Credit Score

It is common practice to obtain credit or to acquire a loan for a major purchase such as a car or a house, and the individual seeking the credit or loan usually does so from a credit card company, a credit union, or a bank. Because these sources of credit or capital usually do not know the individual personally, the decision to issue credit is based upon the individual’s credit history. The single most important piece of information in that history is the individual’s credit score, because it is an indicator of the risk of lending money to that individual. This three-digit number is not only vital to whether the lender will offer credit or not—the credit score will also play a key role in determining the amount that can be borrowed, the terms of the loan, and the interest that will be charged on the outstanding credit balance or on the loan amount.

Background

The concept of using data about individuals to make intelligent business decisions dates back to 1956, when Bill Fair and Earl Isaac founded FICO (originally Fair, Isaac and Company). They had their first business customer in the 1960s, with other businesses joining their customer list in the 1970s. FICO introduced the first credit bureau risk scores in the 1980s, with those scores being made available at the three major US credit reporting agencies (Equifax, TransUnion, and Experian) in 1991. In 1995, Fannie Mae and Freddie Mac (two government-sponsored companies that ensure access to home loans) began using FICO scores to evaluate potential borrowers. By 2001, FICO scores were available directly to individuals. Today, FICO provides credit scores for individuals worldwide. These scores form the basis for a variety of decisions involving the financial risk of extending credit to individuals.

FICO scores are calculated for a specific point in time and according to a proprietary algorithm. The data used in the calculation consists of an individual’s payment history, outstanding debt, length of time the individual has had credit, the amount of new credit, and the types of credit used. Of these factors, the payment history and amount owed account for 65 percent of the score. When the length of the credit history is added, it rises to 80 percent. Under provisions of the Equal Credit Opportunity Act of the mid-1970s, FICO scores cannot take gender, race, nationality, or marital status into consideration.

The range for FICO scores runs from 300 to 850. The higher the score, the lower the risk assigned to that individual. Different scores are required for different types of loans and different lenders. The majority of credit scores are based upon FICO scores, but the major credit reporting companies make adjustments of their own to the scores. The result is that an individual will receive three credit scores that are very close to each other. Equifax has BEACON scores, TransUnion has EMPIRICA, and Experian has Experian/FICO scores. The Fair Credit Reporting Act of 1970 requires all three credit services to provide individuals with a free copy of their credit report each year.

Impact

Credit scores have a tremendous impact on the financial life of an individual. A good credit score nearly ensures favorable lending terms and access to credit at favorable rates. A bad credit score, on the other hand, makes it difficult to borrow money at favorable rates and is time consuming to repair. For this reason, it is important that individuals take advantage of the opportunity to receive a free copy of their credit report each year to check that the report is accurate. If there are any items on the credit report that are incorrect, the individual should follow the procedure to contest these items immediately.

It is much easier to build a good credit history than it is to repair a bad one. It is essential to make credit card and loan payments on time. Missed or late payments will result in a lower credit score than timely payments will, even if all that is paid each month is the minimum amount due. Likewise, using all the available credit on a credit card is not advised, because the percentage of available credit used is one of the items taken into consideration by the scoring agencies. Accounts in collection are another item that negatively impacts a credit score, as is "old debt" that is still carried because the balances have been transferred back and forth between credit cards. To repair the damage done by these practices, one must consistently make timely payments, have credit cards with some credit left unused, and make steady payments on outstanding balances.

Most credit scores range between 301 and 850. A score above 749 is reflective of excellent credit, and an individual with that score can expect favorable rates and credit card offers. A good score will fall between 700 and 749. Fair credit falls between 650 and 699, and an individual can expect to have problems qualifying for a mortgage with a score in this level. Poor credit is between 599 and 649. A score below 599 is considered bad credit.

Because of the advantages associated with a good or excellent credit score, it is worth taking the time to build a credit history that will result in an excellent score. If an individual never has credit and never takes out a loan, there is no way for a credit scoring agency such as FICO, TransUnion, Equifax, or Experian to calculate a score. It is not assumed that anyone is an excellent risk. It is up to the individual to make timely payments and manage credit wisely.

One way to establish credit is for an individual to start with a store or gas credit card. Once there is a solid credit history, the individual can apply for a credit card. Even if there is no need for a car loan because an individual can pay cash for the car, obtaining a loan for at least part of the purchase price will provide the opportunity to make timely payments and build credit. These in turn will weigh favorably in that individual’s credit score.

Benefits of Excellent Credit

In addition to avoiding the negative aspects of bad or poor credit, maintaining a top-notch credit score can bring substantial benefits unavailable to those with no credit or even simply good or fair credit. Excellent credit is highly regarded by everyone from financial institutions to potential landlords. Perhaps most importantly, the better one's credit the less one typically will be charged in interest over the life of a loan, such as a mortgage. The exact numbers vary according to many factors, but according to credit companies in 2016 an average person in the United States with excellent credit could potentially save approximately $60,000 in lifetime interest on a mortgage, car loans, and credit cards compared to someone with fair credit.

Mortgage rates are generally seen as the area in which an excellent credit score is most valuable, as interest levels on average increase with each step down in credit rating (and securing a mortgage at all is difficult without at least good credit). Though the dollar amount month to month may be almost negligible, that money can build up significantly over the long life of a mortgage, potentially leading to thousands of dollars saved or charged in interest. A similar trend has been observed for automobile loans, with average rates for those with excellent credit often a whole percentage point or more lower than for those with good credit. While the generally lower value and length of car loans compared to mortgages means the savings are typically in the hundreds rather than thousands of dollars, the difference can still be substantial. Along the same lines, student loans and small business loans can often be obtained at more favorable rates when the borrower has demonstrated excellent credit.

Credit cards are another area in which excellent credit can bring a real boost in benefits compared to simply good credit. Better credit will typically allow one to qualify for cards with a lower annual percentage rate (APR). Though average values are difficult to calculate due to the diverse ways in which consumers use credit cards, typical savings in the hundreds of dollars have been suggested by experts. Cards with perks such as zero percent APR for an introductory period and balance transfers with no fee are also generally offered only to those who have prequalified due to their excellent credit. Certain exclusive cards for those with excellent credit also include special introductory or ongoing benefits such as airline miles, cash back for purchases, and points systems. Credit card companies are also usually more inclined to give those with the best credit high limits, as are banks.

Finally, excellent credit is often helpful in reducing the premiums paid on car insurance, home insurance, and other forms of insurance. Insurance companies use consumers' credit scores as one part of their assigned insurance risk credit scores. Studies have found that compared to those with excellent credit those with poor credit may pay more than 90 percent more for insurance and those with fair credit may pay 24–29 percent more.

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