Introduction
A recent survey by Compare Cards found that 37% of people have no idea how their credit score is determined. That’s why I’m here to provide you with a comprehensive guide to credit scores, including what they are, the different credit bureaus, the two scoring models, and other crucial determining factors.
Let’s dive right in!
What is a Credit Score?
A credit score is like a snapshot of your financial history. It’s a numerical representation that helps lenders assess your ability to repay loans. Imagine your friend Sally asks to borrow money; you’d likely say yes because you trust her. But when it comes to banks, they lend to strangers, so they rely on credit scores to gauge reliability. If you consistently pay your bills on time and manage your credit responsibly, you’ll have a higher credit score, making it easier to secure loans. Conversely, if you have a history of late payments or high debt, your credit score will be lower, making it harder to borrow money.
Credit scores are vital because they determine your eligibility for mortgages, car loans, and other financial products. If your credit score is low, you may only qualify for high-interest credit cards or even be denied credit altogether.
Understanding Credit Score Ranges
Credit scores typically range from 300 (poor) to 850 (excellent). Here’s a breakdown of the different tiers:
Excellent (800-850): Consistently good credit history, on-time payments, low credit utilization, and a lengthy credit history.
Good (670-739): Generally responsible credit management, eligible for most financial products.
Fair (580-669): Some financial challenges, might encounter limited options and higher interest rates.
Poor (300-579): High-risk borrowers with a history of late payments and high debt, may struggle to access credit.
If you have no credit history, your score may be zero, making it difficult to apply for credit.
Different Credit Bureaus
Credit scores are generated based on the information collected by three major credit bureaus: Equifax, Experian, and TransUnion. Each bureau compiles credit data, such as outstanding debts, payment history, and credit history length, into a credit report. Your credit score is then calculated using a scoring model like FICO or VantageScore.
It’s crucial to review your credit reports from all three bureaus to ensure accuracy. You can obtain a free annual report from AnnualCreditReport.com or use tools like Smart Credit to simplify the process.
Two Scoring Models: FICO and VantageScore
Two primary scoring models, FICO and VantageScore, calculate credit scores. While both consider similar factors, they have some differences:
FICO: Developed in 1989 by Fair Isaac Corporation, FICO scores are widely used by US lenders. They range from 300 to 850 and consider five factors:
Payment history (35%)
Amounts owed (30%)
Length of credit history (15%)
Credit mix (10%)
New inquiries (10%)
VantageScore: Introduced in 2006 by Equifax, Experian, and TransUnion, VantageScore ranges from 300 to 850. It also evaluates credit card balances and utilization but emphasizes payment history.
Lenders choose which scoring model to use based on their preference and policies, so you can’t select one over the other.
Other Determining Factors
Besides your credit score, several other factors influence your creditworthiness:
1. Payment History (35%): Consistently making payments on time is crucial. Late payments, collection accounts, judgments, bankruptcies, and tax liens can severely damage your credit.
2. Amounts Owed (30%): High credit card balances can negatively impact your credit score, particularly if your credit utilization ratio exceeds 30%. Reducing balances and requesting credit limit increases can help.
3. Length of Credit History (15%): A longer credit history generally results in a higher credit score. Keep old accounts open and consider adding responsible users, like your children, to help them build their credit history.
4. Credit Mix (10%): Having a mix of different types of credit accounts, such as credit cards and installment loans, demonstrates your ability to manage various financial responsibilities.
5. New Inquiries (10%): Each hard inquiry from applying for credit can temporarily reduce your score. However, if you shop for loans (e.g., mortgage, car loan) within a 14-45 day window, they typically count as one inquiry.
Conclusion
In conclusion, your credit score plays a significant role in your financial life. Understanding how it’s calculated, the credit bureaus involved, the two scoring models, and the factors that determine your creditworthiness is essential for making informed financial decisions. Remember to manage your credit responsibly, monitor your credit reports for accuracy, and strive to maintain a good credit score to access better financial opportunities.
Below is a transcription of the podcast. This transcription was taken from Otter.ai so it might not be completely accurate:
Unknown Speaker 0:02
This is the digital nomad quest podcast with Sharon Tseung. teaching people how to build passive income, become financially free and design their best lives.
Unknown Speaker 0:13
Hey guys, it’s Sharon Tseung. And today we are going to do a complete breakdown of what a credit score is and how it all works. So compare cards by lending tree conducted an online survey of more than 1000 people. And they found that 37% of people agreed with the statement that I have no idea how my credit score is determined. And that’s why I wanted to make this episode we’re going to go over what a credit score is the different types of credit scores and some of its determining factors. So let’s go over what is a credit score. A credit score is basically a summary of your credit history. And it helps prove to lenders your ability to repay back the loan. So as an example, what if your good friend Sally needed to borrow money, you guys have known each other since five years old, you know, she’s normally good with her word and follows through. And then she asks you for $100 and says she’ll pay you back next month with interest, you’re more likely going to say yes to her than some random stranger. But banks are basically lending to strangers all the time. They don’t know you at all, but they still lend money to people all the time. And that’s why they look at things like your credit score. So if you have a credit history where you’re always able to pay on time and in full, like your credit card or mortgage payments, you’ll have a higher credit score, and you’re more likely to be approved for loans in the future. If we go back to that scenario, what if your good friend Sally never ends up paying you back, you’re probably not going to want to lend her another $100 in the future. So it’s the same thing with banks in this scenario, she would likely have a lower credit score and future banks would be cautious about lending her money again, before credit score’s banks would just rely on their personal relationships with clients. But now banks can use credit scores to measure your reliability as a borrower and that matters more than personal relationships or reputation. Now it’s important to have a good credit score because it will help determine whether you can get a mortgage a car loan or student loan. Meanwhile, if you have bad credit, it’ll be hard to get a credit card with a low interest rate and it’ll cost more to borrow money or you might even be denied for loans aren’t so now let’s go over the range of a credit score. So what is the range for credit score? Well, credit scores range from 300, which is poor to 850, which is excellent. And I’m gonna go over the different tiers of ranges with the two scoring models that I’ll talk about later on. The higher scores mean consistently good credit histories, meaning on time payments, low credit utilization, and a long credit history and then under 650 usually is considered problematic. Those with lower scores mean borrowers are riskier because of late payments or high credit utilization. Now if you have no accounts and credit history, you would have a credit score of zero This would basically be the case for someone who’s never had a credit card loan or any other form of credit. If you don’t have a score, it’s going to be hard to apply for credit as well. Now let’s go over how your score is determined. And first talk about the credit bureaus there are three major credit bureaus Equifax, Experian, and TransUnion. And they basically collect and maintain credit information about you like your outstanding debts, payment history and the length of your credit history. This information is then compiled into credit report so your credit score is calculated with a credit scoring model like FICO or Vantage score, which analyzes the information on your credit report, each of the three credit bureaus might have slightly different information about you so your credit scores from each bureau might vary. That’s why it’s important to check your credit reports from all three bureaus to make sure your information is correct. Now if you’re curious about your credit report, you can pull a free one yearly through annual credit report.com. But also, if you’re signed up with smart credit, which is a great tool to help you with boosting your credit, they also have their smart credit report because it can be hard to read credit reports so their smart credit report lets you understand it a lot easier, so I definitely recommend checking out smart credit. They also offer three Bureau reports monthly which is included in the membership. So if you were to get the three Bureau reports alone by itself elsewhere, it’s going to cost more than what smart credit costs. Without all the credit tools and features. Smart credit also has this feature called score boost that helps you add points fast in case you need to get a loan approved sooner than later you can move the dial to the amount you have for paying off your cards and the payment plan is going to adjust accordingly. So you can see the best balance to pay off to gain the most points. So go ahead and check out smart credit through the link below. They have an offering right now for seven day free trial for just $1. Now let’s get back to it. So when you apply for credit, many lenders follow a practice called try merge or middle score lending. They’ll basically pull credit scores from all three bureaus and use the middle score instead of the average. So if the three scores differ, the middle score is considered to be more reliable. So for example, if your credit scores are 710, from Equifax, 730, from Experian and 740 from TransUnion, the lender might use the 730 score to evaluate your credit application if they’re doing the middle score lending practice. So I briefly mentioned the two scoring models but now let’s go
Unknown Speaker 5:00
for them so FICO and Vantage score are the two different credit scoring models that calculate credit scores but even though they use similar factors to calculate scores they have slightly different methods in scoring ranges. The FICO scoring model has been around since 1989. And it was created by Fair Isaac and company now called the Fair Isaac Corporation. FICO scores are more widely used by lenders and creditors in the US and in this article it mentions according to my FICO over 90% of top lenders use FICO credit scores to make lending decisions it’s basically the industry standard like many banks, credit card companies and mortgage lenders use FICO to decide who to lend to now with the FICO credit score ranges exceptional is 800 to 850, very good is 740 to 799 Good is 670 to 739 ver is 580 to 669 and poor is 300 to 579. And FICO considers five factors in the calculation of your credit score, which is payment history, which is 35% Amounts Owed which is 30% length of credit history which is 15% credit mix, which is 10% and new inquiries, which is 10%. Now let’s talk about the Vantage score. The Vantage score model, on the other hand was started in 2006 by the three major credit bureaus Equifax, Experian, and TransUnion as an alternative to FICO scores. So over the years VantageScore has gained some traction and certain lenders credit monitoring services and personal finance websites use Vantage score to provide consumers with credit scores. Now the difference with FICO credit card balances and credit utilization are the most influential factors with FICO its payment history. So let’s go over the credit score ranges for Vantage score excellent is 781 to 850. Good is 661 to 780. With fair it’s 601 to 664 is 500 to 600 and very poor is 300 to 499. So a person with a strong FICO score is probably going to have a good vantage score, especially since the differences between the two are pretty minor. But ultimately the choice of which one to use depends on the lenders preference and their internal policies. So you can’t actually choose which one the lenders will use. Since FICO is the most common, let’s go into their five factors for calculating your FICO score so you can understand it more and know what you need to look out for. So again, 35% is payment history. And that means how consistently you’re making your payments on time, it’s the biggest contribution to your credit score. So if you make sure you pay your bills on time, you’re already a third of the way there. And if you’re doing this with multiple cards, it gives you more opportunities to demonstrate that you are a good and responsible borrower. The key thing is to really make sure you are paying your bills on time and in full. And if you have late payments, the degree of that impact depends on factors like how late the payment was how often you’ve had late payments and the total amount of debt owed. Now usually payments more than 30 days past due will be recorded to credit bureaus and can stay on your credit report for up to seven years. That’s why it’s very important to keep track of this and make sure you’re organized and collection accounts judgments, bankruptcies and tax liens can also severely damage your credit score, these items can remain on your credit report between usually seven to 10 years now 30% of your credit score is going to be based on your amounts owed. So having a high credit card balance will negatively impact your credit score. Because of the utilization ratio, the credit utilization ratio is taken by dividing your total credit that you’re using by the maximum that you’re allowed to take. So for example, if you have a total credit card balance of $2,000, and a total credit limit of $10,000, your credit utilization rate is going to be 20%. And you get this number by dividing are 2000. By 10,000. It may indicate that you’re relying heavily on credit or experiencing financial difficulties which makes you a high risk borrower high credit utilization can negatively impact your credit score utilization ratio above 30% is seen as a negative to creditors, so it’s good to use less than 30% of your credit limit. So here’s some tips to increase your credit utilization you can pay off balances so you reduce the total credit you’re using you can also request a credit limit increase, you also don’t want to close unused accounts because it will decrease your total available credit which increases your credit utilization rate. So you should continuously monitor this rate. Now let’s go to the next factor. So 15% of your credit score is going to be determined by the length of your credit history. And this reflects the age of your credit accounts and your experience managing credit over time. So a longer credit history generally means a higher credit score because it provides data for lenders to evaluate your credit worthiness for credit cards the longer you’ve been borrowing and paying responsibly, the better and this is why some people actually recommend adding their kids to a card because it helps them build their credit history by the time they’re 18 for loans the sooner you get rid of them the better so here’s a breakdown of how length of credit history impacts your credit score. One is the age of oldest account so a longer credit history with a good payment record shows you have experience handling credit responsibly
Unknown Speaker 10:00
leak, so it’s best to keep her old accounts still open. And then age of newest account is another one. When you open new credit cards, it’s going to be classified as new accounts which will affect your credit history. But this impact usually decreases over time when you show a positive payment history with the new accounts next is average age of accounts. The average age of all your credit accounts is calculated by adding the ages of each account and dividing by the total number of counts higher average age indicates a longer and more stable credit history, which is viewed favorably by lenders are going back to what determines your credit score. 10% is credit mix. So credit mix refers to the variety of credit accounts you have, it’s good to have a mix of revolving credit, which is like credit cards and lines of credit and installment loans, which include mortgages, auto loans and personal loans. So lenders like to see you can handle different types of credit accounts and that you’re not overly reliant on one form of borrowing. It’s not required to have a ton of different accounts as it’s just 10% of your score, your score could increase if you responsibly use different types of credit. So when I’m saying this, I’m saying don’t deliberately just open lines of credit to try to boost your score, you should only do it if you have to. And then the last 10% is new inquiries, and we kind of mentioned this earlier, but new credit inquiries refer to the number of times you’ve applied for new credit which usually results in hard inquiries on your credit report and these hard inquiries assess your credit risk when you apply for a loan credit card or other types of credit. On the other hand, there are also soft inquiries and the soft inquiry happens when you receive an offer from a lender like a pre approved credit card when you check your own credit. So basically with soft inquiries, a company reviews your credit information for reasons other than evaluating your credit worthiness or a loan or credit extension. So this doesn’t drop your credit score, but hard inquiries can negatively affect your score and each inquiry can stay on your report up to two years, but it affects most people score by less than five points. So don’t apply for new credit unless you really need it. As an exception though, if you’re shopping around for a loan, like a mortgage, car loan or student loan, then it should only count as one hard inquiry if you do it within a 14 to 45 day window. So as an example, maybe you’re shopping for a mortgage and you inquire with three different lenders, your score should only decrease once during the shopping window instead of three times. So I hope you guys enjoyed this episode. Please make sure to rate review and subscribe. It really helps our podcast grow. And thanks again. I’ll see you guys in the next one.
