You have almost certainly heard of the infamous “credit score,” that critical number that not only impacts what credit cards you can qualify for but may even be considered for a hiring decision. But what actually is a credit score and why is it important?
Why Do We Need a Credit Score
Let’s imagine a world without credit scores. Imagine you’re a banker. A customer walks in and says she wants a 5-year, $20,000 loan for a car. She shows paystubs for the last month that seems to indicate that she has an annual salary of $80,000. Do you give her the loan and at what interest rate?
Of course, you don’t have enough information. She could be an outstanding borrower and pay you every month, on time and in full. If that’s the case, you should certainly give her the loan and at a low interest rate. However, she could be grossly irresponsible and default within the first year. In this case, you shouldn’t approve the loan. This lack of information is called information asymmetry, because the lender has far less knowledge of the borrower than the borrower, herself.
Credit scores help to solve this information asymmetry by estimating a probability of default. This probability is mathematically determined using significant amounts of data that are collected by credit reporting reporting bureaus.
How a Credit Score is Calculated
The most common credit score is the FICO Score, named after the initials of the company that created it. The FICO score is based on a proprietary algorithm created by FICO (the company), and it will vary based on the data used to create it. The three major credit bureaus–EquiFax, Experian, and TransUnion–each have their own set of credit data. This is why your credit score differs based on the data used. The best credit score is the one that is calculated using the data of all of the credit bureaus, but this is often NOT the score you will see when you get a “free credit score.”
Your FICO score, regardless of the data used, is based on:
- 35%: Payment History
Do you pay your bills on-time? Of course, default or bankruptcy will significantly hurt your credit score. The best way to improve your credit score is to always pay bills on time.
Note, it doesn’t matter if you pay your bills early, but any late payment will impact your credit score.
- 30%: Credit Utilization
How much of your credit are you using? In general, you want to limit your credit card utilization to less than 30%. Paying off your balance every month is typically important for reducing your credit card utilization.
Note, utilization on your credit card is based on your monthly statement, not the amount of debt you carry month-to-month. If you have a $10,000 credit limit, rack up $10,000 in purchases every month, but pay it off every month, you are still seen as having 100% utilization on that credit card. This may negatively impact your credit score.
- 15%: Length of Credit History
How long have you had credit? There are essentially two factors in this: average age of your credit accounts and the age of your oldest account. The longer you have credit, the better your credit score will be, assuming you are a good borrower.
- 10%: Credit Mix
What types of loans do you have? Ideally, you want to have a diverse mix of both revolving (e.g. credit cards) and installment (e.g. mortgage) loans.
- 10%: Credit Inquiries
How many times have you applied for credit? Essentially, you don’t want to apply for too many loans within a year or two.
How To Improve Your Credit Score
Based on how a credit score is calculated, it should be relatively obvious that the general ways to improve your credit score is:
- Always pay your bills in full and on-time
- Limit your credit card utilization
- Get installment loans, like a car loan or mortgage
- Don’t apply for too many (i.e. 10+) financial products within a two year timeframe