Credit Scores 101
America runs on Credit. We all know this, but very few of us can be considered credit experts. The number of myths, fables, and just outright lies about how credit scores work is too long to list, so let’s break it down as simply as possible.
Credit is defined as “the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately, but promises either to repay or return those resources at a later date.” In other words, credit is telling someone, “hey spot me now, and I promise, I’ll pay you back later”.
In essence, it’s a promise and a promise is only worth the trust someone has in you. What creditors and banks want to see is how many promises you’ve kept in the past, how many promises you’re making now, and decide if you’re going to keep your promises in the future.
Now you may ask, how can one score tell someone all of that information about me? Well, they don’t just use your credit score, they combine a number of factors that they have to make that decision, but the credit score is one of the most important factors. And fun fact, there are actually 35+ different credit scores, created by the 3 credit bureaus and even thousands more by other data agencies. Scores can specifically be for a certain type of product like the FICO score is used for credit cards or it can be more complex scores for things like a mortgage.
To answer your question transparently, credit scores are very often wrong about predicting the debt outcomes, but many creditors think it’s the best data available today. So if we can’t beat the system, we gotta learn how to play their game. When it comes to credit, there are 5 major factors taken into account:
Payment History. This accounts for 35% of the score. It takes into account your payment history. Do you pay on time? Are you ever late? Have you missed payments? The most pristine the record, the higher the score.
Utilization (30%). This takes into account how maxed out your debts are? If you have $10,000 available on your credit cards and you’re using $9,500, you’re pretty close to being fully maxed out. The bank here might think that you don’t have the funds to cover that amount and you might be closer to defaulting than someone who’s only using $1,000.
Length of Credit History (15%). This is why you always hear people saying you should never close your oldest credit account. Since they’re trying to predict your future payment ability, the longer your history of positive credit use, the more data they have to go by that you’ll be good for the money.
Credit Mix (10%). The more debt products you have, the better. This way they can see you’re responsible for different types of debts and not just good with credit cards and not mortgages.
New Credit (10%). They don’t want you to open up 10 accounts in one week and max them all out, so although it’s not a high impact on your score, you still want to spread out the times you get new credit.
There’s a lot more we can say about credit, we might do another post on tips and tricks for improving a credit score. For now, just know that they’re using data to see if you are able to and are responsible enough to pay back what you owe on time. If you monitor your score and understand the different factors listed above, you should be good. Above all else, make sure you’re not spending more than you have, and not borrowing more than you need.