| What is a credit score?
You know what your GPA score is. Chances are you also know the score of your favorite team’s last game. But what is a credit score? Who uses them? And why should you care?
The Short Answer.
Whenever you attempt to obtain credit (an arrangement for the future re-payment of a loan or purchase that you acquire today), someone has to decide how likely it is that you will pay them back. This decision is made pretty much the way you’d expect it to be: your financial background (bill-paying history, how many credit accounts you have, collections, outstanding debt, yada yada, yada) is plugged in to a statistical program to compute a number, which becomes your credit score. To further identify your level of credit risk, many lenders will then compare your score to other credit records with similar scores—sort of the way Amazon.com makes its music and book recommendations—to identify your level of credit risk.
A Rather Longer Answer.
There are five categories that comprise each credit score, weighted according to their importance to creditors. It’s important to remember that, although lenders may look at a variety of factors when making their credit decisions (such as your income and the type of credit you’re applying for), your credit score only evaluates information from credit reporting agencies. The law prohibits factors like ethnic group, religion, gender, marital status and nationality from being used in the credit scoring mix.
If you’ve made a few credit mistakes, all is not lost. One strength of credit scoring is that it has a dynamic component—no one bad aspect should totally sink you, just as one good aspect won’t guarantee you credit. Although late payments will lower your overall score, having an otherwise good credit history with little outstanding debt can make up for it. Below are explanations of the categories from Fair, Isaac, and Co., the company that developed the software used for most credit scores (sometimes referred to as FICO scores).
Payment History (35% of score).
The first thing any lender wants to know is whether you have paid your past credit accounts on time. The payment history factor of credit scoring takes into account:
Payment information on many types of accounts. These include credit cards (such as Visa, MasterCard, American Express and Discover), retail accounts (credit from stores where you do business, such as department store or gas station credit cards), installment loans (loans where you make regular payments, such as car loans), finance company accounts and mortgage loans.
Public record and collection items. These include reports of events such as bankruptcies, judgments, suits, liens, wage attachments and collection items. These are considered quite serious, although older items count less than more recent ones.
Details on late or missed payments and public record and collection items. A 30-day late payment is not as risky as a 90-day late payment, in and of itself. But recency and frequency count too. A 30-day late payment made just a month ago will count more than a 90-day late payment from five years ago. Note that closing an account on which you had previously missed a payment does not make the late payment disappear from your credit report.
How many accounts show no late payments. A good track record on most of your credit accounts will increase your credit score.
Amounts Owed (30% of score).
Owing money on different credit accounts does not mean you’re a high-risk borrower with a low score. However, owing a great deal of money on many accounts can indicate that a person is overextended, and is more likely to make some payments late or not at all. Part of the science of scoring is determining how much is too much for a given credit profile.
Length of Credit History (15% of score).
In general, a longer credit history will increase your score. However, even people with short credit histories may get high scores, depending on how the rest of the credit report looks.
New Credit (10% of score).
Research shows that opening several credit accounts in a short period of time represents greater risk, especially for people who do not have a long-established credit history. This also extends to requests for credit, as indicated by "inquiries" to the credit reporting agencies (an inquiry is a request by a lender to get a copy of your credit report).
Types of Credit in Use (10% of score).
This factor considers your mix of credit types: credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. It also looks at the total number of accounts you have; for different credit profiles, how many is too many will vary. This means it is not necessary to have one of each type, nor is it a good idea to open credit accounts you don't intend to use. The credit mix is generally not a key factor in determining your score — unless your credit report does not have a lot of other information upon which to base a score.
Why Do Credit Scores Vary?
The major credit reporting agencies—Experian, Equifax and Trans Union—consider only the data in your credit report at that particular agency. Since different lenders report to different agencies, one firm may generate a different score than another one.
How Much Do Credit Scores Really Count?
That’s a tough one. Credit scores usually range between 375 and 900 points (the higher, the better). In mortgage lending, 675 points would be considered very good, while 625 will require some scrutiny, perhaps resulting in a demand for more money down and/or a higher interest rate. However, the same score may be more than adequate when buying a car or shopping in a department store. Furthermore, since credit scoring cannot make an infallible prediction about whether an individual will be a “good” or “bad” customer, each lender devises its own strategy for determining what level of risk it finds acceptable. So the scores do count, but what they mean vary from lender to lender.
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