As young professionals starting their careers, we soon realize that our grades in highschool, college and even graduate school no longer matter. Instead, there is one numerical score that starts to loom larger than the rest - the credit score. Whether you are looking to buy a house, a car, apply for a credit card, the credit score repeatedly shows up during life's most important transactions. Let's take a look at what makes up this all-important number that will rule our financial lives...
What is a credit score? Your credit score is a numerical representation of your likelihood to repay a loan - credibility or "credit" for short. The higher your credit score, the lower the risk you represent to a potential lender, and the easier it is for you to borrow money.
Who calculates your credit score? The credit score is pioneered by the Fair Isaac Corporation (FICO) based in San Jose, California. As a result, the FICO score has become the Kleenex of credit scores. But there has to be a Pepsi to every Coke. As the demand for credit increased, so did the market for credit scores. Today, all 3 of the major credit bureaus (Equifax, Transunion and Experian) have their own proprietory credit scores. But make no mistake - FICO still rules the world of credit scores.
What makes up your credit score? While each credit bureau calculates their scores via proprietary formulas, the ingredients that make up your credit score are fairly constant. Let me illustrate via the following scenario:
If someone is asking you for a loan, which one would you be more likely to loan your money to?
- Would you rather loan to someone who's been borrowing for 10 years or who has never had a loan?
- Someone who's never missed a payment or someone who fails to pay regularly?
- Someone who already owe $10,000 or someone who only owes $100 currently?
- Someone who has been asking everyone for a loan or someone who came to only you?
- Someone who everyone else has loaned to already or someone who no one else has loaned to?
- Someone who went bankrupt or someone who's never been sent to collections?
Here are my answers based on the assumption that past behavior predicts future behavior:
- I would loan to the person who's been borrowing for a long period of time.
- I would loan to the person who's never missed a payment.
- I would loan to the person who owes less currently.
- I would loan to the person who came to me and me alone. If the person asked everyone else for a loan as well, I would question why does he/she need money so desperately?
- I would loan to the person other people already loaned to. I would assume that other lenders see the borrower as a good risk and I probably should as well.
- I would loan to someone without a bankruptcy, collection or other public records.
So as easy as that, the most important factors affecting your credit score are:
- How long you've had credit - the longer the better.
- How consistent you are with your payments - late payments, missed payments etc.
- How much you owe - using 10% of your credit limit is better than 80%.
- Number of recent inquiries - when you apply for credit, that counts as an inquiry. When you apply for credit too many times in a short period of time, it looks bad to the lenders.
- Type and number of accounts - the more accounts you have already, the better you look to lenders - "If all these other people are loaning money to you, you must be a low risk borrower."
- Publics records - of course collections, bankruptcies, liens hurt your credit. Duh...
What's a good credit score? Like a lot of questions we ask in life, the answer is "it depends." Just like different credit bureaus calculate your credit score differently. Different lenders may treat the same credit score differently. A "good" score is one that will get you the loan you are applying for. Generally speaking, a FICO score above 740 can be considered a good score.
I hope this takes some of the mystery out of the all important credit score. Once you have some understanding of what it is and how it works, you can now work to improve your credit score.