You go through school and college for years, judged based on a three-number score – your GPA. This number is “supposed” to give insight to educators to how hard you work, to how “smart” you are, and to how disciplined you are. So, I hate to break it to you kids, being an adult is no different. You will also be judged based on a three-number score called a credit score. Sounds sketchy but believe me that this score can either save you a lot of money or cost you a lot of money. Grab your favorite snack and enjoy the show.
Mr. Nahas, what in tarnation is credit score? Well Timmy, a credit score is a number between 300 and 850 that determines your worthiness as a borrower. It gives insight to your potential creditor on your ability to pay back the debt. The higher your score is, the worthier you are, and the more likely that you will get approved as well as get the best rate possible. Better rate = saving money and who doesn’t love to save money Timmy?
I know you all of you are mad, who has the right to tell you how worthy you are as a borrower? Well, three companies actually. The three credit bureaus are TransUnion, Equifax, and Experian.
Each of these companies have different ways of evaluating you as a borrower but the most popular credit scoring model is the FICO score, which comes from the Fair Issac Company. There is also a Vantage score, which comes from the three major credit bureaus. Despite the Vantage score coming from the three bureaus listed above, the FICO score still remains the most popular. I know this is a lot to take in all at once but just hold on… it gets better from here… I hope.
As you see below, there are many different versions of credit scores but getting into it would just overcomplicate things.
Below, I listed the main factors that are taken into account when credit scores are being decided, based on the FICO credit scoring model. All right kids, let’s take a look at these factors a bit closer.
This is the biggest factor on your credit score. Creditors want to know that they are giving credit to a reliable person who makes their payments on time, so they will take your past into account in order to predict the likelihood of you making future payments. A major thing is missed payments; they are taken heavily into account. So much for not judging based on the past right? In their defense, they just want their money… and something extra too, who wouldn’t?
This includes all of the debt you owe to every creditor. They want to see someone who isn’t heavily in debt, since the more in debt you are in, the higher the chance that you will have trouble paying the amount back. How do they know if a person is heavily in debt? They use your debt to income ratio (DTI) to figure it out. Typically, creditors don’t want to see a ratio of more than 36% but some creditors might go as high as 43%. Additionally, the factor includes something called credit utilization ratio. Just because you have a credit card that has limit of $20,000 doesn’t mean you should actually use all of it or even reach anywhere close to it. To get this ratio, you take the amount used across all of your accounts and divide it by the total amount of credit you have available at your disposal (revolving credit) and then multiply it by 100. A general rule of thumb is to have this below 20% but the lower the better. It may be tempting to buy random things when you have a high credit limit, but you have to resist as that would only hinder your success.
Length of Credit History:
This includes the amount of time all of your accounts have been open. This also includes how long specific types of accounts have been open and how long it has been since you last used these accounts. A long history with responsible use will likely lead to a higher score, assuming that the other factors are in good shape. Here we go again with the judging you based on your history. I know, I hate it too. Your Fico score, takes into account the average history of all of your accounts, including the news one. So, if you open a new account, that will lower your average age of the account, it might not be by much and eventually it will go back up if you don’t open more accounts.
This includes the amount of times you opened up a new line of credit. Taking on too much credit in a short amount of time can negatively impact your credit score; however, taking on credit may increase your score if opened up correctly as it will increase your revolving credit and reduce your utilization. It’s confusing and weird how it works both ways, I hear you little Billy Bob, I hear ya. The main point is to open up an account or apply for a loan only if you actually need it, not because you got a pre-approval for one or because someone told you to. Be careful with opening up accounts as the creditor will do a hard inquiry, this will temporarily decrease your score, but they usually get removed in about 24 months.
Types of Credit Used:
This includes the different types of credit, credit cards, loans, retail accounts, etc. This isn’t really isn’t that essential unless you don’t have that much information.
But Mr. Nahas, how do I get a credit card or a loan if I don’t have credit? Fantastic question little Lisa, it’s the famous catch-22. In order to get a credit card, you need credit history and to have a credit history, you need a credit card. America baby, don’t you just love it? A good way to get a credit card is to have a bank account and a job. After a little time with the job and receiving regular payments, you can apply for your own banks credit card. Although it isn’t guaranteed to get approved, you would have a better chance since you bank with them, and they know your financial situation already. Another possibility is to be an authorized user on your parent’s credit card. This is a good way to start building your credit of file. Since most students have student loans, you could use this to your advantage and start paying on it as early as you can; this will also help build your credit score.
Mr. Nahas, you said earlier that we can save money by having a better credit score, can you prove it? Silly Roxanne, that is the easiest thing to prove. If you look below, the image shows the total interest paid on a 30-year fixed interest rate mortgage of $250,000. That is the cost of having a bad credit score, and the benefit of good credit; you will get the best rates and save tons of money!
I do want to clarify that these numbers are just examples. Interest rates vary from year to year depending on what the standard rate is. As of 2020, some mortgage loans are as low as 3.125%. I just wanted to show you it pays to be responsible with your credit score as you can save thousands of dollars.
I know that this is a lot to take in all at one time youngins’, but just know that I am proud of you all right now for getting to this point. Just make that you take care of your credit score like you take care of your phone… or your precious dog named Trixie, whichever one you care for the most. Always remember, be responsible!