While credit scores are a modern invention, the concept is definitely not. In 1803 a group of English Tailors gathered to trade information on various customers who failed to pay debts. To protect themselves from being duped in the future they banded together to create a list of who they should not extend credit. According to The History of Consumer Credit in one Giant Infographic, this was one of the earliest recorded instances of credit reporting. Today your credit worthiness is being reported across your city, state, country and even the world. Long gone are the days of creditworthiness being tied to someone’s word or a handshake and even figuring out how to measure and evaluate someone’s credit score has become a global phenomenon.
The sudden complexity of the credit reporting, and subsequent scoring, universe has raised a lot of questions for the average consumer. The most common are:
How is your credit score calculated? What is a good credit score? Is my credit score really that important? & How can I improve my credit score?
We will answer the big four, but also try to put it in the context of your real life so you can understand the impact of your decisions on your credit score, and your credit score on your financial goals.
How is your credit score calculated?
Your credit score, commonly referred to as your FICO Score, is a number from 300 to 850 that indicates your credit worthiness and is used in approximately 90% of major lending decisions. It’s a pretty big deal. There are other types of credit scores, but this is by far the most popular.
How your FICO score is calculated may be the question most susceptible to rumor and urban legend. For example, your credit score is not impacted by overdrawing your checking account, not using a credit card regularly, home loan rate shopping, or checking your own credit score.
Your credit score is calculated at each of the major reporting bureaus: Experian, TransUnion and Equifax. They maintain records, or reports, of your credit data sent from your lenders that is used to calculate FICO scores. The data includes;
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Personal information, like name, date of birth, address, social security number, and employment information.
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All of the details of accounts you have open organized by type, date, limits, balances, and payment histories.
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Inquiries for your credit report by lenders in the last two years. This includes “Hard Inquiries” (used when you apply for credit) and “Soft Inquiries” (used for pre-approved credit cards or when you request your own credit report). Hard inquiries can have a small impact on your FICO score, soft inquiries do not.
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Negative information from missed payments that have been reported, past due debt from collections agencies, and public records of bankruptcies, foreclosures, and tax liens from courts.
This mountain of data is compiled and put into categories to build a composite of you. Let’s start with the major parts of a FICO score.
Payment History (High) – The most important metric, payment history records all missed payments and any late payments sorted by delinquency (30, 60, 90, 120 days). How long past the due date, the dollar amount, the frequency of misses, and how recent infractions occurred all filter into your score. This is pulled from bank credit cards, retail credit cards, installment loans (like car loans), mortgage loans, and more. It accounts for about 35% of your FICO score.
Credit Card Utilization (High) – Your credit utilization is calculated as a ratio by dividing the total of your revolving credit used by your total revolving credit limit. If you are carrying a balance of $3,000 on your credit cards and have a total limit of $10,000 then your utilization ratio is 30%. If you have a ratio over 30% it is negatively viewed and under 10% is the best. In addition, the number of accounts carrying a balance is factored in. This makes up approximately 30% of your FICO score.
Age of Credit History (Medium) – Generally, the longer you have had credit the better your score. FICO considers the age of your oldest account, the age of your newest account, and the overall age of all accounts. A goal would be to have an average credit history of over 10 years. Length of credit history accounts for about 15% of your FICO score.
New Credit (Low) – New lines of credit or loans are weighed by the number, type, time period applied. Adding multiple new lines of credit in a short period of time is considered a risk. Conversely, loan applications of a similar type (all car, home, or student loan) done in a short period of time will be considered one as long as they occur in a typical rate shopping time period (usually 14 to 45 days). New Credit accounts for about 10% of your FICO score.
Credit Mix (Low) – The different types of credit accounts being reported have a small impact. When you have a short credit history, having a diverse credit mix can be helpful. Once you establish a strong credit history this begins to matter less. Credit Mix makes up about 10% of your FICO score.
Now that you feel like you are starting to understand where your score comes from let us muddy the waters. Lenders get to make the decision of which bureau to report your information to so they may have varying information in your credit report. So even if Experian and Equifax are using the exact same formula to create your FICO score, they could come out with different results.
It gets worse. Even if all the bureaus have the same information, they could be using different formulas. As of 2019 there are NINE Versions of the base FICO score. Each new version is slightly different than the previous versions. For example, if you were rate shopping for a mortgage the older versions counted all requests within 14 days as one, but the new version gives you a 45-day window. The newer versions also count rental history (when reported) and weight collections from medical expenses less than before. Plus, there are variations of the base score such as the FICO Auto Score or FICO Bankcard Score. There is a lot going on here.
The silver lining is that they all use a similar starting point. While weights may shift between versions and variations, they are likely to be close and any positive or negative actions you might take will have a similar impact across them all. When we discuss FICO scores moving forward, we are referring to them all generally.
What is a good credit score?
Just as beauty is in the eye of the beholder, the attractiveness of your credit score is determined by the lender. Lenders may have different standards, depending on what you want the money for. According to The Lenders Network a FICO score of 620+ is needed for most Conventional or VA loans, while it is possible to qualify for a FHA loan with a FICO score of 580+, and as low as 500 in some rare circumstances. Based on Experian’s Q4 2018 analysis of car loans a score of 781 or above gets you the best Super prime rate. Remember, no matter what you are borrowing for, the higher your score over the requirements the more opportunities you have to receive a lower rate.
Our advice is to ask before making a big purchase. If you want to buy a home in a year or two, try talking to a mortgage broker at your bank and ask them what score would qualify you for the best rates with them. That will give you time to review yours and make improvements before you apply. If you don’t have any upcoming need to borrow, we can still benchmark ourselves to the average US consumer. Using those standards here are the ranges.
| FICO Score | Rating | What this score means |
| 800+ | Exceptional | Well above the average score of U.S. consumers |
| 740 – 799 | Very Good | Above the average of US consumers |
| 670 – 739 | Good | Near or slightly above the average US consumer |
| 580 – 669 | Fair | Below the average score of US consumers |
| <580 | Poor | Well below the average score of US consumers |
The national average FICO Score is 695, but you want to strive for a credit score of 740 or above for reasons we’ll cover in a bit. It is natural to start off your adult life with a lower score and improve it over time. Because of this a lender may view your FICO score in the context of your age and consider a short history, but a good track record, favorably.
Is my credit score really that important?
“Is it really that big a deal?” YES
“But what if I pay cash for everything?” Still YES
“I’m not buying a house or car anytime soon.” Doesn’t matter, still YES
Intuitively you already know that your credit score impacts your cost to borrow money, but we should quantify it, so you know exactly what is at risk.
Using the Q4 2018 Experian data referenced earlier, here were the average rates for new and used cars based on credit score:
| Score | New Car Loan | Used Car Loan |
| 781 – 850 | 4.19% | 4.69% |
| 661 – 780 | 5.01% | 6.38% |
| 601 – 660 | 7.91% | 10.91% |
| 501 – 600 | 12.17% | 16.78% |
| <500 | 14.88% | 19.62% |
If you decided to buy a used car for $25,000 and take out a 5 year auto loan the difference in interest payments between the top credit score range and the middle would be roughly $4,452 ($3,094.31 vs $7,546.35), or over 140% more!
Buying a home doesn’t have nearly the rate difference but the stakes are higher. According to a Forbes article from earlier this year your FICO score would impact a $244,000 30-year mortgage in the following way.
| Score | APR | Monthly Payment | Total Interest Paid |
| 760 – 850 | 4.147% | $1,186 | $182,840 |
| 700 – 750 | 4.369% | $1,217 | $194,261 |
| 680 – 699 | 4.546% | $1,243 | $203,476 |
| 660 – 679 | 4.76% | $1,274 | $214,745 |
| 640 – 659 | 5.19% | $1,338 | $237,797 |
| 620 – 639 | 5.736% | $1,422 | $267,829 |
If you could improve your credit score from 675 to 685 it would save you over $10,000 in interest over the course of the loan. Because the rate differences and monthly payments don’t look that different, we undervalue the lifetime savings. If the monthly payment was a one-time purchase we’d agree it wasn’t a huge deal, but it’s not. You are making that small overpayment 360 times over!
If you won’t be buying a home and you pay for everything else in cash, you might be surprised to know all the ways your credit score can still impact you. Here are the most common:
Rent – Your ability to rent an apartment, requirement to have a cosigner, AND the amount of your deposit can be influenced by your credit score (see here).
Insurance – Your auto insurance carrier likely uses your credit score as part of your underwriting, and it can and does influence your rates (see here).
Utilities – If your credit score is fair or poor utility companies may require a security deposit to establish service and cell phone providers could deny you or charge you more upfront for new phones.
Employment – Positions in upper management, in the financial industry, or government agencies may have specific criteria related to your credit score that they look for when hiring. According to the Society for Human Resources Management, 47% of employers consider credit history when making hiring decisions.
How can I improve my credit score?
A Google search for “How can I improve my credit score?” yields about 260 million results. They include gems such as pay your bills on time, pay off debt, and limit your new credit applications. It is true that many of the steps to building a good credit profile are obvious and intuitive. We won’t waste your time with that here as you can find those yourself in a few seconds. Let’s discuss a few strategies that are not talked about as much.
One of the major drivers of credit score is the credit card utilization rate discussed earlier. Saying not to use your credit card so your limit stays low is not practical, especially if you are trying to maximize reward points by using your card for primary spending. One solution is to not only pay off your credit card in full every month, but to pay it off semi-monthly. The result is on any given day of the month your utilization rate won’t get too high and you will stay in a more favorable range. In addition, ask your credit card issuer if they know what day of the month they report to the different bureaus a snapshot of your utilization and do your second monthly payment prior to that. The other is to call your credit card company and ask them to increase your limit. This is considered applying for new credit so don’t do this often and of course, only do it if you can responsibly handle a higher limit.
Parents looking to help their children, who have no real credit history, can consider adding them as an authorized user on a credit card. The parents are the only ones who will be liable for payments, but it is usually included in both of their credit histories. The child doesn’t even need to have access to the card and the parent can use it, and pay for it, as they normally would. Some companies will allow the card to be fully transferred, with the history intact, to the child when they are older. This allows them to get a leg up without the risk of the card being abused. Two quick warning. Parents should only allow their kids access to the card if they are mature enough to understand the consequences. Only consider this if you ALWAYS pay your credit card balance off in full every month and never miss a payment or you will be doing more harm than good.
A final tip is to practice the art of negotiation. Just like negotiating for a higher credit limit on your card, there are other places this can apply. First, if your credit history doesn’t show any positive accounts see if they can be reported in the future. While they are not required to, it never hurts to call your utility or cell phone provider to inquire if they will report your payment history to the credit agencies. Second, if you have a rare, one-time, late payment in your history, try writing to the lender and ask for a good faith adjustment to remove it from your report. Finally, if you are currently behind on a payment, ask if your lender will agree to a pay for deletion, which means once you pay the past due amount it will be erased from your credit report. Achieving these will depend on the combination of company policy, individual circumstances, and how charming you can be on the phone.
How to get the most out of the credit you need?
We’ve established the importance of having a good credit score, whether you like using credit or not. Credit cards are one tool that are important in building and maintaining a good credit score. When used responsible, they can also provide a wide variety of additional benefits. Not every card has the same features, but here are a few we have found that are useful:
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Rewards points – Almost all cards these days give you at least 1% cash back, with additional bonuses available. For example, if you shop a lot with Amazon, they offer a 5% cash back card for all purchases through Amazon, and 1% or more on everything else.
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Protection – This is the most important if you ever need to use it. Fraud liability protection means you won’t be responsible for charges on a lost or stolen card, so long as you report it. Also available are return protection (extra time to return items for full refunds), price protection (price matching benefits), and extended warranty protection (usually an extra year onto the manufacturer warranty).
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Insurance – Related to protection, but more specifically rental car insurance, mobile phone insurance, and a whole host of travel insurance provisions are commonly included.
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Discounts – Many cards will provide discounts to restaurants, concerts, travel packages and more. The choices can be hit and miss depending on their corporate partnerships, but you may find that they are available for things you are already spending money on, and who doesn’t like that.
Another smart way to use credit is to have it available before you need it. This is where a HELOC (Home Equity Line of Credit) comes in. Most banks will allow you to take out a line of credit against your home as long as you have more than 20% equity in your home. For example, if you own a $300,000 home and owe $150,000 on the mortgage, your bank may allow you to take a HELOC for $90,000, taking your total debt up to 80% of the home’s value. This is generally approved for your use as needed for 10 years. There is typically a competitive interest rate and you have the option of making minimum monthly payments or paying it all bank much quicker.
The key is to only tap these funds in an emergency, or when you would be making a high interest purchase. You want to avoid ever having to carry high interest credit card debt or be forced to pull month out of a retirement account for a large short-term emergency. Even when you have enough in your emergency fund to cover the expense, the HELOC can provide peace of mind while you rebuild your reserves. Having access to an immediate source of capital at reasonable rates is a good tool to have in your financial toolbox.
Playing the long game
The best thing about your credit score is also the worst thing about your credit score. It can, and will, change frequently. If your credit score is not where you want it to be you have a variety of ways you can work towards improving it and many can be done over a few months. If your credit score is outstanding, then you should remember to stay vigilant and protect it because it is a key to saving you thousands of dollars in interest over your lifetime.
Improving and maintaining your credit score is rarely talked about as a way to improve your overall finances. Despite that trend, just one look at the interest savings on car or home purchases should tell you that it is more effective than cutting cable or fighting your latte a day habit. It also directly impacts your fixed costs, or those areas where you HAVE TO spend money like shelter and transportation. Credit Scores can seem confusing and opaque at first, but doing your homework to know where you stand and what you can, and should, do, is well worth your investment in the long term.