A Word from Jason Smith: What in the world is a Credit Score?

A credit score is a number that ranges from 300 (Your friends won’t lend you a dollar for a soda) to 850 (You probably have the black Amex card that I believe to be the stuff of legend). The FICO credit score is the most commonly used score and it is based off of the information found in one’s credit report. Seems logical enough. The exact formula of a credit score is actually owned and licensed by the company that created it, Fair Isaac. However, I did a little bit of research and found a rough breakdown of how the score is calculated.

It is a lot like a grade in a college class. The total score is made up of smaller parts that are given weights based on how important they are perceived to be.

The breakdown is something like this:

35% - Is based off your payment history

Do you pay your bills? Do you pay on time? Do you pay the whole balance or does it take you a year to pay for that can of Pringles you so desperately needed at 1AM to get you through your psych midterm paper? If there are any missed payments or things like that your score will be adversely affected. The more recent the slip up the bigger the hit.

30% - How much debt do you carry?

If all of your cards are maxed out then your score will be lower. The rule of thumb is to keep your debt below 25% of the limit with each of your creditors.

15% - How long is your credit history?

This is why your parents probably advised you to get a credit card. The longer that you have had credit, then the more information there is to draw from about your habits. In general, the longer the history more likely the creditors can know what you might do in the future.

10% - Open a new credit card this weekend?

Then your score will be a little bit lower. Inquires into your credit score will temporarily lower it. To decide if you are worthy of more plastic a creditor will make an inquiry and your score will lower slightly because of it.

10% - How diverse is your credit?

Only got plastic? Your score could be higher. The more different kinds of credit you have will show your experience with what is available and will give a better picture about what you can handle. So, plastic + student loans + car payment will lead to a slightly high score than each of those by themselves.

All of that explains what the credit score is, but we still don’t know why it’s important.

The lower your score is, then the higher your interest rates on credit will be. This is an inverse relationship and you might recall that from your summer math class. This means that it will cost you more money to borrow than if your score was higher. Also, all of your activity is tied together. So, if you decide that your Van Gogh Starry Night Card is not your friend and that you don’t want to talk to them anymore and they put that on your credit report then you might be surprised to see your interest rate go through the roof on your beloved Kittens in a field of sunflowers card.

To summarize all 577 of the preceding words:

Keep your debt low (25% of the limit). If you get into trouble do not despair but know that your credit score can go up as easily as it goes down. So you might have to wait 6-12 months longer to get a loan on a new car while you work to improve your score. (Though I would recommend staying in what you have until no mechanic on earth can repair it. Don’t take on more debt just to look cool) Understanding the tools of the financial world are an important step to being able to use credit to your advantage and eventually gain real financial freedom and independence.

Jason

Comments

1) Lauren S - 10/22/2008
Jason, thanks for explaining that! No one our age seems to know what is in a credit score- which is leading to many people having bad credit!

2) m j - 10/22/2008
great advice and insight. Thanks!

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