Recently, I received a lengthy email from a reader who had a ton of basic personal finance questions contained within. I thought it might be interesting to start an irregular “personal finance 101″ series to answer and explain some of her questions.
Anyone who has tried to get a loan in the last fifteen years or even anyone who has tuned into basic cable in the last year and a half is at least familiar with the basic idea of a credit score: it’s a number that lenders use to determine what interest rate to give you on your loans. But how does it really work? I’m going to discuss how credit reports work in the United States, but most of the general concepts apply to other countries.
So, what is a credit score? A credit score is a single number that represents how trustworthy you are from the perspective of someone who would lend you money. If you haven’t proven yourself trustworthy, your credit score is low; on the other hand, if you repeatedly show yourself trustworthy (by paying bills on time and such), your credit score will be high.
Who determines a credit score? In the United States, a small number of companies, called “credit reporting agencies,” are in the business of collecting information about you. They do this by exchanging information with companies that offer financial items, such as loans, credit cards, and so forth. The agencies generally care about three things: the money you’ve borrowed, the amount you owe, and whether you’ve been making your payments. They collect this information from everyone you are indebted to and create a picture of how trustworthy you are in terms of credit. In the United States, the three main companies engaged in this business are Experian, Equifax, and TransUnion.
Why? Think of it this way. Let’s say three people walked up to you and asked to borrow $5. You’ve known two of them for years: one is as trustworthy as can be, and the other one is the biggest backstabber and scoundrel you’ve ever known. The third, you’ve never met before. Who would you be more likely to lend money to? Obviously, I’d loan money to the person I trusted, then the person I didn’t know, then the scoundrel.
Now, let’s say you’re a bank and three people come in and ask for a loan. You’re going to want to have some way to determine who is the trustworthy person (who you would want to lend money to), the unknown person (who you would nervously loan money to), and the rogue (who you wouldn’t want to loan money to at all). This is the exact purpose of a credit score: it’s a number that says how trustworthy – or how much of a scoundrel – you are in terms of money.
What makes up a credit score? There are five main elements to the credit score in the United States. From MyFico:
FICO scores are calculated based on your rating in five general categories: Components of the FICO score
Payment history – 35%
Amounts owed – 30%
Length of credit history – 15%
New credit – 10%
Types of credit used – 10%
What can I do to make my credit score better? The biggest thing you can do is pay down your debts, not open up new credit cards and such, and pay everything on time. Many people try all sorts of crazy things, but the truth is that most common moves people make to help their score are mistakes.