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.
|Credit card utilization||High||Less than 10%|
|Payment history||High||100% on time|
|Length of credit history||Medium||9+ years|
|Total accounts||Low||20 + (including closed)|
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.
You 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.
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.
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.