If you don’t know what a credit score is, it’s time to learn. Your credit score is an essential aspect of your finances. Maintaining a high credit score can save you tens or hundreds of thousands of dollars over your lifetime. But, on the other hand, a bad credit score can do more than just cost you tens or hundreds of thousands of dollars. A bad credit score can prevent you from accomplishing many life goals that, usually involve debt. Here’s what you need to know about credit scores.
Table of Contents
What Is A Credit Score?
A credit score is a numerical representation of a person’s creditworthiness based on their credit history. It is calculated using information from a person’s credit report, which is maintained by credit bureaus such as Equifax, Experian, and TransUnion. The credit score provides lenders with an assessment of a person’s ability to repay debts and manage credit responsibly.
Credit scores typically range from 300 to 850, with higher scores indicating better creditworthiness. A credit score is calculated using various factors such as payment history, credit utilization, length of credit history, types of credit used, and recent credit inquiries. Each factor is weighted differently, and the exact formula used to calculate the score can vary depending on the credit scoring model.
Credit scores are used by lenders to assess the risk of lending money to a person. A higher credit score can result in better loan terms and lower interest rates, while a lower credit score can make it harder to obtain credit or result in higher interest rates and less favorable loan terms. It’s important to regularly check your credit report and credit score to ensure that the information is accurate and up-to-date.
A credit score is one of some people’s most feared three-digit numbers. Fortunately, you may not have to be scared. A credit score is a numerical representation of the risk lenders take on when they loan you money. In theory, the better chance you’ll miss a payment or default on loan, the lower your credit score will be. Unfortunately, the opposite is also true.
Is My Credit Report the Same Thing as My Credit Score?
Your credit report and your credit score aren’t the same things. Your credit score is based on the information in your credit report. Therefore, you must review your credit report before taking out any significant loans to ensure there are no errors. If you find a mistake that could hurt your score, correct it before applying for a loan. That way, you can make sure you get the best rate possible.
How Lenders Use Credit Scores
Most lenders will use your credit score to help them make lending decisions when you apply for a loan. If you’ve applied for a mortgage, car loan, private student loan, credit card, or many other types of debt, the lender most likely pulled your credit score. While lenders don’t solely make their decisions on credit scores, they play a significant factor in the final decision. If your credit score is low enough, you might get denied simply on that factor alone. Even if you’re approved for a loan, your credit score still plays a significant factor. Credit scores often help determine what interest rate you qualify for. The higher the credit score, the lower the the interest rate you’ll receive on your loan.
Here is an important example to help you understand how important it is to try to keep an excellent credit score.
An Example of How Important Credit Scores Are
Two identical twins, Billy and Bob, do everything the same. They went to the same college, got the same grades, got similar jobs,, and were paid the same. The only thing different about the two is their credit scores. Billy has an excellent credit score, while Bob only has a fair credit score. Billy and Bob decide to build identical houses next to each other. They both apply for a mortgage for $200,000 to purchase a $250,000 home.
Billy gets an interest rate of four percent. Sadly, Bob’s fair credit score means he gets an interest rate of 4.625 percent. You wouldn’t think a 0.625 percent difference in interest rate would significantly affect the total cost of the loan. Sadly, it does. Over the life of the 30-year mortgage, Billy will pay $143,739 in interest, but Bob will pay $170,180. Bob ends up paying $26,441 more than his brother Billy because he has a lower credit score.
Now that you know how important it is to keep an excellent credit score, you probably want to understand how credit scores are calculated and what you can do to keep your credit score perfect. Here’s what you need to know.
How to Calculate Your Credit Score
First, a distinction needs to be made. There are many different types of credit scores, more on that later. However, the most commonly cited is the Fair Issac Corporation score. Your FICO credit score is calculated using five major categories of data. While FICO closely guards the formula used to calculate your FICO score, FICO shares the importance of each of the five major categories. Each category is worth a certain percentage of your credit score calculation. The categories include payment history, amounts owed, the length of your credit history, the mix of your credit types, and credit inquiries.
Calculating a FICO score is not something that can be done manually. The formula used to calculate a FICO score is proprietary and is not publicly available.
FICO scores are calculated by analyzing the information in a person’s credit report, including their payment history, amounts owed, length of credit history, new credit, and types of credit used. Each of these factors is weighted differently, and the FICO score is calculated using complex algorithms that take into account various combinations of factors.
The best way to find out your FICO score is to obtain a copy of your credit report from one of the three major credit bureaus – Equifax, Experian, or TransUnion. You can then purchase your FICO score from myFICO.com or from the credit bureau directly. You can also obtain a free FICO score from some credit card issuers or banks that offer the service as a benefit to their customers.
It’s important to regularly monitor your credit report and FICO score to ensure that the information is accurate and up-to-date. If you notice any errors or inaccuracies in your credit report, you can dispute them with the credit bureau to have them corrected.
Payment history is the most significant factor that helps determine your credit score. It accounts for roughly 35 percent of your score. Getting the maximum number of points for this part of your credit score is straightforward. All you have to do is always make every single payment on time. If you miss a payment, make the payment as soon as possible. The longer it takes you to make a late payment, the more the late payment hurts your score. For instance, a 30-day late payment hurts less than a 60-day one.
Amounts owed on your debts are the second most significant portion of your credit score. Approximately 30 percent of your score comes from this category. This section is a bit more complicated than your payment history regarding getting the ideal score. In general, you should try to keep your revolving debt, such as credit cards, at under 30 percent of your total credit limit on each card. If you owe a significant amount compared to your credit limit on a card, that’s a wrong signal that can lower your score in this area. Credit card companies usually report your statement balance to the credit bureaus. Your monthly statement balance mustn’t be a high percentage of your credit limit because it could hurt your credit score even if you pay your credit card in full each month.
Length of Credit History
The length of your credit history accounts for an estimated 15 percent of your credit score. This section looks at the total length of your credit history, the average history between all of your accounts, and the length of time since you opened your newest account. It isn’t much you can do to increase your credit history. However, you can always keep your oldest account open to help increase your score. You can also increase your average account age and newest account age by not applying for any new credit. Each time you open a new line of credit, your average account age will get younger, and your newest account age will start over again.
Mix of Types of Credit
One of the two most minor areas affecting your FICO score is your mix of types of credit. This is roughly 10 percent of your credit score. Lenders like to see that borrowers can manage many different types of credit effectively. Different types of credit include installment loans like car and student loans, credit cards, retail accounts, mortgages, and finance company accounts.
New Accounts and Inquiries
Your new accounts and credit inquiries determine the last portion of your credit score. A lender usually inquires to view your credit score each time you apply for a new line of credit. Racking up multiple inquiries in a short period of time usually isn’t good for your score. The same goes for opening multiple new accounts in a short period. Both activities correlate to higher risk for lenders as you may be overextending yourself. There is an exception to the rule if you are rate shopping for a loan within a short period. You can excel in this portion of your score by refraining from applying for new credit. This area accounts for about 10 percent of your score.
Is a FICO Score and a Credit Score Always the Same Thing?
A FICO score is a credit score that is calculated based on information in a person’s credit report, which is maintained by one of the three major credit bureaus – Equifax, Experian, and TransUnion. The FICO score is created by the Fair Isaac Corporation (FICO) and is widely used by lenders to assess a person’s creditworthiness.
FICO scores range from 300 to 850, with higher scores indicating better creditworthiness. The score is calculated based on five factors: payment history, amounts owed, length of credit history, new credit, and types of credit used. Each of these factors is weighted differently, and the exact formula used to calculate the score is kept confidential.
A higher FICO score can make it easier to obtain credit and may result in better interest rates and loan terms. It’s important to regularly check your credit report and FICO score to ensure that the information is accurate and up-to-date.
While a FICO score may be the most commonly cited score, lenders use many different credit scores today. While the FICO score may be used by some lenders, others may use credit scores such as the VantageScore. Each score has its own point range as well. For instance, your FICO score can range from 300 to 850, but your VantageScore 1.0 or 2.0 could range from 501 to 990. The important thing to remember is you should be able to get excellent credit scores on all the different scoring models if you stay on top of your credit.
Places to Check Your Credit Score for Free
If you’re curious what your credit score is, you can get it for free. Recently, many new free credit score websites have popped up. Many of these sites give you your VantageScore or another credit score that is not your FICO credit score. Some of them include Credit.com, Credit Sesame and Credit Karma. However, it is possible to get your FICO score for free as well. FreeCreditScore.com offers a FICO score without having any products. You can also get a free FICO score from Discover without being a customer. If you already have a credit card with Citi or American Express, you can get a free FICO score by logging into your account online.
FICO and credit ratings are essential to your financial future. But what exactly are they? And what’s the difference between a FICO score and a credit score?
FICO Score vs Vantage Credit Score
FICO Score and VantageScore are two different credit scoring models that lenders use to evaluate a person’s creditworthiness. Here are some key differences between them:
- Development and Ownership: FICO scores are developed by Fair Isaac Corporation, whereas VantageScore is developed by the three credit bureaus – Equifax, Experian, and TransUnion.
- Scoring Range: FICO scores range from 300 to 850, while VantageScore ranges from 300 to 850 as well.
- Credit Data Used: Both scoring models use similar credit data such as payment history, credit utilization, length of credit history, types of credit used, and recent credit inquiries, but the weightings may differ between the two models.
- Credit File Requirements: FICO scores require a minimum of six months of credit history and at least one account that has been active for six months, while VantageScore only requires one month of credit history and one account reported to a credit bureau in the last two years.
- Model Versions: There are different versions of FICO scores and VantageScores, and new versions are periodically released to improve the scoring algorithms.
- Industry Use: Both scoring models are widely used by lenders, but some lenders may prefer one over the other. FICO scores are more commonly used in mortgage lending, while VantageScore is used more in personal loan and credit card lending.
It’s important to note that while there are differences between the two scoring models, both aim to predict the likelihood that a person will repay their debts on time. Maintaining a good credit history by paying bills on time, keeping credit utilization low, and having a diverse credit mix can help improve both FICO and VantageScore credit scores.
It’s helpful to start off with some definitions. A credit score is just a tool that lenders use to work out your creditworthiness. They take into account all sorts of financial information, including how much debt you owe, whether you pay all your bills on time and how often you take out new credit. All this information is then fed through computer algorithms on a regular basis, updating your score in the process. Lenders can then use this score to figure out how much they should lend you and at what rate of interest. If your credit score is high, then you’ll be able to borrow a lot and pay it back at low rates of interest. If your credit score is low, then the amount you’ll be able to borrow is less, and you may end up paying more in interest charges.
Importance of Credit Score
As a result, your credit score is remarkably important in determining your future financial health. When your credit score is good, it’s a lot easier to take out a loan on a car or a mortgage on a house than when it’s bad. A good way to monitor your financial health is through Credit Sesame.
A FICO score is actually a kind of credit score. The FICO score was first defined by the Fair Isaac Corporation back in 1956. They came up with a very simple scoring method to determine a customer’s creditworthiness, without having to go through the rigmarole of checking their history every time they applied for a loan, which could be ineffective. Before that time, lenders had had to use their personal judgment to determine whether somebody should receive a loan, which led to all sorts of errors. Some people who were terrible with money were given loans, thanks to their smart appearance. Others who would have paid back the loans with interest were denied on the basis of characteristics which were unrelated to their ability to repay. Banks soon realized that these errors were costing them an enormous amount of money and vowed to make use of more objective methods.
FICO Score’s Rise to Dominance
By the 1980s, FICO scores had taken over the industry and were being used on a daily basis by lenders keen to avoid making costly errors. By collecting dozens of pieces of financial information about each customer from their transaction records with various lenders, the Fair Isaac Corporation was able to construct individual credit scores, which it arbitrarily assigned to be between 300 and 850. Soon it began selling the rights to access this information to lenders and started to make a lot of money.
Before long, new credit reporting agencies began offering services to the public with the aim of making these scores more accessible. It was soon becoming clear to people in the market for loans that having information about their credit score was important since it was a major determinant of whether they would be accepted or not. New reporting agencies such as Experian, TransUnion and Equifax began popping up all over the place, offering to give customers a credit report, for a fee.
Once FICO began automating the process, the entire industry changed. No longer did lenders have to guess whether a person was creditworthy. Instead, they had all the reliable information they needed, right in front of them. Being the first entrant, FICO dominated the market and soon became the industry standard.
FICO Has Many Different Versions
One of the confusing things about the difference between FICO scores and credit scores is that FICO scores can differ according to which formula is applied to your data. Each time you try to take out a loan or get access to credit, your lender will request a credit score. FICO provides the formula for deriving the credit score, based on how likely they think it is that you’ll repay the loan.
But credit scores are also determined by the actual data fed into the formulas. Since there are three different credit bureaus: Equifax, Experian, and TransUnion – all of which have slightly different information in their reports – borrowers end up with three different credit scores, one from each bureau.
Differences Between Credit Bureaus
It’s also worth noting that credit scores from the same bureau are rarely stable over time. Every so often, credit rating agencies update the way that their algorithms work, rather like an update to your mobile phone operating system. Right now you might be using Google Android Nougat which has a particular set of features, but in the future, you might shift over to “Android O” which has a whole raft of new features. Each time the scoring algorithm is tweaked, your credit score will change as agencies apply new weights to the data in your credit report.
Despite the fact that it was introduced all the way back in 2009, FICO 8, as it is called, is currently the most popular FICO algorithm used by companies in the financial industry. Since then FICO has updated its facilities, adding FICO 9 after the turn of the decade, although this is less popular. Thus, the type of method lenders choose could have an impact on your final score calculation, especially if you are an unusual case not accounted for by earlier software versions.
VantageScore vs FICO
During the first few decades it was in use, FICO score made a lot of money. Every time a company wanted to lend to an individual, they would use FICO’s scoring system and Fair Isaac would get a payment. However, smart entrepreneurs eventually realized that there was big money to be made here and set about developing their own competing system.
The rival system was drawn up by the credit bureaus themselves, Experian, Equifax and TransUnion. They got together and decided that, with the advent of the internet, they would target both consumer and lender markets with a new credit rating product they called VantageScore. Like FICO, VantageScore used numbers to assign credit ratings, this time between 502 and 999. In 2006, VantageScore embarked on a massive marketing campaign, informing customers that there was an alternative to FICO which promised to be more intuitive and cheaper. Soon, the rating system was gaining market share.
Vantage Credit Score is Becoming More Popular
FICO, of course, weren’t happy. They launched an antitrust and false advertising lawsuit against their upstart competitor, claiming that VantageScore used rating numbers that overlapped with their own. The case was ultimately overturned by a US District Court judge in 2010 who ruled that FICO couldn’t claim ownership of score ranges, and so lenders now have a choice of two agencies to calculate scores.
It turns out that there are some pretty significant differences between VantageScore and FICO. Though FICO is still used by the majority of lenders, VantageScore is slowly gaining ground.
Main Differences Between FICO and Vantage Credit Scores
One of the main differences is the calculation of how recently a credit account was used. Under the FICO system, accounts have to have been active in the last six months for their data to be fed into the algorithm. VantageScore takes a more comprehensive view and looks back more than 24 months, before churning out a final number.
Another big difference is the way in which VantageScore and FICO go about using alternative data. VantageScore, for instance, includes things like utility and rent payments in its calculations, so long as they’re reported.
FICO is also piloting something similar under the name FICO XD. This is essentially a way of discovering a person’s likely credit score if they have no accounts which report to a credit bureau. There are, according to the Consumer Financial Protection Bureau, on the order of 26 million people who are mostly invisible to credit bureaus and are impossible to score using traditional methods. Many of these individuals do not use credit in any form, and so lenders are demanding ways of assessing these people without having to rely on a credit history. The new FICO XD approach will use things like your cable and utility bills, cell phone payment history and so on. According to the Wall Street Journal, people assessed using this method have an average FICO score of 620.
Alternative Credit Data
FICO XD, although new, doesn’t actually replace the tradition FICO scoring method. If FICO has enough information to calculate a regular credit score, it will use this and not FICO XD since it is likely to be a lot more reliable. Ultimately, FICO would like it if people eventually graduated from FICO XD and moved into the regular credit scoring arena.
FICO and VantageScore differ in another important way too: they way they deal with paid-off collections. Paid-off collections stay on your credit report for seven years, but VantageScore disregards them for scoring purposes. The new version of FICO – FICO 9, does the same. However, the most popular FICO product, FICO 8, does not, and will take into account any paid-off collections on your credit report. Clearly, this could significantly impact your score.
Finally, VantageScore and FICO differ in how long they take before they calculate your credit score. FICO needs at least six months in order to come up with a score whereas VantageScore claims it can produce reliable statistics after just 30 days. Of course, whether lenders believe any of this is up to them: some might prefer a longer run in before relying on a credit assessment, others might just want something as quickly as possible, no matter how provisional it might be.
Which Scores Are Used Most?
Of course, the question for the consumer is: which credit score is used the most? As discussed, FICO 8 is still very widely used, but it should be mentioned that individual borrowers don’t have any choice over which credit score is used – that’s at the discretion of the lender. What’s more, many lenders only check your score with one bureau because they have to pay for each inquiry. As you might imagine, this can be harmful to customers, especially if credit scores vary wildly between different agencies.
When lending large sums of money, lenders will check credit scores using both FICO and VantageScore, but they won’t usually inform you of their processes. Many customers, therefore, take matters into their own hands. The first thing they do is check their individual FICO and VantageScores by requesting credit reports based on each method. Once they’ve found out which scoring method yields the best results, they then begin scouting around for lenders who use that particular method. If their Vantage Score is higher, they look for lenders who use Vantage Score, and if their FICO score is higher, they look for lenders who use FICO score. Many people find that researching lenders helps to reduce the overall amount of interest they pay, as well as increase the total amount they can borrow.
How Differences in Credit Score Impact You
It’s worth pointing out that credit score differences don’t end with the major rating agencies. Retailers and businesses will often tweak your score too to suit their particular application. The reason for this is that the risk you won’t repay is likely to vary between different credit products. For instance, you might have a terrible record when it comes to the repayment of payday loans, but you might be excellent when it comes to paying off your mortgage every month. A mortgage broker doesn’t care whether you manage to pay off your other obligations at the end of the month, so long as you pay him.
Companies, therefore, have developed software that modifies the information in your credit report to reflect your specific credit risk for their product. This type of scoring is commonly used when applying for auto and mortgage credit and might explain why your interest payments on a particular loan are higher or lower than you expect. There are even issues with a family member stealing your credit report, so these new algorithms are even more important.
When it comes to the difference between credit scores and FICO, there’s a lot to consider. Not only are there different algorithms – chosen either by Fair Isaac, their competitors at VantageScore or retailers themselves – but there are also different data sources that can have a significant impact. Knowing the small details is important if you’re going to get the best deal when you borrow.
Your credit score is only one piece of the financial puzzle when dealing with credit, but it is an important one. Your credit score is a number between 300 and 900 that quickly tells a potential lender or company how well you manage credit. The algorithm used to determine this number is complex, but we do know the different weight distribution placed on each factor that affects this FICO credit score.
FICO Credit Score is Based on Five Different Weighted Factors
35%: Payment history
The quickest way to improve your credit score is to make your payments on time. Alternatively, the quickest way to ruin your credit score is to have one or more missed payments. This is because 35% of the weight placed on figuring out your credit score is your ability to make your ‘minimum payments’ on time. Minimum payments is the lowest amount you are required to put towards your debt each month in order to keep it in good financial standing. Missing your payments, or paying less than the minimum payment required will negatively impact your credit score quickly. This is why it is so important to talk to your lenders to come up with other payment arrangements if you are unable to make your minimum payments in full and on time.
30%: Credit utilization
Your credit utilization looks at how much of credit you have available to you versus how much is used and converted into debt. The closer you are to reaching the credit limit on your credit products, the higher your credit utilization and the more your credit score will be negatively impacted. Alternatively, the further you are from reaching your credit limit, the lower your credit utilization and the better your credit score will be. Avoid maxing out any particular credit product and try and keep your credit utilization 40% or less.
15%: Credit history
Credit history looks at a borrowers overall history in managing credit (usually over a 7 year revolving period). The longer you have had credit, the easier it is to establish your credit history as there is years of credit information to assess your risk as a borrower. Alternatively, someone that is new to credit would not have years of credit history so it would be difficult for them to have a near perfect credit score, even if they are diligent in repaying their debts in full and on time.
10%: Number of Inquires
Every time a borrower requests new credit or to increase the limit on their existing credit, lenders will typically review their credit score (among other things) to determine if they are approved. Each time a lender pulls your credit score and report, they initiate a hard inquiry which gets reported to the credit bureau and appears on your credit report. Multiple hard inquires in a short period of time can signal to lenders that the borrower is shopping around for credit and possibly getting denied. Too many inquires can negatively impact your credit score. It is advisable to wait 6 months before shopping around for credit and be strategic in how many lenders you visit and how many times your credit gets pulled as this impacts your credit score.
10%: Types of Credit
Types of credit looks at the diversity of credit you have available to you. The more diverse the credit, the better. However, the weighting on this is low compared to other factors so it is important not to place too much weight and emphasis on this when trying to improve your credit score. Examples of types of credit include: revolving credit (credit card, line of credit), instalment credit (student loans, car loans), M (mortgage), open credit (i.e. cell phone bill, utility payments).
Let’s look at different ways a bad credit score can cost you
Renting a place
Most landlords and property management companies will request some personal information about you including your income, past references and request to pull your credit report. In a hot rental market with many favorable applicants applying for the same unit, a good or bad credit score may be the deciding factor of who gets to rent the unit. Even though your landlord is not extending you credit, a good credit score signals to them that you are responsible with your money. A bad credit score may narrow your rental search in a competitive rental market and affect where you eventually live.
Deposit for utility set-up
Two bills that typically show up on your credit report are your utility bill and cell phone bill. Utilities are a form of open credit. They are a form of credit because you are first provided the service (i.e. heat, water electricity etc.) and then charged for the amount consumed. It is open because the amount charged each month varies with consumption. A bad credit score will usually require a deposit before setting up utilities at your residence. This additional outlay is a cost to you that could have been used to cover another expense or service a debt. With a good credit score, this deposit is not needed so you get to keep more of your money.
Higher interest rates on credit cards, lines of credit and loans
Probably the biggest and most notable impact of a bad credit score is unfavorable higher interest rates on credit products like credit cards, loans and lines of credit. A bad credit score signals to lenders that the borrower may be a high risk borrower so lenders will have to hedge their risk by increasing the interest rate of the money they lend you. This in turn means you are paying more in interest expenses each month compared to someone with a good credit score for the same or similar loan. This additional expense could be put towards other financial goals like debt reduction, or saving for the future. Higher interest rates is probably the biggest reason and motivator to work towards improving your credit score, so you can still benefit from getting credit, but at a more favorable rate.
Deposit or limited options on cell phone plans
Similar to a utility bill, your cell phone bill (if on a contract) will be reported on your credit report. Your cell phone plan is a form of open credit similar to your utility bill. A bad credit score may require you to include a sizable deposit before setting up a cell phone contract which can be extremely costly or inconvenient. Some carriers may also require you to provide pre-authorized debit payments and the deposit before setting up the service.
Trouble getting a job or security clearance (bondable)
Some employers may want to ensure you are bondable and pass security clearance, like a background check before getting hired. For example, most financial institutions and the government will complete a thorough background check, including a credit report, before offeriSuppose employment if your position will require handling cash, working in a vulnerable sector, and handling clients’ sensitive and private information such as customer credit cards and banking details or another persons. In that case, all information, it is more likely your credit report will be pulled. A good credit report and score can signal to employers the applicant is trustworthy, reliable, and responsible. A bad credit score may signal the opposite. In banking roles like financial advisors or financial planners, a person is no longer allowed to work in this profession if they have filed for bankruptcy. Therefore, depending on your career path, a bad credit score may even limit your job prospects.
Higher insurance premiums
Insurance companies may use your credit score in assessing your premiums. However, they have their proprietary way of analyzing your score that will affect your premiums. A bad credit score can mean higher premiums, even if you have a clean driving record. On average, for example, a poor credit score could add $1,301 to your premium.
Relationship with your significant other
A bad credit score may impact your relationships if there is no plan to improve your financial situation. For example, getting into a committed relationship with someone else may mean joining or working to build assets together. In addition, someone with bad credit may negatively impact the approval of a credit application, leaving much of the financial burden on the person with good credit.
If not resolved, this can cause strain and stress on the relationship as one person feels they are taking on more risk than the other. In addition, a bad credit score can signal to your partner that you are not responsible for your money. In both instances, it is essential to plan to improve your credit score by making your payments on time, reducing your debt, and living within your means. If both partners have poor credit, they will benefit from improving their credit scores. A good credit score provides more options and flexibility for financing, which will become important as couples work to build their assets and lives together.