Credit scores are important for a variety of reasons. They affect what types of loans we can get, can influence our ability to get an apartment or house, and they can even be a factor in our job hunt. Because our credit score is so important, we need to understand exactly how it is determined and how we can improve it. This post tries to help you make sense of it all and gives you some takeaways that you can start putting to use.
How Credit Scores are Calculated
Your FICO credit score is designed to give lenders an idea of how risky you are as a consumer. Because of this, your credit score is based entirely on items that are found in your credit report, which is a history of the accounts you have, who you owe, how much you owe, and whether you have paid on time. (We’ll talk more about credit reports later in the article.)
In recent years, the credit scoring and reporting industry has undergone many changes, including the rise of free credit score products, the development of VantageScore 3.0, and the trend toward including new demographics of consumers who have historically been underbanked or have had less access to credit. We will discuss these developments in more detail, but it’s important to remember that for now, FICO is still the leader in credit scoring.
Your FICO score is what most lenders will use to evaluate your level of risk, and it is divided into five parts:
- Payment history
- Amounts owed
- Length of credit history
- New credit
- Types of credit used
FICO gives the following pie chart as the standard of how much each category counts toward your overall score:
It’s important to note, however, that the importance of each category can vary for different consumers. For instance, younger consumers who have not had credit for a long time might have credit scores that emphasize payment history more so than length of credit history. For some, this might be a favorable policy that helps the consumer develop a good credit score at an early age. For others, this policy could work against them. It really depends on the specifics of your situation.
A Closer Look at the Categories
Let’s take a closer look at each component of a credit score and review some strategies you can use to improve them.
Fico isn’t playing around here. Payment history is all about whether you have paid on time, and from a lender’s perspective this is one of the things they will care about most. They want their money when it is due.
Tip for improvement: Keep track of when you owe each creditor and set reminders for payment. When available, consider having payments draft automatically from your checking account. And if you do miss a payment, reach out to the creditor immediately, pay the bill, and see if they can keep the information from reaching the bureaus, as a courtesy gesture.
This one is somewhat tricky and has several wrinkles. Here, it’s not just about how much you owe in total. It’s also about how much you owe on different types of accounts. For instance, installment loans (like student loans) will not bring down your score like high balances on revolving accounts (credit cards) might. Typically, FICO wants to see you consistently bringing down your total debt while also maintaining a low utilization ratio. Utilization is defined by how much available credit you are using.
Tip for improvement: Pay down installment loans over time. Keep balances on revolving accounts low. Keeping credit cards empty is a great strategy for financial health, but utilizing a small balance is best for your FICO score. Also, note that you can “carry a balance” without paying interest. “Balance” is defined by the amount on your statement when it is reported to the bureaus, so you can report a small balance but still pay it off in full each month.
Length of credit history
This one is fairly straightforward. FICO looks at how long you have had credit (the age of your oldest account), when you last obtained a new credit account, and the average age of all accounts.
Tip for improvement: Don’t take out new credit that you don’t really need (like store cards at the mall). Also, don’t panic if you are “new” to credit. Focus on smart repayment and trust that FICO will account for this by putting greater emphasis on other scoring factors in your case.
FICO takes note of new accounts that you open. Opening a new account sends a signal that you are looking for credit, and if you do this too frequently in a short time period, it could be a red flag. This doesn’t mean that you can’t shop around for credit cards, mortgages or other loans. Before opening a new account, the lender will do an “inquiry” into your credit. FICO will notice this, but inquiries within a short time period are treated as one inquiry. And, inquiries have a small impact on your score. In fact, the impact could be five points or less. Also, your score will reflect all inquiries made in the last 12 months, while all from the last 2 years will remain on your report.
Tip for improvement: If you need to shop around, do so efficiently. Keep the inquiries within a close time range, and if you’re buying a mortgage try to get a rate lock so you won’t have to have multiple rounds of inquiries.
Types of credit used
Here, FICO evaluates the different types of accounts you have, from credit cards, to installment loans, to mortgages. FICO says that this is more important for consumers who don’t have a lot else on their credit report on which to base a score. FICO also claims that having credit cards can lead to a better overall score. Once consumers have proven that they can manage a credit card responsibly, FICO will “trust” them more than a consumer who has never managed a credit card.
Tip for improvement: Don’t try anything fancy here, and don’t go obtaining new credit just for the sake of “diversifying.” When you are ready, open a credit account that you can manage responsibly as this will have a positive impact on your score.
Why Your Credit Score Matters
Your credit score matters because it affects the terms of your loans and other lines of credit. The better your credit score, the better terms you will receive. This is important, because good terms will be more favorable to you, easier to repay, and more affordable. By being able to access such good terms, consumers with good credit may also have opportunities that aren’t available to those with lower credit ratings, such as taking out loans for a business or buying a bigger home.
Here is an example using FICO data that shows how a credit score can influence the price you pay for an auto loan:
|FICO Score||APR||Monthly Payment||Total Interest Paid|
Checking Your Credit Report
As we mentioned, your FICO score is determined by items that are found in your credit report. So if you really want to gain insight into your credit score, be sure to get familiar with this report.
While it typically costs money to access your FICO score for free, it’s easy to get a copy of your credit report. Each year, you are allowed one copy of your credit report from each of the three bureaus. You can get this at www.annualcreditreport.com.
If you have not checked your credit report in quite some time, it may be a good idea to pull all three of them and check for errors. Dispute these errors immediately with the bureaus and get them resolved. Once this is done, it might be a good idea to check your credit report every four months. You can do this by spacing out your three free reports throughout the year. Just remember that each report will be from a different bureau.
The VantageScore 3.0
The VantageScore is an up and coming credit score model that serves as the main competitor to FICO. One major benefit of this score is that it is the same across all bureaus. In the case of FICO, a consumer may have a different score for each agency, so one for TransUnion, one for Equifax, and one for Experian. The VantageScore model does not have this issue.
The VantageScore is also more inclusive than FICO because it puts a greater emphasis on recent credit history, which can favor younger consumers or those new to the credit world. Similarly it is more accessible and open to incorporating “non-traditional” data into its model, such as rent and utility payments. For more information, visit the VantageScore website. Keep in mind that FICO is still used by an overwhelming majority of lenders.
What about those Free Credit Score Services?
In recent years, services like Credit Karma and Credit Sesame have become increasingly popular. These free web-based tools allow consumers to create free usernames and then monitor their credit score after providing their social security number. This can be a convenient way to track credit progress, but we must give a few warnings. These services do not use official FICO scores, which means they may not be reliable.
Here is more specific information on some of the popular free credit score companies, including which models they use.
Credit Karma offers the TransRisk score to consumers. As the name suggests, this score is based on your TransUnion report. While Credit Karma claims that this scoring model resembles a traditional model, it is still not the same as receiving a FICO score. Credit Karma also offers the VantageScore.
Credit Sesame uses Experian’s National Equivalency Score. This score, which actually ranges from 360-840, is also quite different from a FICO score. One noteworthy point about this score, however, is that it is available to lenders, which may be a sign of its value.
Quizzle, another popular free score service, offers the VantageScore to its customers.
These credit score products, while helpful, should be used with caution. We suggest using them as a reference and as a way to monitor trends that might be taking place within your credit report. In other words, if over the course of several months you notice an increase in your score with these products, that could be a sign that you are doing something right and paying your creditors consistently. Or, seeing a downward trend in these scores could be a sign that something is wrong.
When seeking out an important loan, such as a mortgage, we advise you to put very little stock in these scores. The reason is twofold. First, as we have already pointed out, these scores are not identical to what your lender will use (FICO). Secondly, when you make big purchases, just a few points can make a huge difference.
For instance, consider the following example. Let’s imagine that you need to obtain a 30-year mortgage loan of $200,000. With a FICO score ranging from 680-699, your APR is estimated at 4.361% while your monthly payment is estimated to be $997. On the other hand, if you are one tier up, with a score between 700-759, your APR is predicted to be 4.183% and your monthly payment is estimated to be $976. Over the life of the loan, you can save over $7,000 if you are in the preferred tier.
|FICO Score||APR||Monthly Payment||Total Interest Paid|
If you are relying on a free credit score service to estimate your credit score, you could be in trouble in this type of situation. That’s because you might overestimate your credit worthiness. While your free score is likely in the “ballpark” of your official FICO score, just a few points difference can cost you thousands. For this reason, it is best to monitor your official FICO score when leading up to a big investment or credit move, such as taking out a mortgage.
[Related: Why your credit score might be wrong]
You should now have a good idea of what your credit score represents and how you can positively influence it. We hope that you will put these strategies to work so that you look more financially stable to lenders and so that you can maintain an error-free credit report. One of the biggest obstacles to these strategies is pre-existing debt that may be burdensome. If that’s something you’re struggling with, read more about our Debt Management Program, which can get you back on track and potentially lead to long-term credit recovery.