Personal Finance 101: What Credit Scores Are, How They Work, and Why They’re Important to You

Not too long ago, I was at a community gathering when I overheard people discussing the difficulties of getting a loan for their first home. They were talking about a lot of things, but the part that really stuck out at me was the talk about credit scores.

101The talk was simply littered with a lot of falsehoods and half-truths, mostly gleaned from commercials about credit score services. Statements were being made along the lines of banks intentionally lowering a person’s credit score to give them a poor loan package and how you can reset your credit score to the maximum value by declaring bankruptcy, both of which are completely wrong.

I did a quick search through the archives of The Simple Dollar after overhearing that conversation and I realized that, although I’ve written about credit scores before, I never really gave the basics of what a credit score is and why they’re useful in modern society.

So, today, I’m starting from scratch. I’m assuming that you don’t know anything about credit scores whatsoever and starting from the very beginning: lending money.

Trust and the Basics of Lending Money

Let’s say you have a friend that wants to borrow some money from you. You’ve made the decision in the past to loan money to your trustworthy friends, but you’re not going to loan money to your friends that are a little bit… sketchier.

So, when this friend asks you to borrow some money, you spend some time thinking about what you know of that friend’s history. Is that friend trustworthy? Has that friend been reliable in the past? Have you loaned money to that friend before and he or she has paid you back? Have you heard stories from other friends or seen clear evidence that this friend of yours has a reputation for paying back loans?

That information is what you’re going to use to decide whether or not to lend money to that friend of yours. It’s all about trust. Do you trust that your friend will pay back the money that you loaned to him or her?

Now, let’s look at the exact same situation, except change the participants. Let’s say you’re a bank and a customer comes in the door wanting to borrow some money from you for, say, a home mortgage. You’re a bank – you’re in the business of lending money to people. But, just like an individual person loaning money to friends, you feel much better about lending money to trustworthy, reliable people.

Thus, the bank wants to find out some information about you. They want to know where you’re employed and how much you make. They also want to know places from which you’ve borrowed money in the past and whether you’ve paid it back.

In the old days, a banker could just ask around town about people and find out these kinds of things, but the world really doesn’t work that way any more. You may have borrowed money from a credit card issuer on the other coast and a furniture company in Nebraska. It gets even trickier, because other bills you have can also be considered loans. For example, your utility company may be considered by some to be a lender as well, as you’re “borrowing” electricity or phone service from them and you have to pay them back for it.

In other words, there actually is a lot of information out there about your reputation and your history of paying back debts, but it’s now spread all over the United States and perhaps even all over the world. A bank can’t simply talk to the other businesses on Main Street to find out if you’re reputable any more.

That’s where credit bureaus come in.

Credit Bureaus: The Middle Men

A handful of companies exist that work with businesses all over the world to collect information about whether or not you’re paying back your debts. They’re called credit bureaus, and the three main ones in the United States are Equifax, Experian, and Transunion.

Here’s how they work. Those bureaus enter into working relationships with almost every business in the United States that lends money to customers, even businesses like utility companies.

That relationship works two ways.

First, individual companies that work with the credit bureaus report the account status of their customers to the credit bureaus. So, if you have a credit card account somewhere or a loan from a bank somewhere or, likely, even a utility bill somewhere, that company is likely reporting that information to the credit bureaus. They report identifying data (so that the credit bureau knows who you are) along with things like your current outstanding balance and whether or not you’re behind on your payments. (Typically, a bill is only reported as being late if you’re 30 days or more behind schedule.)

Second, companies who are trying to decide whether to do business with a customer will request the information that the credit bureaus have about that customer. They’ll send identifying information about a customer to the credit bureau and the credit bureau will respond with the information they have about your various accounts, including information about whether you’re current on your bills. This set of information about you is called your credit report.

In other words, these credit bureaus act kind of like an information middle man. They collect information from lots of companies, reorganize all of that information by customer, and then share summaries of information about specific customers back to those companies.

Surprised that your information is being shared like that? Well, you signed off on it when you signed up for your utilities or you agreed to a loan. Agreeing to that kind of data sharing is part of the package today when you borrow money, sign up for a credit card, or sign up for utilities.

So, What’s a Credit Score?

In reality, though, a person’s credit report contains a lot of information for someone to evaluate. Someone¬†who has their name on a number of utilities and bills, has a few credit cards, a student loan, and so on – in other words, a pretty typical American consumer – has a pretty long credit report, one that would fill up a lot of pages if you were to print it out.

It can also be very hard for someone to figure out how important those pieces of information really are. How big of a deal is it really if someone is 30 days late on their credit card? Does that make them untrustworthy? Is someone with five up-to-date credit cards more trustworthy than someone with just one up-to-date credit card? Do the balances of those cards make a difference?

And, most of all, how trustworthy does a person have to be before it makes sense to lend that person money?

That’s where a credit score comes in. A credit score is a single number that summarizes all of the positive and negative elements of your credit report.

It’s actually not that all different than a teacher grading your test in school. As your credit report is “graded,” you earn and lose points along the way based on your history of keeping your bills paid, and in the end the quality of your work is summed up with a single number.

Quite often, businesses will make decisions about whether to lend money to you – or what interest rate you’ll have to pay – based solely on your credit score. It saves them the time of reading through your full credit report, and for a business, time is money. (Sometimes, for large loans, a person at a bank will actually look at your credit report and your full application; this is called “manual underwriting” and it can be a good thing for people in unusual situations.)

Aside from reporting back to the credit bureaus about your payment or nonpayment of your debts, a bank cannot alter your credit report or adjust your credit score. Honestly, banks don’t care whether your score is high or low. They simply want the information so they can offer you an accurate loan package based on your trustworthiness (at least as far as your credit report says).

Why Should I Even Care?

Credit scores matter to people who are considering taking out a loan in the near future, but what about everyone else? Why should anyone who isn’t in that boat care about their credit score? There are actually several reasons.

One, insurance companies rely on credit scores to set rates for customers. Your credit score is a factor in determining how big of an insurance risk you are. Someone with poor credit is going to face higher insurance rates as a result.

Two, property management companies rely on credit scores to decide whether or not to rent to you. This is mostly true of larger property managers, of course, but even smaller managers will still sometimes request a credit score before renting. A poor credit score can indicate that you won’t reliably pay rent, which means that the property manager has a good reason not to rent to you.

Three, employers often use credit scores during the hiring process to help determine your potential reliability as an employee. If you’re hunting for a job, especially anything above the entry level, there’s a good chance that your employer will check your credit score during the hiring process and a poor credit score will not reflect well on you.

Those three reasons are more than enough for any American to care at least a little about their credit score. It affects almost every avenue of life.

How Can I Improve My Own Credit Score?

One of the challenges with regards to a person’s credit score is that it’s not publicly known exactly how a credit score is calculated. We do know that there are a number of formulas that credit bureaus use to calculate credit scores, the most common of which is called FICO (short for Fair Issac and Company, which is the name of the company that devised the formula).

So, in a rough sense, what happens is that a company requests your credit information from a bureau and is provided with a copy of your credit report and a credit score that the company has calculated using a proprietary formula. Quite often, the company just uses that number to decide what to do regarding your loan application.

So, what do we know about credit scores and how they’re calculated? According to MyFICO.com, your credit score is made up of these five elements in these proportions:

35% Payment History
30% Amounts Owed
15% Length of Credit History
10% New Credit
10% Types of Credit in Use

They look at a lot of different elements! But what do they each mean?

The payment history part is the biggest, but it’s the easiest to fix going forward. Simply pay your bills on time. If you’re late on any payments, get current and stay there. If you’re having difficulty staying current due to simply being unorganized, introduce some organization. Use the calendar on your phone or your computer to send you reminders of when bills are due. Read your mail every day. If you’re having legitimate problems keeping your bills paid, contact your creditors and see if you can find an arrangement that works for both of you.

The amounts owed part looks at whether or not you carry high balances or low ones. In general, high balances are seen as a credit risk and can hurt your score, so you should keep your credit card balances low. You should also make sure that you’re paying off credit steadily instead of playing “games” like moving debt via balance transfers.

Surprisingly, closing unused credit card accounts actually hurts your credit score, because this section actually concerns how much debt you have compared to your overall total credit limits on your cards. So, closing an unused card actually lowers your overall total credit limit without lowering the amount of debt, making your situation appear worse.

The length of credit history part looks at how long you’ve had credit or outstanding loans. If you’ve had a credit card or a loan for several years, you’re fine with regards to this part, so don’t worry about it. Just avoid canceling your oldest credit card.

The new credit part looks at how many people have checked your credit report recently and how many new debts or lines of credit or credit cards you’ve received recently. In other words, don’t apply for multiple new credit cards at once, especially when you’re shopping around for another loan. Just shopping around for a single loan won’t hurt this part, as the credit bureaus can tell when you’re just shopping.

The types of credit in use part looks at what kinds of credit you have. You should avoid having a lot of credit cards, especially if you don’t have other kinds of debt (like student loans, car loans, or a mortgage). You’re better off just having one or two credit cards and keeping them paid down.

Here’s a simple checklist of things you should be doing to ensure a good credit score.

One, keep current on your bills. Don’t be late on any bills. If you are late on any bills, make it a key focus to get up to date on those bills.

Two, get organized. Make sure you have some sort of reliable method for paying your bills on time, whether it’s scheduling payments online, using calendar reminders, or something else. Try different methods and stick with one that works for you. (I personally prefer automatic online bill pay.)

Three, keep your credit card balance low. Ideally, you shouldn’t even carry a balance from month to month, but if you do, keep it as low as possible. Your credit card balance should at worst be staying level and ideally it should be going down. If it’s going up, you’re headed for credit score problems.

Four, only use balance transfers if they’re part of a plan to actually pay off debt. Using a balance transfer just to avoid credit card debt for a while so you can buy more stuff on credit is a recipe for credit disaster in your near future.

Five, don’t cancel your oldest credit card. It helps to establish the length of your credit history, so if you don’t want to use it any more, just pay it off and stick it in your closet.

Six, don’t apply for new credit cards in multiples, especially at the same time as you’re trying to get a loan. New lines of credit and new debts aren’t disastrous themselves, but done in a small timeframe they really can hurt you.

Seven, don’t actively use more than one or two credit cards. Keep your oldest one around without a balance on it if you’re not actively using it, then only actively use one or two cards. Cancel the rest.

If you follow those steps, you will wind up with good credit. It may take a while, as bad events last for seven years on your credit report, but things will get better.

650? 780? Help!

Quite often, you’ll see numbers quoted on commercials or other sources describing different people’s credit scores. Ads where people compare their scores are often shown on television and in print, often giving the impression that these arbitrary numbers are important and powerful.

Usually, the score being quoted is a person’s FICO score, which we mentioned earlier. Remember, your FICO score is just a single number that represents your credit report, which is itself just a listing of all of the companies that you borrow money from.

A person’s credit score is somewhere between 300 and 850. The average American has a credit score somewhere between 720 and 725 (this fluctuates a bit). A “good” credit score is anything above 700, and anything above a 720 is considered to be pretty low risk. You’ll usually get good rates on your loans, your insurance, and other things with a credit score in that range.

 

Scores in the 600s are mediocre, and below 600, you’ll start seeing some real challenges, with high interest rates and high interest rates on loans (assuming you even get loan offers at all).

The best place to see your credit score for free is through a credit card issuer that offers it on your monthly statement, such as Discover, or at Credit Karma. The “catch” with Credit Karma is that the site tries very hard to sell you on additional products of all kinds, especially if your score is even remotely subpar.

Final Thoughts

A person’s credit score can sometimes seem like a magic number pulled out of a box, and given the impact that it can have on someone’s life, that can seem a little bit mysterious and powerful. However, the reality is that a credit score is simply a number that represents how you behave towards companies that extend credit to you, whether it’s a credit card or a loan or something else.

Do you pay your bills on time? Do you push your credit cards to the limit? Those things are signs of what kind of trustworthiness you have as a lender, and they’re summed up in that one number.

It is always a good idea to have a good credit score, but what’s really nice about it is that the steps you would take to establish a good credit score – paying bills on time and so forth – will save you money in other ways, too. You won’t have late payment fees. You won’t have finance charges. You won’t have high insurance rates.

A good credit score is good for your finances in lots of ways. It’s well worth the time to understand it and to take the simple life steps you need to take to improve it.