We all have a general idea of what “credit score” means but how many of you can define it in concrete terms?
Credit Score Definition
Here’s the definition of a credit score:
Your credit score is a number that tells lenders your creditworthiness. It attempts to figure out the probability that you will repay your debts based on your credit history. Your credit score ranges from an abysmal 300 to a lofty 850. The higher the score, the more financially trustworthy lenders assume you are. Usually the lower your credit score, the harder it is to obtain a loan and the higher your interest rate will be.
A Short History of the Credit Score
The credit score is a recent invention of the modern economy (1950’s). Before then, when you needed a loan your fate was at the hands of the loan officer at your local bank. Getting a loan was based on the loan officer’s subjective judgment. There were many faults with this system, but the biggest two were (1) the inability of the loan officer to accurately assess the likelihood that you would pay your loan back and (2) discrimination based on the loan officer’s own biases towards race and gender.
Your loan application could be denied because the loan officer was having a bad day.
Two statisticians, Earl Issac and Bill Fair, tried to solve this problem by finding patterns of behavior that predicted a good or bad credit risk. Their model became popular during the 70’s but not until 1989 did the modern version of the FICO score come about. This score is based on consumer credit files of the three national credit bureaus: Experian, Equifax, and TransUnion.
How is a Credit Score calculated?
The exact makeup of a Credit Score is a secret, but FICO has disclosed some general information:
- 35% payment history: Any kind of negative information such as late payments, foreclosures, bankruptcy, settlements, liens, judgments, charge-offs, etc will have a negative effect on your credit score.
- 30% debt burden: There are 6 different measurements that make up this category. This includes your debt to limit ratio, the amount paid down on installment loans, number of accounts with balances, and the amount owed across different types of accounts.
- 15% length of credit history: This is composed of the average age of your accounts and the age of the oldest account on your report. The older your accounts, the better.
- 10% type of credit used: Having different types of credit (mortgage, installment, revolving, consumer) can have a positive impact on your credit score.
- 10% recent credit searches: Hard credit inquiries have a negative affect on your credit score. These usually happen when you apply for a credit card or loan. Luckily, you can still “rate shop” around when looking for a home or car loan because FICO considers all credit inquiries within a certain time frame as one credit inquiry opposed to however many actually happen.
What factors do NOT affect your credit score?
Unlike what some people believe, your credit score never takes into account your race, age, gender, or marital status.
How many credit scores do you have?
Not many people know this but you actually have more than one credit score. Equifax, Experian, and TransUnion all create different credit reports. These credit reports are used by credit scoring models such as FICO and VantageScore to come up with different credit scores. When someone requests your credit score, they’ll receive a credit score from each bureau. It’s common that the scores you receive from the different bureau will vary from each other.
This happens if lenders don’t report to all three credit bureaus or if the bureaus update their reports at different times.
Did you know what a credit score was?