Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Credit Score

What it is:

Credit score refers to the FICO score, which is created and calculated by the Fair Isaac Corporation and is a measure of an individual's creditworthiness. It is a mathematical summary of the information on a person's credit report. Note that it is not the same as a credit report; rather, a credit score is based on information in a credit report.

How it works (Example):

Credit scores range from 300 to 850. The higher a person's score, the more creditworthy he is. According to Fair Isaac, the median FICO score is 723. The best rates tend to go to borrowers with FICO scores above 740, but this is a generalization. The FICO-score algorithm considers several things.

  • Payment history accounts for 35% of the score. This includes whether the person has made late payments, how late those payments were, the number of past-due payments, the number of accounts paid on time and similar factors.
  • Amounts owed accounts for 30% of the score. This includes how much the person owes on his various accounts, the number of accounts with balances, the amount of available credit that the person is using, the proportion of balances to his original loan amount and similar factors.
  • The length of the person's credit history accounts for 15% of the score.
  • The amount of new credit accounts for 10% of the score. It includes the number of recently opened accounts, the number of recent credit inquiries, the time since the person opened an account, the timing of the last negative activity (such as a late payment) and similar factors.
  • The types of credit used accounts for 10% of the score.

The weightings may be different for people who have not been using credit a long time.

It is important to note that credit scores are based only on credit reports from the three major credit bureaus (Experian, TransUnion and Equifax), so it is possible for a person to have three different credit scores. In accordance with the Equal Credit Opportunity Act, Fair Isaac does not consider age, race, color, religion, national origin, gender or marital status when calculating a FICO score. Salary, job title, employer, where the borrower lives, interest rates on the borrower's other debt and employment history are also not factored in. Credit scores also do not reflect participation in credit counseling.

Credit scores are not free, although in many cases lenders pay for and then disclose the scores to borrowers when they apply for credit.

Why it Matters:

The credit score is perhaps the most widely used and widely recognized measure of creditworthiness. They tremendously affect the amount of credit a person qualifies for and the interest rate he or she pays for that credit. A person with a low credit score, for example, might have to pay 10% on a loan for which a person with a higher credit score would only have to pay 6%. Thus, when it comes to mortgages, car loans and other large borrowings, a good credit score can save a person thousands of dollars.

However, credit scores are not the only factor that lenders consider when deciding whether to extend credit to a person. In particular, lenders also look at a person's income, employment history and character (three things not reflected in a credit score) when making these decisions. Nonetheless, credit scores give lenders a fast summary of a person's creditworthiness. They also streamline and equalize the lending process, create less paperwork for the borrower, facilitate faster lending processes and lower lending costs.

Many people try to predict what will happen to their credit scores if they do or do not take certain actions. The algorithm that calculates the credit score is both complicated and proprietary, meaning that it is hard to say exactly what a person's score will be if she, say, is late on a mortgage payment. Ultimately, however, improving a credit score generally centers on a few concepts: paying bills on time, getting current and staying current on bills, keeping credit card balances low, avoiding unnecessary credit, avoiding opening a lot of new credit accounts at a young age, checking one's credit report for mistakes and judiciously using credit accounts.