What is a credit score and why is it important?

What is a credit score, how is it calculated, and why it is (or is not) important?

What is a credit score?

Let us take a personal example in order to understand what is a credit score. We do not know each other. You have extra money that you are willing to lend in return of interest expectations. Apart from asking me details like my salary, my other debt obligations, my employment history; you will want to know have I taken loans from others before, and if yes then have I paid them back on the agreed terms and conditions (payment history).

In addition, you would want to know if I borrowed as much money as they were willing to give me, or my ‘needs’ were less than what I could have borrowed (utilization).

In addition, you would like to know how long have I been borrowing from others (age of credit history), you might want to know in total how many times have I borrowed and how many of the loans are still active (total accounts), you might want to know how many loans did I take recently.

And finally, you would like to know how many loans did I ask for (credit inquiries) and if I have any public records that might be of relevance (civil litigation where I was asked to pay damages, or previous loans that went into collections).

This is exactly the way anyone lending money to anyone will think, and the banks are no different. Banks are professional money lenders and a credit report lists all of the facts that we listed above (saying you might want to know).

Factors affecting Credit Score

The lenders (banks) want to know the following about you – credit card utilization, payment history, derogatory remarks, length of credit history, total accounts, and credit inquiries.

Factor Impact Ideal
Credit card utilization High Less than 10%
Payment history High 100% on time
Derogatory remarks High 0
Length of credit history Medium 9+ years
Total accounts Low 20 + (including closed)
Credit inquiries Low 0

A credit report, like the name suggests is a report. That report is summarized into one number, called the credit score. The higher the credit score, the more creditworthy you are considered; and the more willing banks are to lend you larger amounts of money at a lower interest rate.

Naturally the next question is – who is collecting all this information about me… well the credit bureaus. There are multiple credit bureaus but the three most commonly used are Experian, Equifax, and Transunion.

Once upon a time, TransUnion had information on their website that hinted what a perfect credit score profile looks like:

  • A few (say, 3 or 4) revolving credit cards, each with very high lines of credit ($10,000+), and very low balances on only one (or maybe two) of them at a time.
  • At least one charge card (American Express, Diners Club, etc.).
  • All accounts at least six months old, and at least one more than three years old.
  • No derogatory remarks (public records).
  • Very few inquiries — no more than one to three in a six-month period.
  • At least one “installment” account in good standing, i.e., a mortgage, auto loan, or student loan.

One other thing that you should keep in mind is  what I call the ‘recency effect‘. The more recent events have a bigger impact on the credit score, specially the negative ones. If you missed a payment two months back, the impact is far more devastating as compared to the situation if the payment was missed five years ago.

Missing payments will always have a bad effect on your credit score, so try to never miss them. The reason I mentioned the recency effect is – be extra cautious about making timely payments if there is an upcoming big purchase, like buying a house.

How much can a good credit help you save – let us say in the current market, people with excellent credit are getting mortgages at 4%, and people with average credit have to pay 5%. For a 30 year loan of $240,000; the difference between the interest payments over life of the loans is $51,327. Yes, just a 1% interest rate difference can save more than $50,000.

And what is interest rate (mortgage rate) dependent on? Primarily your credit history – there are a couple of other things that determine the interest rate, but it is mainly your credit score that determines the interest rate the bank will charge you. Interest rate has two components – one component is the part that the bank wants to make profit out of the loan business, the second component is that they charge you a little more if they think the chances of your repaying the loan on time are not as high.

FICO credit scoreYou can get a free copy of your credit report from each of the credit bureaus once a year. In addition there are several other free resources to track your credit report/ score. Credit Karma is the best website whose sole purpose is to track credit reports. There are numerous credit cards that show FICO scores free of charge (one of mine does – see the screenshot ). FICO score is analogous to the credit scores provided by the three bureaus – actually all the three bureaus take FICO score into account.

Credit is a powerful tool, not only does it help you buy things now and pay for them in future, it also gives you rewards points and sometimes allows substantial tax savings on the interest paid. BUT remember, credit can backfire. If you are not extremely careful in using credit, you can land yourself into a lot of trouble….I repeat, a lot of trouble.

FICO credit score 737

FICO credit score

Update 1/1/2016: My FICO score (see image above) was 778 on 10/21. And now it has dropped to 737 on 12/26/2015.

This drop has happened because I refinanced both my cars and also got a new credit card, so a lot of new accounts on my credit report.

FICO credit score

FICO credit score 755 on 2/25/2016

I expect this drop in FICO score to be temporary and to come back to original levels in about 3 months. Remind me to share the new score in April 2016.

Update (2/25/2016):  Now my FICO score is 755

OneMoreDime Special: Credit score is never looked at in isolation. It is always looked at together with the credit report. I personally know of an example where Creditkarma showed a credit score of more than 780 but this person was denied a credit card.

10 thoughts on “What is a credit score and why is it important?

  1. Really great work done here. I m involved in risk management. It would be really helpful if you could provide a few insights on how rating agencies such as Fitch and Moody’s work.

    • Thank you, Sankara.

      Fitch, Moody’s, Standard & Poor’s also work somewhat similar to our credit bureaus. When they rate bonds, they look at the issuer’s assets, liabilities/debt, P&L, cash flow, financial ratios and history.

  2. I’m embarrassed because I honestly don’t know why a credit card is such an advantage and how to even get one and I’m 17. From what I’ve gathered, credit cards are mostly useful for rich people and that you can use them to buy items you can’t afford at the moment but then pay at a later date. But how is that advantageous? You’re technically still paying for the items, it’s not like you get a discount and also aren’t you charged with interest?! I don’t get these rewards points thing either, what can you do with them?

    My parents aren’t around but they’ve told me that without a credit card you can’t buy yourself a home? So I guess that’s one advantage? They also said that when I get a job I get a credit card from the employer? I’m interested in learning more but most info I find especially relates to the American system e.g. “401k” and I’m in Britain.

  3. Daniel,

    It is better to be embarrassed than poor. So it is a good thing that you are embarrassed today. Moreover, you are only 17 so you are better than most of the people around me – they did not start to think like you do until much later in life. Remember there is only one place you can start, and that is ‘today’ – you cannot start yesterday and you cannot start tomorrow.

    Credit card if used property is an advantage. Credit (any kind of credit including credit card) is a suicide if not used responsibly.

    Think of credit as a ‘loan’ – someone is giving you money to do what you want to do, this could be buying food, buying a car, pay for tuition or buying a house.

    You have heard “credit cards are mostly useful for rich people and that you can use them to buy items you can’t afford at the moment but then pay at a later date” BUT that is not true for rich people. Rich people have the money to buy things with cash today, it is the middle class/ poor people who use them to buy items they can’t afford at the moment.

    Yes, you are absolutely right – I am still paying for the items – but I am paying for them a month later. And my money is making money during the month. Let us take a simple example – your bank gives you 1.2% interest per year (0.1% per month). Let us say I have to buy a TV for $1,000 – I have the money. Look at these two scenarios:

    Scenario 1 – I can either pay cash today, what do I have? TV
    Scenario 2 – I can buy the TV on the credit card, put $1,000 in the bank and get $1,000 * 0.1% = $1 interest for 1 month, pay off the $1,000 on the credit card. What do I have? TV + $1

    I never buy more (or more expensive) just because I am using a credit card – this is a common mistake people make – they tend to spend more when they are using a credit card instead of cash.

    Discount – actually you are getting a discount, getting 1 – 1.5% cash back on credit cards is very common. So the bank (credit card issuer) is giving me back 1.5% of the $1,000 that I spent on the card. So in scenario 2 above, I have $15 cash back from the bank. I have TV + $16.

    I have never paid a single penny in interest because I never carry balances (from month to month), I always pay my credit card in full at month end.

    When your parents said “without a credit card you can’t buy yourself a home”, they were correct and what they meant is no bank will give you a $200,000 loan to buy a house IF you have not shown responsible borrowing habits before. So when you start out, you start out with a small credit card – $100 limit or $500 limit.

    You use that for sometime, then you graduate to a card with a larger limit – say $1,000 or $3,000. You use that responsibly for sometime. And then your chances of getting approved for a mortgage loan (to buy a house) are higher.

    I have been to England a few times (lived there once for a month in Bournemouth) but I do not know your local laws/ regulations well enough – but I suspect they are very similar to ours.

    • Wow that made a lot of sense. I get it now. Although I’m slightly confused as to the process of putting $1000 in your bank and then somehow interest is put on it? I have a savings account so I’m assuming there is another account dedicated for credit cards. Regardless, I don’t want to be like most people around you at their age! I’m going 2 keep reading this blog and learn more. Thank you very much! (You have a very good way of explaining things btw)

      • Daniel – I will make as much time for you as you like, it would make me happy to see your situation improve little by little.

        I said ‘bank account’ as an example – the idea is ‘time value of money’ – $1,000 today is more valuable than $1,000 one month from now – because I can invest $1,000 today to make it $1,001 in a month. You also might enjoy reading time value of money definition here at my dictionary: http://onemoredime.com/dictionary/

        The easiest example to explain was a ‘bank account’, there is no special account for credit cards – I was talking about a savings account only but the concept is valid for any account that pays interest OR any investment that yields positive returns (yields is the financial term for ‘gives’ in this context)

        • Ah I see so in the end by using a credit card smartly you can actually make MORE money than before even if it is just an extra $1 (the compound effect you posted about will take effect here). So since you said “I will make as much time for you as you like”, I hope you won’t mind if I now pick out your brain a bit.

          During my work experience a couple of guys were complaining about paying off mortgage for the rest of their lives, I understand what a mortgage is but I don’t fully understand why people would take that route. Why not just rent a house/apartment until you can afford your own place?

          I’m going to become a part time investor when I get a paying job, how long do you think it will take for me to learn all I need to generate some profit? And how long did it take you?

          Thanks again & excuse my naivety.

          • An extra dollar was just an example – people save hundreds and thousands of dollars over their lifetimes just by playing the game of credit.

            Your question on mortgage is very valid – why not rent till the time you can afford to buy (without a mortgage). I think the answer is ‘people want to consume (use) as much as possible as soon as possible’? Saving up 100% of the house cost will take say 15 years of working while saving up 20% down payment for the mortgage will take just 3 years. People are in a hurry.

            Also, part of it is ‘cultural’. I do know several European/ Asian countries where people will save 100% of the cost before buying. America is different.

            “All you need to know to generate some profit” – I would say 3 months.

            How long did it take me? My case was different: I was already a Wall Street professional before I started to take my personal investments seriously. I understood this area extremely well even before I become so serious about my personal finances.

  4. Very good post, now I understand why it is important. I am wondering can you teach us some idea to pay credit debts faster and pay less for interest?

    • Hi Shawn,

      Like they say “When it is right, it is right”.

      If you would have asked me the same question 6 months back, I would have said ‘It is simple – spend less than you earn and use the balance to payoff credit card debt’.

      BUT over the last few months, I realized that it is not as simple for everybody (just because I find it simple). I realized this fact because I have been a failure at losing weight. Here are why they are similar:

      If someone tells me “Losing weight is simple, just burn more calories than you consume”, I will not find it useful. Similarly, I know my telling you “Spend less than you earn” is too generic to be helpful.

      Having said that, start here: http://onemoredime.com/2016/02/20/use-ira-accounts-rich-vs-poor/ – This has three sections (Ultra-Rich, Rich, Poor/ Middle class), start with the Poor (Middle Class) section.

      I am not saying you are poor, but that section provides the most accurate tips for anyone looking to increase savings and pay off debt.

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