What is a credit score?
You have probably heard commercials talk about your credit score, but what is it? Does it really mean anything?
Your credit score is a three digit number that tells lenders how risky is will be to loan money to you. The risk they are taking is whether you will pay back that money. If you have an excellent score, the risk is low, so banks happily loan money to you. If your score is good, they will lend money to you, but they will charge high interest. Finally, if your score is low, almost no one will give a loan to you. The lowest score is 350. The highest is 850. Credit bureaus compile the data that goes into your credit score to generate that number. The three main ones you’ll see are TransUnion, Experian, and Equifax.
In your day to day life, this number won’t typically mean anything. It only shows up when you are trying to get a credit card, buy a car, buy a house, etc. However, it may be checked when you are applying for a new job, opening a bank account, opening utilities accounts for your home, or getting a new cell phone. Why? Since it is a measure of risk, some companies use it to determine if you’ll pay your bills on time or be ethical on a job!
How is your credit score calculated?
This part gets to be a little tricky. First, they look at whether you pay all your loans on time. If not, how many times are you late? How long are you late; for example, do you take 60 days to pay your credit card bill?
How much credit are you using compared to how much is available to you? For example, you have two credit cards with $500 limits on each. Are they paid off each month? Do they carry a $100 balance, so you have $800 available to you on a regular basis? Or, are they both maxed out, with $499 on each, so you have no open credit?
Next, they consider how long you have had your accounts. Are they all new, so you don’t have a lot of history, or have you maintained good accounts for years?
They will also look at your total debt. For example, if you have a $200,000 mortgage, $100,000 in student loans, a $50,000 car loan, and $25,000 in credit card debt, you owe $375,000, a lot of money! The type of credit comes into play here. Secured loans are loans with property used as collateral for the loan, so they are less risky. If you don’t pay your mortgage and your car loan, the bank can take the house and car to pay the loans. Unsecured loans are higher risk, so they are weighed more heavily in your score. Those are loans like credit cards or student loans.
Finally, a weird one is how many credit inquiries you have. Each time someone requests your credit score or report, the credit bureau shows that request. A hard request is one made because you are requesting a loan. A soft request is done by a company not by your request, so they are weighed lightly. That may happen when a credit card company is looking for new customers and pings your credit report to see if you match their qualifications. Hard requests are negative because the assumption is if you are making a lot of requests for credit, your finances are in trouble
With all this data, the credit bureaus calculate, throw everything in a blender, and arrive at your credit score. It also changes regularly, as the data changes. Confusing, right?
Two examples might help.
First, a great score can have this mix. Low balances carried with plenty of available credit. Accounts have been opened for years with no late payments. Overall unsecured debt is low and has a mortgage and car loan, with all payments on all time. Zero to one hard credit requests.
Second, a really ow score can be as easy as no credit history. You will see this with someone young. Never had a loan, so nothing to report! Or a low score can be a lot of missed payments, high debt, a lot of hard inquiries, accounts charged off and in collections, and a lot of unsecured debt.