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seems to rule your financial life? How is it calculated and how can you maintain a healthy number? Find out here.
What is a Credit Score?
History of the Credit Score
In 1956, Bill Fair and Earl Isaac founded The Fair Isaac Corporation, an analytical software company designed to determine specific outcomes in relation to paying down debt.
Their measure of consumer risk, known as the FICO (Fair, Isaac, and Company), has now become the de facto method for determining credit worthiness in the United States. It is likely the score that will be used when you're leasing a vehicle or taking out a mortgage for a house. There are other methods for determining risk as well, including the VantageScore.
There are three credit bureaus that keep a version of a "credit score" on you, be it the FICO, VantageScore, or both. These are TransUnion, Equifax, and Experian.
How do you find out your credit score? There are a few ways. I recommend starting by signing up for a free service such as Credit Karma or Credit Sesame. They will give you an idea of your credit score range via the VantageScore system.
However, if you want to find out your exact FICO score, you can go to the source. Check out myFICO with the link below.
What Affects my Score?
This...gets a bit tougher. The exact algorithm that affects your FICO score (as well as when your score is updated) is still tightly protected. However, we do know the weights in each category that determine the outcome. They are as follows:
Payment History (35%)
How well do you pay your payments? Are you on time or late each month? Have you gone into collections or had derogatory marks made against your accounts by credit issuers?
All of these factor into the largest portion of your score. In order to maintain a healthy credit score, you must pay every account each month and avoid collections like the plague.
Amount of Debt (30%)
How much of the credit given to you are you using? How many credit accounts do you have open?
As a general rule of thumb, you should use no more than 10% of your available credit, especially for accounts such as credit cards (which are classified as "revolving" credit).
Length of Credit History (15%)
How long have you had established credit files?
If you are very new to taking on credit, lenders look at you as an increased risk. Two values are factored here - your oldest account and your average age of accounts.
Open accounts continue to age, increasing the average age of accounts. Closed accounts still factor into average age, but they do not gain additional age after closing. Closed accounts will also drop from this calculation after a certain amount of time, depending on the bureau.
Amount of New Credit (10%)
Again, two items are factored into this portion of your score - your most recently opened account and your number of new inquiries. Each time you apply for credit, the lender will likely "run" your credit report. This shows up as a new inquiry and will lower your score slightly (2-20 points). The affect of this inquiry drops off after a certain amount of time.
Credit Mix (10%)
This portion of your score is determined by the types of credit you currently have open. Credit cards, installment loans, mortgages...each affect your score slightly. In general, it is better to have different types of loans than a single type.
Issues and Criticisms
Other than the obvious fact that we do not know exactly how a credit score is derived (past the weights described above), there are a few strong criticisms of the credit scoring system.
First, I take issue with how Amount of Debt is treated. In my case, I utilize a Home Equity Line of Credit for a portion of my home loan. From a credit scoring standpoint, this is viewed as revolving credit (i.e. in the same bucket as credit cards, even though the two types of loans could not be more different).
If the HELOC were considered as a traditional loan, this would not affect my credit utilization (currently sitting at 49% of my available credit). Note that this does not damage my score as if I were utilizing 49% of credit card credit, but it does affect it nonetheless.
Second, the length of credit history metric can drive poor decisions. Taken at face value, it appears to be the best course of action to sign up for a credit card as soon as you can to "begin establishing credit." In fact, I followed this idea my Freshman year of college even though I did not need a credit card.
Fortunately I have always been a frugally-minded person and I generally made good decisions when spending on my card. So should every 18 year-old sign up for a credit card? Probably not. There are alternative ways to establish credit instead of signing up for a card yourself, including being added as an Authorized User (AU) on someone else's account. This is a much better plan for establishing credit, but still has it's potential pitfalls for both parties.
Third, and here's the big one for me, credit mix is incongruent with my long-term goals. My goal is to ultimately pay off all loans (mortgage, car loans, etc.). Being "debt-free" is necessary if my wife and I ever hope to retire early since it will drastically reduce our monthly expenses.
Yet, without these varied types of loans, our credit scores are likely to drop from a credit mix standpoint. Some sources gloss over this point, focusing instead on the fact that paying off loans eliminates some of the possibilities for late payments. If you were already making all payments on time, however, this is a moot point.
The alternate consideration is that if your goal is to eliminate all debt, it may not be necessary to have a good score. After all, you will no longer need it to take out loans. I still argue that taking on varied types of debt (i.e. more debt) is not an appropriate outcome just to build a good score.
On average, however, the credit scoring system seems to be a reasonably reliable method of determining risk, and is based on statistics instead of anecdotes.
Tips and Tricks for Improving Your Score
Here are my tips and tricks for improving and maintaining your score.
Like it or not, your credit score is the yard-stick lenders use to measure you. If you are thinking about taking on debt or signing up for a credit card, you must consider taking steps toward a healthy score.
What did I miss when it comes to credit card scoring? Do you have any additional tips and tricks for maintaining a strong score? Let me know in the comments below!