Everything You Need to Know About Your Credit Score
Credit Scores Are a Tricky Thing
Like many young adults in America you probably care about your credit score. After all, having a high credit score will allow you to purchase that new boat or house you always dreamt of buying when you were a young child. Conversely, having a low credit score will negatively affect your financial potential as you will likely pay higher APRs or be denied credit.
While most would agree that keeping track of your credit score is important, the percentage of adults who actually know their credit score is not reflective of this attitude. Information from ACA International states that only 42 percent of US adults know their score. Another study found that a majority of Americans have superficial knowledge about credit scores.
At this point you may be thinking to yourself, “Well, what do I need to know about my credit score?” First let’s look at what a credit score actually is.
In short, your credit score is basically a snapshot of your financial history. Anything you’ve ever bought or paid with in credit will be incorporated into a number. In addition, any missed payments or loans that you've acquired will also be a part of this score.
Credit scores are a good way for banks or companies to develop a picture of how financially responsible individual is. It would be incredibly risky for a bank like Wells Fargo, for example, to give a loan of $10,000 to a person who earns a low income or a person who doesn’t have a reliable repayment history of preexisting debt. Credit scores ensure that such behaviors are monitored and in doing so, these banks can make informed decisions on whether or not they will approve a loan or investment.
Multiple credit agencies use varying standards, but the main three credit score agencies use in reports are Transunion, Experian, and Equifax. Their score ranges are:
- Transunion: 100-900
- Experian: 360-840
- Equifax: 280-850
As one could guess, the higher the score the more likely the individual is considered to be financially responsible while on the other hand the lower the score the more ‘irresponsible’ he or she is.
If you’re still reading this column, you’re probably wondering when I am going to tell you “all you need to know about your credit score.” As promised, here are some vital pieces of information that you must be aware of in regards to your score and how you can improve it.
Wells Fargo states that there are five major factors that affect your credit score. The chart below breaks down these factors.
Credit Score Determinants
While these numbers give you a proportional representation of how your score is calculated, it doesn’t reveal the whole story. Many people would guess that when a lender reports to a credit agency they either determine if the payment is late or on-time. This is true to an extent, but there are varying levels to how “late” a payment can be classified as.
Lenders will report your payment history, based on any of these nine numbers, and send it to credit agencies. An individual who receives a consistent "1" each month versus one who receives "2s," "3s," and "4s" will obviously have a better credit score.
When it comes to your current debts, one piece of information that credit agencies look at is your credit utilization rate. This is the amount of credit you use versus the maximum amount of credit available. For example, if you had a card that had a limit of $2,000 dollars and you currently have a balance of $1,500 dollars, then your utilization rate would be 75%. It is recommended that you limit your utilization rate to either 30% or less. Having a large amount of debt signifies to credit agencies that you aren't capable of paying off your expenses on time and it also shows that you choose to use credit despite not having the necessary funds to pay it off in the near future.
Credit File Age
Next on the list we have the Credit File Age, which composes of up to 15% of your total credit score. Credit agencies will calculate an “age” of your credit history by using two methods. First, they will look at your credit file and search for the first account that you’ve opened. This will be used as a benchmark for the age of your credit history. The second method is by finding out the average age of your credit file. Credit agencies do this by looking at every open or closed account and averaging their ages. Let’s look at an example.
Say you have 5 accounts and you wanted to determine the average age. All you would need to know is the time you used each of these accounts. If we have the following...
Credit File Age (in years)
Upon adding them together we get a 'total' of 14 years. Dividing 14 by 5, the total number of accounts on file, we get an average age of 2.8 years. This means that on average you keep a credit account open for about 3 years. To credit agencies this indicates that you often jump from one credit line to the other and this indicates instability. While there is no specific number to abide by, Credit Karma users that have an average credit file age of eight years has, on average, a credit score of 700.
'Credit applications' refers to the number of times you request a hard inquiry. A hard inquiry, simply put, is a request made on behalf of you to a lender, requesting a new line of credit. The number of hard inquiries generally will affect your credit score, but they won't always do so. In most cases, the more frequently you request a new line of credit, the more it signals that you are either undergoing or about to undergo financial difficulties so it manifests to credit agencies as a risk.
Type of Credit
Lastly, the type of credit that you hold can also affect the way your score is calculated. As long as you are paying your debts on time, if you have credit line open for the purpose of mortgage, automobiles, and/or credit cards it shows diversity in your credit file. This shows that you can handle all types of purchases, large or small, and are a stable, trustworthy consumer.
For most Americans, credit scores are relatively mysterious. We know we all have one, but we really don’t know anything about them. For minorities in America, however, the this is an even larger issue. Between African Americans and non-white Hispanics, 21 percent of African Americans and 11 percent of Hispanics have subprime credit scores. Compare that to the to the nationwide average of 6.80% percent per demographic, it’s evident that there is a large disparity. While it is difficult to ascertain the exact reason for this, informational asymmetry most certainly plays a role. Whether this informational asymmetry is deliberate or not, it is ultimately up to us to educate ourselves and seek out the knowledge that will lead us to success. In life no one will hold us by the hand and spoon-feed us what we need to know; we must take the initiative and be proactive, looking for ways to grow and prosper despite the odds against us.