What is a Credit Score?

 Credit Scores

What is a credit score?

    A credit score is a measurement of how likely you are to pay back any type of loan. A good credit score tells lenders that you are responsible with your finances and will most likely be able to pay them back for borrowing money. Similarly a bad credit score tells lenders that you are not trustworthy with your money, and lending money to you would be a risky venture. Lenders view us as potential investments or liabilities similar to how you or I would speculate on certain stocks, bonds or ETFs. As with all finances, the common mantra, "high risk, high reward" and "low risk, low reward" hold true, even to lenders. Lenders charge higher loan rates (known as "APR" or Annual Percentage Rate") to individuals who are at a higher risk for being unable to pay back a loan. You can think of this policy as the cost of doing business, and the cost of risking their money on an unsure bet. Inversely, lenders will reward people with a lower APR if they can prove to lenders that they are sure to pay back any loan given to them.

How does one get a credit score?

    You will eventual get started building credit when you get some type of loan. Most people start their credit journey when they get their first credit card since a credit card essentially means you are purchasing items using the banks money, with the implied understanding that you will pay them back when your monthly bill comes due. Similarly, any type of loan will be reflected on your credit history and thus your credit score; student loans, home equity loans, mortgages and car loans all provide lenders a reference for how well (or poorly) you can handle borrowing money. Whenever you borrow money from a bank or financial institution you make a new line of credit that lenders will track to create your credit score.

Who calculates my credit score?

    Your credit score is created using credit reports from the big three credit bureaus. In the simplest terms, 3 credit bureaus (Equifax, Experian, and Transunion) take your credit data and form credit reports. These credit reports then go to a company for scoring. The 3 creditor companies that score your credit reports are: FICO, Vantage, and Equifax. (Note that Equifax is the only company that compiles a report AND creates a score.)

How do these companies measure credit worthiness?

FICO Score

FICO have several different ways of determining your credit score, but the most common is the FICO 8 and the FICO 5. The FICO 8 is the most widely used FICO score and is mainly used by credit card issuers to determine if you are suitable lender when applying for a credit card. The FICO 8 uses the reports from all 3 credit bureaus. The FICO 5 is generally used (along with 2,3 and 4) by lenders when checking your credit worthiness when applying for a mortgage. The FICO 5 is pulled exclusively from Equifax, and is considered more comprehensive because it considers your employment and residential history and is more strict on late payments. 

    Your FICO 5 score considers these factors:

•  Payment History (35%)
• Defined as how often you've paid your bills on time, late, long overdue and how long overdue a debt is. Payment history also considers payment delinquency that goes to a third party collection agency, and any bankruptcies that were filed for the passed 7-10 years.

• Number of Accounts/Amounts Owed (30%)
• Number of Accounts/Amounts Owed looks at 5 factors
• Borrowed amount of an installment loan vs. current amount owed
• Consistently paying down a car loan shows lenders that youa re able and willing to repay debts.
• Number of accounts which carry a balance
• This essentially shows how many accounts you are using without paying back when the bill is due.
• Utilization ration on revolving accounts
• This essentially means how much credit you are using vs how much credit is available to you. The lower the utilization (above 0%) the better. Generally you want to stay under 30% utilization.
• The amount owed on different accounts and the amount owed total

• Length of Credit History (15%)
• This factor considers the age of your oldest accounts and the age of your newest accounts as well as how long a specific credit account has been opened.

• Credit Mix (10%)
• The types of credit lines that you have.
• Revolving credit lines are line of credit where you continuously borrow money occasionally over time i.e credit cards, store cards and Home Equity Line of Credit (HELOC)
• Installment loans are loans which are given one time for a fixed amount with the understanding that each month a balance is to be paid down in full. Examples of installment loans are Auto/Student loans and Mortgages.

• New Credit (10%)
• FICO measures how recently (within the previous 12 months of the inquiry) have you created a new line of credit. How many new lines have you created, how many recent inquires you have, and how long it has been since you've opened an account.

The FICO 5 also considers employment and residential history, medical accounts, and several other factors. The FICO 8 considers the same factors above but is more forgiving for one off late payments but does hold higher sensitivity to high utilization.

The factors listed above are complied by FICO and form a score between 300-850. The lower the number on your FICO score the worse your credit score is. There is certain disagreement on what numbers constitute a good and bad FICO score. Experian has an article that shows the credit score categories for the FICO 8 as the following:

• 300-579 is Poor
• 580-669 is Average
• 670-739 is Good
• 740-799 is Very Good
• 800-850 is Exceptional

VantageScore

    Similar to the FICO score, the VantageScore is another credit score system. It was originally created by the 3 credit bureaus but became its own company and score system. The current VantageScore uses a similar 300-850 score system with the following breakdown.

• Payment History (40%)
• The Vantage Score sees payment history as the frequency and consistency to which you do or don' pay your bills on time.
• Utilization (20%)
• Similar to the FICO score, the VantageScore considers low utilization a good thing. Remember to keep your utilization for revolving credit under 30%.
• Types of Credit and Age of Credit (21%)
• The VantageScore similar to FICO considers how long you have had your lines of credit. The VantageScore also favors when you have varying types of credit (so long as you stay up to date on payments)
• Total Debt/Balances (11%)
• The VantageScore considers your current and delinquent debts in this factor. The lower your overall balances the better.
• Inquires (5%)
• The VantageScore unlike the FICO score considers all inquires as 1 deductible factor in lowering your score, provided that all inquires happen within 12 days. The VantageScore does this because the credit bureaus understand that big life purchases such as cars and homes require financially savvy individuals to suffer a number of hard inquiries to their account as they search for the best APR.
• Available Credit (3%)
• Simply put, available credit is your current credit balance minus what was originally owed.

Equifax Score

    The Equifax score is the 3rd and least used credit scoring system. Unlike the more popular credit scoring system the Equifax Score ranges from 280-850. The components that make up the Equifax Score are very similar to the other two models.

• Payment History (35%)
• Utilization (30%)
• Credit History (15%)
• Inquires (10%)
• Public Records (10%)

    Note that with the Equifax Score 10% (Inquires) relates to liens, bankruptcies and/or judgements.

Why Should I Care About My Credit Score?

    Having a good credit score enables you to stretch your money farther. By being savvy with your credit you can save money in the long run when you apply for a mortgage or auto loan. Just  1 or 2% increase or decrease can mean the difference between saving or owing thousands to possibly tens of thousands of dollars, depending on the type of loan. Likewise, being a good borrower grants you the opportunity to earn rewards and perks from different credit cards that you would not be able to receive without a solid credit history.

    Lets take an example lets say that you are getting a car worth 15k. You decided on a 4 year term with 2 lenders. One lender is offering you a 2% APR while the other is offering you a 4% APR. Assuming a sales tax of 7% and a title fee, registration fee and all other fees being approx. 2k, your total loan amount  would be $18050, with a sales tax of $1050. This means that your total of 48 loan payment would be approx. $18797 with a  monthly payment of about $392 (assuming the 2% APR), and a total interest on that loan of approx. $747.

    On the other hand, all things being equal, if your APR was 4% instead, your total cost of the loan would be $19952 with a total loan interest of $1902 and a monthly payment of about $416.

    Just the difference of 2% on this loan's APR would cost you as a consumer $1155.

    This was just an example, the higher the borrowed amount and the higher the APR, the more you will owe in the long run.

How Do I Build Credit?

    The simplest way to build credit is to pay your loans on time. Whether you have a fixed loan amount with a set monthly cost, or whether you have a utilization on your credit cards, all you as the borrower have to do is:

1. Pay your debts on time and in full
2. Don't carry credit card balances month to month
3. Keep your utilization under 30% for your credit cards.
4. Avoid incurring debt you know you won't be able to pay back
5. Be consistent with your payments