit.
Today there are two main credit scoring systems, FICO and Vantage Score. FICO was created by the Fair Isaac Corporation in 1989 and its scores are used by 90% of the top lenders. Vantage Score was more recently created in 2006 by the major credit bureaus and has been refined to match the scoring range of FICO. Today both range from 300-850. Listed below is a snapshot of that scale:
How are credit scores calculated?
First off, all major financial institutions feed U.S. consumer information to the three major credit bureaus (Experian, TransUnion, and Equifax). The job of the credit bureaus is to store and compile all of that credit information. FICO and VantageScore then pull this data from those credit agencies into their scoring systems to generate a credit score.
There are some subtle differences between the scores of FICO and VantageScore, but we want to talk about the commonalities. The five important criteria that go into creating all credit scores are: history, utilization, length, diversification, and inquires. Let’s discuss those:
History: Payment history has the largest weight on the credit score calculation at 35% of FICO. It looks to see if payments are made on time. Bankruptcies and collections severely affect your history.
What to do?
- Pay bills on time.
- Pay any late bills ASAP.
- Take advantage of automatic payments and calendar reminders as they can be powerful tools.
- Review your credit reports annually, RECEIVE YOUR REPORT. These reports are produced by the three credit bureaus and will include all pertinent credit information. If there are any errors you can dispute them. DISPUTE YOUR CREDIT REPORT
Utilization: Equals the sum of credit you owe / sum of account credit limits. The lower your credit utilization the better. (30% of FICO)
What to Do?
- Keep your credit card balance as low as possible at all times.
- Talking to your bank about increasing your credit card limits is one solution.
- Keeping credit cards open is an easy way to keep your total amount of credit limit higher.
Length:How long has credit been established and what’s the age of credit accounts. (15% of FICO)
What to Do:
- Establish credit at a young age. Some of the easiest ways to establish credit include becoming an authorized user on a parent’s credit card, get a secured credit card, take out a federal student loan, take out a loan with a cosigner, or even a take out a credit builder loan.
- Keep those early forms of credit open and active.
Diversification: Is there a diversified mix of different forms of credit. (10% of FICO)
What to Do:
- Be cognizant that having different types of credit will improve your score, but don’t add debt at the expense of the more important criteria talked about here.
Inquiries: Applications for new credit can reflect poorly on your credit score for up to 6 months. (10% of FICO)
What to Do:
- Limit your interactions with financial institutions and shy away from setting up accounts and applying for credit when possible.
- Understand that when you grant permission for institutions to run your credit report, it may negatively affect your score. These are considered hard inquiries. They will show up on your credit report and have an impact on that score. There are also soft-inquiries. They don’t require your permission, won’t show up on your report, and won’t impact your score. Common examples include looking up your credit score or conducting a background check.
How do you find your credit score?
Unfortunately, FICO and VantageScore don’t just give out your credit score, but there are many different sources to find your score. For example, many banks (Citi Bank, Bank of America, Chase, etc.), credit card providers (Chase, American Express, etc.), and credit unions offer services to track your credit score. There are also free tools available online like Credit Karma to look up your credit score.
A solid credit score can be a powerful tool to have at your disposal. It can help you qualify for a car loan or mortgage and can save you big time by paying lower interest rates. All the more reason to understand and improve your score.