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What Your Credit Score Means
July 1st, 2013
What Your Credit Score Means
According to the online financial website Investopedia, credit score is formally defined as "A statistically derived numeric expression of a person's creditworthiness that is used by lenders to access the likelihood that a person will repay his or her debts. A credit score is based on, among other things, a person's past credit history. It is a number between 300 and 850 - the higher the number, the more creditworthy the person is deemed to be."
In laymen's terms, this simply means your credit score is a number that lets banks know how likely you are to repay any money you've borrowed. A high credit score opens a vast number of financial pathways, including increasing your leveraging ability, saving money in interest, while applying more of each payment to your principal, and being eligible for a whole host of card benefits you may not be otherwise.
What Is a Credit Score?
Credit rating agencies use the information contained in your credit report to develop your FICO (Fair Isaac Company) score. The FICO score is a three-digit number between 300 and 850, with anything above 700 considered a "good to great" score. The higher an individual's credit score, the more likely it is that the lender will view them as a lower credit risk. Each credit rating agency's proprietary algorithm measures activity in five categories; payment history, utilization, credit history, credit inquiries, and credit type. A detailed explanation of each category can be found here.
Currently, the average credit score in the U.S is 690, which would fall squarely in the "good" range. Borrowers with good credit can expect to pay less interest than an individual with a lower score, which could save many thousands of dollars over the course of a lengthy loan such as a home mortgage.
The Three Credit Score Bureaus
In the U.S., there are three primary credit rating agencies responsible for providing lending institutions with an individual's credit score. These are:
However, despite the fact these three companies produce the same product, they can differ, sometimes significantly, in what they report.
For instance, each company has a range of scores that they will report. Equifax produces FICO scores between 280 and 850, while Experian only operates within the 330 to 830 range, and TransUnion will report scores from 300 to 850. As you can see, this may cause an issue depending on the agency your lender favors.
For example, if you have a perfect credit score of 850, you will see this exact number reflected in a statement from Equifax. However, if you were to request your score through from Experian, it will come back at 830, since this is the highest number they produce.
What this xmeans is that you should keep a regularly updated file that holds your credit score from all three reporting agencies. There are countless companies available online that can offer this service to consumers, and they typically offer a free report upon signing up for their services.
In addition to offering your credit score, these monitoring companies can also notify you when there has been a change to your FICO score, and even alert you if fraudulent activity is suspected.
Maintaining a Consistent Credit Score
Your credit score fluctuates frequently, so it is generally recommended that consumers obtain their FICO score from all three reporting agencies at least once per month. By why does your credit score constantly go up and down?
Once of the primary reasons for a varying credit score is differing information available to each of the reporting agencies. Each of these companies only utilizes data about a consumer based on what they have on file. On other words, if TransUnion mistakenly reflects a bankruptcy in your recent past, but Experian does not, it stands to reason that your FICO score will be lower with one than with the other. Admittedly, the above is an extreme example, but your credit score can fluctuate considerably between the companies even based on seemingly minor information. For additional consumer help to ensure your information is balanced between all three agencies, it is recommended you thoroughly understand the data in your file.
Another trigger for credit score fluctuation is a credit inquiry. Investopedia defines a credit inquiry as "A transaction whereby a bank or other credit-issuing institution views an individual's credit report in connection with a loan or credit card application. The purpose of a credit inquiry is to evaluate an individual's likelihood to repay money that is lent to them (known as creditworthiness)." In other words, any time a consumer applies for a loan, whether it is for school, an automobile purchase, or a mortgage application, the lender will access your credit report to determine if they want to lend you money. This is a process anyone who wishes to borrow money will be subjected to, and is commonplace.
However, depending on how many lenders access your account, and in what length of time, this activity can cause a dip in your credit score. The statistical algorithm used by reporting agencies looks at frequent, repeated credit inquiries to be a negative rating variable, as it can mean the individual is searching around for a loan, and is unable to obtain it for one reason or another. As a result, each inquiry made by a third party (i.e. bank, credit card company, auto dealership, etc.) can impact your credit score. Because of this, if you've recently been applying for various lines of credit, it would be beneficial to obtain your updated credit score.
Lastly, there are a vast number of miscellaneous changes in your lending history that can cause your FICO score to change. Among these are:
- Having a credit limit increased or decreased - If a lender decreases the amount of available credit, this may indicate the individual is viewed as a high credit risk, and is unable to obtain additional funds. Alternately, an increased credit line typically indicates the bank feels the individual has proven themselves to be a good credit risk, consequently allowing them to offer more funds.
- Total debt load - If you've recently paid off a significant amount of debt, or have a newly obtained home mortgage, these will affect your credit in different ways. Have a lower debt-to-income ratio generally increases your score, and vice versa.
- Making late payments on existing debt - Although it will certainly negatively affect your credit score, one late payment is normally not going to destroy your rating. However, more than one late or missed payment within close proximity to one another will undoubtedly be reflected in your credit report. Try to avoid this at all cost.
- Defaulting (also known as a "Charge Off") - Each lender varies slightly, but a default, or a charge off, occurs when a lender has written off debt owed by an individual as a loss. Contrary to how the term sounds, the lender has not completely waived any balance owed; it has simply deactivated the account, reported it as having defaulted, and will then attempt to collect repayment. Defaults will have a hugely negative impact on an individual's credit score.
- Bankruptcy - Bankruptcy occurs when an individual declares that they are no longer able to repay any of their existing debt. After bankruptcy is filed, a portion of the individual's assets may be sold off to help reduce the total amount waived. More than almost any other change, a bankruptcy will cause a sharp decline in credit rating for a period of up to seven years.
You Have Control Over Your Credit Score
Ultimately, your current financial status and activity will affect your future credit score. This means that only you can decide which way you want it to go. By practicing good borrowing techniques, such as not overextending financially, repaying debt in a timely manner, and closely monitoring the information used to calculate your FICO score, you can remain on top of the situation.