by Odysseas Papadimitriou. CardHub CEO
Your credit score is essentially your credit history expressed as an easy-to-reference number. You can think of it as a grade for how responsibly you’ve managed loans, lines of credit, and other financial obligations over the years. Credit scores are extremely important because they affect your mortgage rates, the credit card offers that you receive, the premiums that you pay on your car insurance, your ability to buy a car, and even where you are able to live and work.
Credit Scores In Depth
Credit scores are all based on the information in your major credit reports, and understanding that connection is the first step to understanding your credit score. This also represents a knowledge gap for a lot of people.
“Most consumers don’t have a clear idea how credit scores work and what on a credit report determines a credit score,” says Larry Garvin . a professor at The Ohio State University College of Law who specializes in small business and entrepreneurial finance. “I suspect most know that the two are related, but I also suspect most don’t know how. Probably most of this deficiency is due to weak financial literacy, with some due to weak literacy and some due to the sheer amount of information and disinformation that’s out on the Web or elsewhere.”
So, let’s clear a few things up.
Contrary to popular belief, you don’t have just a single credit score that everyone references. There are actually more than 1,000 different types of credit scores available, and they use different calculation methods and information sources and are based on different ranges (i.e. they’re out of different maximum numbers).
The most widely used type of credit score is called the FICO score – offered by the Fair Isaac Corporation. Its ubiquity explains why people will sometimes refer to your credit score as your FICO score (or even FICA score. which is incorrect).
FICO Scores are calculated using five different types of information, which are weighted according to their importance. While other credit scores may be calculated differently, it’s fair to expect that if you have good marks in each of the following categories, your credit score will be good regardless of the particular model used.
Payment history is the most important component of the FICO model, accounting for 35% of your overall score. It is based on the records the major credit bureaus – Experian, Equifax, and TransUnion – keep, which indicate the following:
- The number of loan and credit accounts that you have always paid on time.
- The number of accounts for which you are currently at least 30 days behind on payment.
- Whether or not you have gone bankrupt, been ordered by a court to pay amounts owed, had past due accounts sent to collections, or have fallen at least 30 days behind on a loan or line of credit. The recency of these items will also factor in.
- How many days past due you are on delinquent accounts.
- The dollar amount past due you are on delinquent accounts and/or accounts sent to collections.
Given that a credit score is a reflection of your financial responsibility, it makes sense that you will be knocked for failing to make payments as agreed on certain types of accounts.
The money that you owe to creditors and lenders accounts for 30% of your FICO score. The decision makers who use credit scores want to get a sense of whether or not your spending habits are sustainable as well as the likelihood that your current debt burden will lead to serious problems with your finances in the future.
The Amounts Owed component of your score is comprised of:
number of accounts that you carry a balance on.
- Your credit utilization ratio .
- How much you owe on existing credit cards and installment loans.
Lower is better with each of these data points.
Length of Credit History
This portion of your FICO score merely reflects the length of time that you have been using loans and lines of credit. People with a long track record of responsible money management are viewed favorably by creditors, and years of positive information will make the occasional missed payment less impactful.
FICO uses this “what have you done for me lately” component of its score to emphasize recent financial performance, as it – perhaps more than anything else – indicates future performance. This section includes:
- The number of loans and lines of credit you have taken out in recent months as well as how that number compares to the total number of accounts in your credit history.
- How long it has been since you’ve opened your newest accounts.
- The number of hard inquiries (i.e. how many times you’ve applied for credit) made into your credit history in the last 12 months.
- How long it has been since your last credit inquiry.
In short, creditors want to determine whether or not you are desperate for additional credit, as that may reflect negatively on your current financial situation.
Types of Credit Used
This section of your FICO score indicates how well-rounded your financial management skills are based on the different types of accounts (e.g. credit cards, installment loans, retail lines of credit, mortgages, etc.) you’ve used, how many of each you have used, and how recently you have used them.
How Credit Scores Change Over Time
As you might expect given the aforementioned metrics and the fact that credit scores are based on data from your major credit reports, your credit score is a fluid entity. In other words, it stands to change over time as you open new accounts, your spending and payment habits change, etc.
This new information is factored into your credit score each time an inquiry is made (i.e. someone requests your score from a credit scoring agency, like FICO). It’s interesting to note that people have reported month-to-month credit score fluctuations of around 20 points without anything significant changing in their credit profiles.
Checking Your Credit Score
If you are interested in checking your credit score, there are a number of ways that you can do so. However, you should also note that doing so may not be necessary.
For starters, there are countless different credit scoring models and creditors often modify them with proprietary algorithms, therefore creating their own credit scores which you will not be able to access. Depending on the particular model, ordering your credit score may also cost money. It’s therefore an inefficient (and potentially endless) pursuit to try to get the exact credit score that your lender uses.
Taking advantage of your right to a free copy for each of your major credit reports once a year is far more beneficial. Credit scores are based on the information in these reports, after all, and you can easily get a sense of your standing (as well as identify errors and fraud) by simply reviewing your reports.
Many consumers fail to recognize the value of reviewing their credit reports relative to checking their credit scores because they don’t differentiate the two in their minds. But don’t worry if you’re in that boat. Consumer law expert Cary Flitter . who is a practicing attorney and an adjunct professor of law in the Philadelphia area, says that he “would not expect them to” comprehend the difference. “It’s a bit subtle.”