Credit Scores: What’s In a Number?
Written by Thomas M. Geier, CPA, CFP ®, PFS
How It Works
When you buy a house, a car, or apply for any loan, the bank or credit union (lender) will review your credit history to determine how much of a risk you may be to default on the loan. There are three primary credit bureaus (Transunion, Experian, and Equifax) that lenders report activity to, such as late payments, the number of loans taken out, how much of your loans have been repaid, and more. The bureaus take this information and create credit reports. Due to the time-consuming nature of reading these reports, they utilize a scoring system, which enables lenders to quickly analyze risk.
Vantage Score and FICO are the most popular scores used for home and auto loans. No matter what scoring model is being used, the idea is the same—figuring out how likely you are to pay your bills on time. Both Vantage Score and FICO have a range of 300 to 850. Although each lender creates its own parameters for what is considered “good,” the scores tend to fall within these general guidelines:
- 300 -629: Bad Credit
- 630-689: Fair Credit
- 690-719: Good Credit
- 720 and above: Excellent Credit
Scores are derived using a mathematical algorithm based on many factors such as overall debt, repayment history and more. The graphic below from The Balance breaks down not just the areas they focus on, but also the weight each one carries.
Good Habits That Promote Healthy Credit
As you can see from the chart, payment history and current debt comprise the lion’s share of this magic number. Credit bureaus maintain records of late payments and the percentage of payments missed for seven years.
Here are some habits that promote healthy credit:
- Pay your bills on time every time—this is very important.
- Use a low percentage of your available credit. A good rule of thumb is to use no more than 70% of your total available credit.
- Only apply for credit when you absolutely need it.
- Time is on your side. The longer your average credit account age, the better.
- Avoid any negative public records such as bankruptcies.
- Monitor your credit by running a credit report every year. A free credit report is available to all U.S. consumers by federal law at annualcreditreport.com. Some mobile apps like Mint and Credit Karma offer free scores to anyone with an account too. Sometimes there are mistakes on credit reports that pull a score down. Those errors could make a big difference in your score, so take the time to correct them.
Length of credit and types can be zero or very minimal for some. This oftentimes occurs with younger people who may not have ever applied for a loan or applied for a credit card. In this situation, “alternative” scores are used, which look at sources like utility bills or rent to gauge patterns and assess risk.
Credit Report Myths
Checking my credit report will hurt my score.
Checking your credit score or requesting a copy of your report is known as a “soft inquiry,” and does not affect your score. Other “soft inquiries” occur when companies send you promotional credit card offers or perhaps when your bank sends you an offer. These inquiries are not visible to potential lenders. They are visible to you and will stay on your credit report for 12-24 months depending on the type.
All debt is the same.
Not true! Mortgage debt is weighted very differently than revolving credit card debt.
Closing my credit card will increase my score.
Credit scoring models measure risk by how much credit you are using (referred to as “credit utilization”, not how much credit is available. When you close an unused account, your credit utilization number goes up because you reduced your total available credit. Sometimes closing the account can lower your overall credit score.
There is only one credit score.
False. There are thousands of scoring models currently being used. Your score will vary based on the model being used.
If I pay the debt, I’ve erased it from my credit report.
Just because you’ve paid off the debt, doesn’t mean it vanishes from your credit report. Evidence of that debt can remain on the report for years. In fact, negative information can remain on your report for up to seven years. Bankruptcies can linger for up to 10.
Co-signing doesn’t mean you are responsible for the account.
If you open an account jointly or co-sign a loan, you will be held legally responsible for the account. Activity on the joint account will be displayed on both account holders’ credit reports.
Lenders Look Beyond Credit Scores
Sometimes it takes more than a good credit score to secure an ideal interest rate. Your income level and outstanding debts are important factors lenders consider when making lending decisions. A debt-to-income ratio calculation is used to determine if you can repay a loan. Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. This is one way lenders measure your ability to manage the payments you make against the money you have borrowed. If you add up all your monthly debt payments and divide them by your gross monthly income, you have calculated your debt-to-income ratio.
Some other areas lenders may look at are cash flow/liquidity. Creditors prefer applicants who have liquid assets to pull from to make debt payments in the event of an emergency or financial setback. Employment history is yet another area lenders look at to estimate income stability. Job hopping is frowned upon and is a cause for concern for lenders.
The key takeaway when it comes to credit scores and your ability to secure attractive rates or obtain a loan, in general, is to understand what lenders use as a barometer to determine risk, and practice financially responsible habits so your risk level is low and your opportunity level is high.
Sources: Nerdwallet/ Experian/ The Balance
© Geier Asset Management, Inc. February 2019. Thomas M. Geier, CPA, CFP ®, PFA is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The articles & opinions expressed in this material were gathered from a variety of sources, but are reviewed by Geier Asset Management, Inc. prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of February 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual circumstances. In all cases, please contact your investment professional before making any investment choices. Geier Asset Management, Inc. is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.