CHAPTER 19
Understanding Your Credit Score
Credit reports are essential, but the mathematical formula derived from them is even more crucial. It is your credit score, a three-digit number that predicts whether you will pay your bills. If you have a good credit score, you will get loans for less and SAVE BIG. A bad score costs you tens of thousands of dollars.
Credit scores now reach into every corner of our financial lives. They used to be just for loans. Then insurance companies discovered a correlation between people with low credit scores and people who make excessive claims. Phone companies use credit scores to decide how big a deposit you have to pay to get service. Your bank may even consider your score when it sets the maximum amount of cash you’re allowed to take out at the ATM. Who knows what will be next. That’s why a good credit score is so important.
In this chapter, learn to SAVE BIG by:
• Understanding how credit scores are derived and making that work to your advantage.
• Recognizing all the different types of credit scores and which one matters.
• Ordering your credit score from the right source.
• Knowing what score you must have to qualify for the best loans.
• Comprehending how badly a low score can hurt you when you apply for a loan.
How Does a Report Become a Score?
The relationship between a credit report and a credit score can be confusing. Think of your credit report kind of like a school report card. Instead of listing the classes you took and how you did, it lists the loans you took out and how you did in paying them back. By contrast, your credit score is more like an SAT score. It’s a three-digit number that sizes up your potential—only it’s your potential as a customer rather than as a college student.
So credit reports are words. Credit scores are numbers. The credit score is derived from the credit report. In the 1950s, some pocket-protector types—engineer Bill Fair and mathematician Earl Issac—had the audacity to believe that they could predict human behavior using—get this—math. They studied thousands of people, looking at hundreds of factors like late payments, types of credit, how long they’d had a credit card, and their ratio of debt to credit. They figured out which factors were good predictors of whether somebody would pay their bills. Then they assigned numerical values to those factors and created their secret scoring formula. They called this mystery number the FICO score, named after their company, Fair Isaac Corporation.
Today, computer programs analyze a couple dozen different indicators in your credit report and then assign you a score. That’s it. That’s all a credit score is—a prediction of whether you’ll pay. That prediction is usually expressed as a number between 300 and 850 (why the scale doesn’t start at zero is beyond me). Like most sports, the higher the number, the better. This is not golf.
Go to the Right Site to Find Unclaimed Money
Is all this talk about your credit score depressing you? Then maybe scoring some unclaimed money would cheer you up. Unclaimed money accidentally abandoned by citizens is held by each state. You could even use it to improve your credit score. Lots of companies ask for a cut to lead you to the pot of gold. Instead, you can use the website set up by the states to find it for free:
www.unclaimed.org.
It all sounds kind of cold, but cold and clinical is good in this case. By comparison, when bankers decide your fate on their own, they have the potential to be biased. Scoring applies the same mathematical, methodical standards to everybody. So you don’t have to worry or wonder whether some loan officer has preconceived notions about your race, religion, age, gender, and so on.
The statistical models are remarkably predictive, but they’re not perfect. Credit scoring models give preference to people who have credit, use it, and pay it off on time. Ironically, that means if you’re so rich that you pay cash for everything, you won’t have a high credit score. Additionally, young people—even the really responsible ones—may have low credit scores because of the classic catch - 22: You have to have credit to get credit.
How Is Your Credit Score Calculated?
Since I’ve been harping on how crucial credit scores are, I bet you are wondering how these mysterious numbers are determined. A few years ago, this would have been a very short section, because the FICO scoring model was such a big, sneaky secret. But in 2000, just as legislators were huffing and puffing that something as important as a credit score should be accessible, Fair Isaac went public. It started selling people their scores and explaining roughly how they are calculated.
Credit scoring models are multivariate, a nerdy new vocabulary word I learned, which means that they are sort of three-dimensional sliding scales. No one piece of information can be judged on its own. Each morsel’s meaning is reliant on other scraps of information to form the complete picture. The precise details of the elaborate multivariate mess are still murky, but Fair Isaac did release the broad categories it tracks and how important each factor is to your score. Below are the factors that make up your FICO score:
FICO Score Categories
| Payment history | 35% |
| Amounts owed | 30% |
| Length of credit history | 15% |
| New credit applications | 10% |
| Mix of credit | 10% |
Payment History
The fact that your payment history makes up the biggest chunk of your credit score is predictable. I mean, whether you’ve done a good job of paying your bills in the past is probably a pretty good indicator of whether you’ll do a good job paying in the future. Lenders are looking at whether you pay on time, when was the last time—if ever—that you paid late, and how late you were. Collections also fall into this category, and under the classic FICO scoring model, it doesn’t matter if the amount was small. The mere presence of a collection action is a huge drag on your score.
Amounts Owed
It’s also pretty understandable that the size of your debts would be the second most important factor in determining if you’re a good risk and deserve a good score. After all, if you owe a ton of other money already, you may have a hard time paying off a new loan. Surprisingly, your income level is not part of your score. Instead the FICO scoring model is really obsessed (not to give a statistical model human emotions!) with how much debt you have compared to how much credit you’ve been approved for. This is called your credit utilization ratio. In other words, being near your limit, maxed out, is bad.
Length of Credit History
The third largest factor in calculating your credit score is the length of your credit history. This is a frustrating one because you can’t exactly control your age and we don’t want to start issuing credit cards to two-year-olds. Apparently ol’ Bill and Earl discovered a correlation between people who have been banking for a long time and people who bank responsibly. It shows stability. The FICO model weighs how long you’ve had your oldest account and also the average age of all your accounts.
New Credit Applications
New credit applications are next on the list, and this is where it starts to sound contradictory. It’s good to have more credit than you’re using. It’s good to have a long credit history. But you shouldn’t apply for new accounts? The key is not to apply for a bunch of credit—especially credit cards—all at once. That makes it look like you’re about to go on some wild shopping spree, you have a gambling problem, or you’re financing an independent film or something. Fortunately, credit scoring models look at mortgage and car loan applications differently. It’s understandable that people will shop around for these large loans, and every application you make in a 14- to 45-day time period counts as just one entry.
Mix of Credit
The final factor is your mix of credit. This one is not so intuitive, but apparently Fair Isaac’s sociological studies way-back-when revealed that people are better risks if they have a combination of revolving loans and installment loans. In other words, it’s best to have a mixture: a home loan, car loans, and credit cards. Mortgage debt is considered good debt since a house can be an investment and is backed up by the piece of property. The thinking on auto loans is that at least the lender vets the borrower more carefully than a credit card company does. Credit card loans get the least respect.
FICO versus Fako Scores
I’ve spent several pages now talking about your “credit score,” but actually there is no such thing—not just one, anyway. You have multiple scores, since your credit scores are based on your credit reports and there are three main credit bureaus, each with slightly different information on file about you. Not only that, but your score is constantly changing. It adjusts with every payment you make—or fail to make.
You have multiple scores, but they mostly originate from the same place. Remember the pocket-protector guys? Actually, Bill Fair and Earl Isaac may have been dapper and debonair, for all I know, and they were so far ahead of everybody else that the FICO score is still the only one that really matters. Yet there are other scores out there.
Those other credit scores are sometimes referred to as Fako scores! I’ll just call them others. For years, credit bureaus resisted telling people their credit scores, but now they’re falling all over themselves selling people their credit scores.
In 2006, the big three credit bureaus, Equifax, Experian, and TransUnion, got together and came out with something called a VantageScore, which was meant to compete with the FICO score. The VantageScore uses a scale from 501 to 990. Each tier of the VantageScore corresponds to a letter grade. So a score in the 900s is an A, a score in the 800s is a B, and so on. VantageScores were touted as the next big thing that would topple Fair Isaac, but that hasn’t happened.
One more detail to add to the madness: Fair Isaac itself has developed several versions of its own FICO score. Just as Microsoft makes Windows ‘98 and 2000 and so on, Fair Isaac occasionally updates its scoring system. One is called FICO 08 and another is named FICO NextGen. There’s also a FICO system for scoring people who don’t have much credit yet, called the Expansion score. And just as computer customers are still using all the different versions of Windows, different banks use different versions of the FICO score. In fact, some will run your score through multiple FICO scoring editions to see if it makes a difference.
How Do I Get My Score?
How do you get your hands on a gen-u-ine FICO score? Simple: You buy it from Fair Isaac directly. If you want to get your credit score, the only website you need to use is
www.MyFICO.com. Many people are under the impression that they are entitled to a free annual credit
score, when in reality they are only entitled to free annual credit
reports. The MyFico site charges about $16 for a single bureau score. Just be sure to scroll through all the other stuff Fair Isaac is selling and choose “FICO Standard” if all you want is your score.
If you are just doing a routine check or you’re about to make some small credit application, buying one score from
MyFICO.com should be enough. But if you are about to buy a house or a car or apply for a small business loan, you should order every FICO score you can get your hands on. Normally, that means purchasing three scores, the ones based on your credit reports at Equifax, Experian, and TransUnion.
Unfortunately, as I write this, Experian has gotten into a tiff with Fair Isaac and isn’t allowing Fair Isaac to sell consumers their Experian FICO scores. Yet Experian is still selling those scores to businesses. So your banker can learn your Experian FICO score but you cannot. If this continues, you can always ask your banker for your Experian FICO score. You should also check your Experian credit report, and if it is nearly the same as your other bureau reports, the scores will be very close, too.
What’s a Good Score?
After the mortgage meltdown of 2008, a good credit score became more crucial than ever. The threshold for what is considered good moved up. It used to be that anybody with a score of 680 or above could land a great loan with the best possible interest rate. In the fall of 2008, when credit tightened up, lenders started telling me that now only people with scores of 720—maybe even 740—and above could qualify for the best loans.
The definition of subprime changed, too—and engulfed far more people. Subprime borrowers are people with lower credit scores who can’t qualify for the best interest rates. People used to be considered subprime prospects, eligible only for more expensive loans, if their scores were 580 or below. That benchmark moved up to 620. Do you know what percentage of the population has a score below 620? Twenty percent. That’s a fifth of Americans who can’t get a mortgage loan at all, or only one so expensive that it’s cost prohibitive.
Want to know where you stand? How your credit score compares to the Joneses? The list below shows what percentage of the population has which score, according to Fair Isaac.
What’s Your Score?
| Credit Score | Percentage of Population |
|---|
| 800-850 | 13% |
| 750-799 | 27% |
| 700-749 | 18% |
| 650-699 | 15% |
| 600-649 | 12% |
| 550-599 | 8% |
| 500-549 | 5% |
| 300-499 | 2% |
Score Some Forgotten Funds
There are more than $12.5 billion worth of forgotten savings bonds waiting to be claimed. If you have a low credit score, one way to qualify for a mortgage is with a big down payment. Finding a forgotten savings bond in your family’s name could be just the ticket! Since savings bonds take so long to mature—20, 30, or 40 years—many families forget they have them. The bonds stop earning interest and just sit there. You can do a simple search online by going to
www.TreasuryHunt.gov.
Why Does Your Score Matter?
We’ve finally come to the point in the chapter where I get to prove to you that your credit score is a big, fat, hairy deal. Consider this: Fair Isaac says somebody with a 550 credit score will always pay about three points more in interest for a mortgage than somebody with a 720 credit score. Interest rates rise and fall with the markets, but that painful point spread remains about the same, and if you have a low credit score it will cost you tens of thousands of dollars.
Let me use myself as an example, because I have a special talent for embarrassing myself more than others! I had some credit problems coming out of college. The usual story: I had three credit cards and zero jobs. I struggled to make the minimum payments. I don’t know what my credit score was back then, because FICO scores weren’t available to consumers at that time. But thankfully, over the years, I worked diligently to dig myself out of debt. I now have a credit score of 785. That’s as of five minutes ago, when I checked online.
So let’s look at what kinds of loans I can get with my present, healthy score compared with the mediocre score I must have had when I was young and clueless. Let’s say my old self would have had a score of 635 because of a short credit history, debt near my limits, and a couple of late payments. If anything, I’m being too generous to my former self, but that score will prove my point just fine.
We’ll start with a four year, $25,000 car loan. With a stellar score of 785, I can qualify for an interest rate of 5 percent. But with a middling score of 635, my interest rate leaps to 11.234 percent. Let’s see how much that is going to cost me over the life of the four-year loan.
Auto Loans: Benefit of High Credit Score| FICO Score | Cost of Loan |
|---|
| 635 | $31,152 |
| 785 | 27,648 |
| BIG SAVINGS = | $ 3,504 |
With the 150-point lower credit score, “Bad Eli” would have to pay an extra $3,504 in interest over the life of the loan. If I didn’t have to spend that money on interest, it would be a nice chunk of change to put toward paying cash for my next car. Even if you break it down into smaller time frames, the additional interest I have to pay because of my mediocre score is significant. It costs me an extra $73 a month, which might well be enough to gas up my car, and $876 a year, which would be plenty to pay for some big, bad repair.
If you think that scenario is bad, you’ll feel the real pain when you need a loan for a larger amount over a longer period of time: a mortgage. Let’s choose a 30-year fixed rate mortgage for $250,000. With a score of 635, I can only qualify for a 6.034 percent mortgage rate. With a score of 785, as I write this I would be able to get a mortgage at just 4.46 percent. Here’s how that impacts me over the life of the loan:
Mortgages: Benefit of High Credit Score| FICO Score | Cost of Mortgage |
|---|
| 635 | $ 541,440 |
| 785 | 453,960 |
| BIG SAVINGS = | $ 87,480 |
As you can see, if I hadn’t cleaned up my act and improved my credit score, I would have to pay $87,480 more in interest over the course of that 30-year mortgage. Jeez, that’s enough to finance a college education! That amounts to $243 more per month—nearly $3,000 a year—because of a 150-point difference in my score.
BIG TIPS
• Pay for one score if you’re applying for minor credit, all of them if you’re applying for a big loan.
• Know which credit scores matter.
• Order your score from
MyFICO.com for a genuine Fair Isaac score.
