Credit Scores Explained
A common question that people have about their finances is how to improve their credit score. It makes sense that people would wonder about this because credit scores are such a big part of our economy. Lenders rely on credit scores to determine the interest rates they can offer you on all credit products from car loans to home mortgages, as well as whether they can lend to you at all. How to get a better score is an interesting topic and not nearly as straightforward as you might assume.
First of all, there isn’t one credit score for everyone. There are actually a handful of “brand names” that build credit scoring models. The two most dominant brands are FICO and VantageScore.
FICO, or Fair Isaacs Corporation, was founded in the 50s by Bill Fair and Earl Isaacs. They were the innovators behind the concept of a data-driven score for measuring the potential risk for the lender from a given borrower. FICO is a for-profit corporation that makes money primarily by licensing its credit scoring formulas to credit bureaus and lenders. They don’t have just one credit scoring model. They actually have more than 50, each one tailored for a specific credit product or industry. While FICO does publish the factors that are incorporated in the scoring models and even weights them, the exact formulas are intellectual property, and therefore not available to the public.
This “brand” is the product of a collaboration between the three major credit bureaus, TransUnion, Equifax, and Experian (each of which also has their own in-house models). Just like FICO, there are actually multiple VantageScore models geared towards different types of lenders and the models are also updated from time to time in the same way that software is updated regularly or automobile designs are altered slightly from year to year. Also like FICO, VantageScore models are proprietary. VantageScore is the model used by Credit Karma.
So when you ask how to improve your credit score the first interesting thing to realize is that we don’t know the formulas. They’re trade secrets. However, we do know some basic factors that these models are looking at. According to Credit Karma, VantageScore 3.0 uses the following information to build your score:
Payment history - This is the record of missed or late payments on any of your credit accounts.
Credit card use - This refers to how much of the credit limit on your credit cards you are currently using. The ratio on each card is included as well as the ratio across all of your cards. Using less of your limit is better.
Derogatory marks - These are accounts in collections, bankruptcies, civil judgements etc.
Credit age - Credit age is the age of your oldest open account.
Total accounts - This is the total number of open and closed accounts.
Hard inquiries - How many times you have applied for credit.
When you look at the elements that make up your credit score what you can determine is that the way to improve your score is to continuously borrow money and pay it back. So this is not so much a measure of financial well-being as it is a prediction of how profitable you will be for your lenders. It’s unfortunate then so many people believe that a high credit score, which doesn’t even consider your net worth or income, is evidence of success.
Credit scoring is not without some merit. Using large data pools to automate the lending process to a degree and remove human bias and error from credit decisions makes sense. Unfortunately the undue focus on this one number leads people into trying to game the credit score system by doing things that aren’t really good for them overall. For instance, Credit Karma recommends that if you are paying off your credit cards that you keep the oldest card open in order to maximize your credit age. This is the type of gimmick that is evidence to me of a flawed system and a great way to end up in more debt. Not to mention that the extent to which our economy relies on these scores gives a few for-profit companies enormous influence over our lives.
I’ve chosen not to make my financial decisions based on how they impact my credit score. I believe in getting out of debt and building wealth. If you have no consumer debt, pay off your home, have savings for emergencies, and begin to build wealth through retirement savings and other means then you have no need for more debt and therefore no need to worry about your credit score. This is the overall philosophy I’ve adopted and it’s what I recommend to others as well.