Dude, What's a Credit Score?
Last week, I covered what credit is and how to get started building credit for those who don’t have any. This week I will go a little deeper into credit scores, the different types of credit scores, and what factors are used to measure them.
Now, before I get started I want to make sure one thing is clear: You have more than one credit score! Yes, you read that correctly. We all have multiple credit scores. Why? Because companies report to credit bureaus voluntarily, each company determines which credit reporting agency or agencies they will report to. This means that you could potentially have three different scores for the three major consumer credit reporting agencies (Experian, Equifax and TransUnion); however, while the scores may not be identical in theory, they should be similar.
What is a Credit Score and Why is Matters?
A credit score is a numerical value used to rate your creditworthiness to potential lenders and/or creditors. Lenders and creditors use the score to assess how likely you are to repay a loan or your credit balance and how likely you are to do it in a timely manner. Credit scores range from 300 to 850. A score over 700 is usually deemed to be good. This means that lenders are more likely to offer you lower interest rates which allows you to pay less money in interest over the course of the loan, thus saving you money! ← This is the whole point of striving to get and maintain a good credit score.
To help drive the point home, let’s break this down with an example:
Person A and Person B are both looking to get car loans for $15,000 for a 5-year loan term (or 60 months).
Person A has a 750 credit score, falling into the ‘good or very good credit’ category. Due to this, their creditworthiness is deemed high. Meaning that the lender is more likely to offer them a lower interest rate. For this example, let’s say they’re offered the loan with a 3.5% interest rate.
A 3.5% interest rate on a $15,000 loan for a loan term of 5 years means that at the end of the loan Person A, overall, would pay $16,172 (which includes $1,172 in interest).
Person B, on the other hand, has a credit score of 600, falling into the ‘fair credit’ category. Due to this, their creditworthiness is deemed riskier. Meaning that the lender is more likely to impose a higher interest rate or may even pass on issuing the loan all together. However, for the sake of this example, let’s say they are offered the loan with a 10% interest rate.
A 10% interest rate on a $15,000 loan for a loan term of 5 years means that at the end of the loan Person B, overall, would pay $19,122 (which includes $4,122 in interest).
That’s a huge difference! Person B paid approximately $3,000 more in interest because, ultimately, the lender deemed that their risk for Person B not paying the loan back was a lot higher than Person A. This is why your credit score matters!
Types of Credit Scores
There are multiple types of credit scores but the two scores most widely used by lenders to determine your creditworthiness are the FICO Score and the Vantage Score.
FICO Score
Created by the Fair Isaac Corporation, the FICO score focuses highly on payment history, total debt and amounts owed, and length of credit history. The FICO score also takes new credit inquiries and credit mix, meaning the types of accounts that you have, into consideration. FICO Scores range from 300 to 850. The rating breakdown is below.
Vantage Score
Created in 2008 by Experian, Equifax, and TransUnion, the Vantage Score focuses highly on your payment history, age and type of credit, and the percentage of your credit limit used (a.k.a. Credit Utilization). Other factors that are taken into account include total balances and debt, and credit inquiries. Vantage Scores range from 300 to 850. The rating breakdown is below.
Factors Used to Measure/Determine Your Score
Payment History - Basically, how consistent are you with making your payments and are those payments on time? As you will read below, payment history is one of the most influential factors of credit scores. So don’t miss making your payments. If you are going through a financial hardship and aren’t able to make a payment or will be late with a payment, make sure to call your lender and see if you can work something out with them. That would be way more beneficial than just missing the payment or making it late.
Credit Utilization - This is the amount of credit you’ve used divided by the amount of credit you have available. So if you make a $500 purchase and your credit limit is $1,000, then your credit utilization rate would be 50%, …and that’s pretty high. However, if you make a $500 purchase and your credit limit is $5,000, your credit utilization rate would be 10%,... and that’s pretty good. Now, I’m not telling you to go out and get high-limit credit cards, but I am saying be sure to keep your limit in mind when making larger purchases.
Type, number, and age of credit accounts - Do you have a good mix of credit? Loans? Revolving credit (which is just another way of saying credit cards)? How many accounts do you have? Are you good at managing the amount of accounts that you have? Finally, how long have you had your accounts? The longer your credit history, the better.
(Tip: If you have paid off a credit card, then first-off, let me say, Congrats! And then let me follow-up with, and this is important, DO NOT close the account. This is the quickest way to hurt your age of credit and for us younger folks this is not something you want to do. I almost made this mistake years ago, but a helpful rep from the credit card company advised me to keep the account open since it was the oldest credit account that I had. This advice saved me from unknowingly, at the time, hurting my credit score.)
Total Debt - This is pretty self-explanatory. How much debt do you have overall? This includes mortgages, loans (including student, car, personal, etc.), and revolving credit.
Credit Inquiries - This is when a lender or creditor asks a credit bureau to look at your credit report. There are two types of credit inquiries: hard and soft. Please read this article from Experian that further explains credit inquiries, the difference between these two types of inquiries and how they might affect your score.
How to Get Your Credit Score for Free
Don’t know your credit score? Well there are several ways that you can get your score for free. You are entitled to a free copy of your credit report from Experian, Equifax, and TransUnion every year. You can do this by going to Annual Credit Report.com to request your report.
Here are some other resources that you can use to get your credit score for free:
Also, be sure to check with your bank and credit card companies. Some offer updates of your score for free as a part of their services. Wells Fargo sends me monthly updates of my FICO Score; my credit union also offers updates on my credit score.
I really like the break down at the start of this post. Sometimes when I head 3% or 10% I don't know how much that is actually costing but when you say that the bad credit and getting a 10% rate is going to cost 3k extra it really snaps things into focus. I always learn something new when I read this blog and always it's great to be informed.
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