Daddy, where do Credit Scores Come From?
Throughout my career in Finance, I have reviewed thousands of Credit Reports. Literally, thousands! One thing that has always stood out to me is how little the average consumer truly understands “credit”, what is actually on a “credit report”, how “credit scores” are determined, or really how that impacts your financial transactions…and ultimately your quality of life. By and large, Credit is a great example of “what you don’t know CAN hurt you”. Ignorance regarding one of the most important yet underestimated facets of our economy can certainly cost you REAL money.
Let me give you one real life example to get your attention, and then I’ll explain a little bit more about it.
As I write this today, I have a client that has done several mortgage transactions with me. Last time we refinanced his house, his FICO credit score was 741. Last month, he had his first EVER blemish on his credit report…he was late on his Chase Visa credit card because he misplaced the bill and assumed he must have already paid it (more on this later, because this is inexcusable in the age of auto-payment technology). Because of that ONE mistake, his FICO dropped to 669. I have seen larger drops than that, but this still had a major impact. Now, he has come back to me to take some cash out of his property. If his FICO had still been 741, he would have been offered a rate 3.875% on a 30 Year Fixed cash out mortgage, which would have been outstanding! However, at a 669 FICO, his rate jumped to 4.25%. What does that mean in terms of American Dollars? Well, the additional interest results in a monthly payment jump of $52 a month on his $240,000 home loan. Now, he probably won’t keep this house for the full 30 years, but even if he only keeps it for another 10 years, that means an excess of $6,240 that he will pay as a result of missing that $25 minimum credit card payment. Dare I say, “ouch”?
You listening? Credit matters, and if you make a mistake you could (quite literally) spend years paying for it.
Now, how does all of this work, and who keeps track of everything? Well, there are three major Credit Reporting Agencies (also called “bureaus” at times), and some or all of them track each and every loan, balance and payment you make to a creditor. They are Equifax, Transunion and Experian. Keep in mind—they track creditors and loans only. Therefore things like your cell phone bill or homeowners insurance are definitely bills, but they are NOT reported on a monthly basis like loan information. However, it’s important to note that if you miss payments with them, or leave a balance open for too long, they WILL report that to the reporting agencies as a “collection account”, which will likely have an immediate and dramatic negative effect on your FICO credit score.
That brings me to my next point. The next biggest factor in determining your FICO credit score—which is a numeric representation of the strength of your credit history ranging from a low of about 350 to a high of about 850—is TIME. They say time heals all wounds, and that is true for credit as well.
Time affects your credit score in two ways:
- The overall length of time that you have each individual credit account, as well as how long you have used credit consecutively in general, impacts your score. The longer, the better. This is important to know when you are deciding whether to close an account vs. letting it sit there unused. If it’s an old one, you may consider keeping it.
- The length of time since something negative hit your report matters a lot as well. In other words, if you have a collection or late payment show up, it will have a huge immediate impact, but that your score can slowly recover over time.
There are many more determining factors for your credit score that we will discuss in a later post, but payment history and length of accounts is a good start. A great way to look at the big picture is this: your score is a number that tells lenders how well they can trust you. In order to trust someone, you first have to KNOW them (length of time) and you then have to see RESULTS (payment history). Therefore, the longer you use credit, and the more you use it responsibly, the higher your score. I will also share some next level tips, common myths, and some do’s and don’ts as we continue this discussion. Stay tuned for more information!
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