Demystifying Credit Scores

Credit – it’s a term that carries immense weight in the world of finance. It also plays a crucial role in your financial well-being, impacting everything from insurance premiums to rental applications to loan approvals and interest rates. Whether you're buying a home or want to secure a loan for your dream car, your credit score plays a pivotal role in determining your financial opportunities. The health of your credit can open doors to better loan terms, lower interest rates, and financial opportunities. Yet, many people find credit scores confusing and intimidating.

In this blog post, we’ll dive deep into the realm of credit scores, exploring what they are, why they matter, and most importantly, how you can navigate the landscape of credit to build a solid financial foundation."

Credit is one of my favorite topics to talk about. I think the reason I love it so much is because credit is NOT subjective.

When I say subjective, I mean, that it's not based on personal opinions or feelings; rather, it's based on concrete financial data and behavior. Your credit score is calculated using an algorithm... a mathematical formula that the credit reporting agencies and other organizations created. And the best thing of all… THEY TELL YOU, US, THE FORMULA. No, I’m not yelling at you. I’m talking with excitement LOL! It’s exciting because there is no secret sauce to having good credit. They aren’t hiding it from us and there is no invitation into a secret society needed to know how to obtain good credit. Understanding the formula that is used by the credit reporting agencies is like having a roadmap that tells you exactly what actions will impact your credit score. It's like having a superpower in the world of finance.

I realize that you may have not had credit education in school and growing up but don’t worry, that’s why you have ME 😊! Credit is my jam, and I am here to help you tap into your superpower. Lack of credit knowledge is a thing of the past. It’s time to educate yourself so you can make better financial decisions in the future and change your financial situation around. Let’s get into it!

What is Credit:

Credit is the ability to borrow money to purchase goods and services with the agreement that you'll pay it back later. Creditors (lenders, service providers, and merchants) extend credit to you based on their confidence that you will pay it back and any interest that may apply.

Purpose of Credit:

Credit provides financial flexibility and convenience, allowing you to make purchases and payments over time. Responsible credit use can help you build a positive credit history and improve your credit score, making it easier and more affordable to access credit in the future.

Why Credit Matters:

Credit plays a vital role in financial health, influencing your ability to secure loans, obtain favorable interest rates, and even qualify for rental housing or utility services. It's essentially a financial snapshot that reflects your creditworthiness and financial responsibility. A good credit score can open doors to better financial opportunities, while a poor credit score can limit your options and lead to higher costs.

Understanding Your Credit Report:

Your credit report is a detailed record of your credit history, including credit accounts, payment history, credit inquiries, and public records like bankruptcies or liens. It's essential to review your credit report regularly to check for errors, inaccuracies, or signs of identity theft. Look for:

1. Incorrect Personal Information: Ensure your name, address, and other details are accurate.
2. Credit Accounts: Verify that all credit accounts listed are yours and check for any unauthorized accounts.
3. Payment History: Review payment statuses to ensure they're reported correctly (e.g., no late payments if you paid on time).
4. Credit Utilization: Check credit card balances and credit limits to calculate your credit utilization ratio.
5. Negative Items: Identify any negative items like late payments, collections, or charge-offs that may be impacting your credit score.

What is a Credit Score?

A credit score is a numerical representation of your creditworthiness, indicating to lenders how likely you are to repay borrowed money. Scores typically range from 300 to 850, with higher scores indicating better credit health. The higher the score, the better you look to potential lenders, increasing your odds of getting approved with more favorable interest rates and rewards. The lower your score, the riskier you appear to lenders. When you seem risky, they believe you will be less likely to repay your loans on time, hence why you may have gotten denied in the past.

Your credit score is directly linked to your past financial behaviors and habits (except when fraud is involved). It's like a financial report card that provides insight into your financial habits and discipline. It reflects how well you manage your debts, pay your bills on time, and utilize credit products. This objectivity makes credit a powerful tool for assessing financial health and making informed decisions. And the best news of all... since your credit score is based on your behaviors and habits, it's easy to fix! Well, easy in the sense that you don't need to rely on anybody else to see results. It's all based on you and the financial moves you make.

FICO and VantageScore are the two popular scoring models that use different algorithms to calculate your credit scores.

The FICO model is currently the most used model by lenders, using data reported by Equifax, Experian, and TransUnion.

The key factors that influence your FICO credit score include:

1. Payment History (35% of your credit score): Your track record of making on-time payments for credit accounts, loans, and bills. Creditors typically report late payments once you’re more than 30 days past due.
2. Credit Utilization (30% of your credit score): The amount of credit you're using compared to your total available credit limits. Commonly known as your utilization rate, this percentage can be determined by dividing your credit card balance by the credit limit. For example: You have a $5,000 limit with a $500 balance, the calculation would be $500/$5,000 = 10%. People with exceptional credit scores keep their utilization rates under 10%.
3. Length of Credit History (15% of your credit score): The average length of time your credit accounts have been open and your overall credit history. Every time you open or close an account, your credit age changes slightly because that account that you opened (or closed) is removed from the calculation used to figure out your average credit age. You could see a slight change in your credit score but don’t worry, it’s only temporary. Your credit score will rebound within a month or two.
4. Credit Mix (10% of your credit score): The types of credit accounts you have, such as credit cards, loans, and mortgages. A good credit mix will have both revolving accounts (credit cards, retail store cards or a line of credit) and installment accounts (auto loans, mortgage or student loan)
5. New Credit Inquiries (10%): Recent applications for credit or new accounts opened, which can temporarily lower your score. These inquiries are commonly known as “hard inquiries” and they appear on your credit profile every time a creditor checks your credit. These inquiries will stay on your credit report for two years.

The VantageScore model is determined by the data reported on Equifax, Experian, and TransUnion and is weighed as follows:

1. Payment history - 41%: On-time payments are the most important way to build and maintain good credit. The later a payment is - and the more late payments you have - the more your credit will suffer.

2. Age and type of credit - 20%: The average age of your credit accounts and the types of credit you use, such as revolving and installment debt.

3. Credit utilization - 20%: The amount of available credit you have and how much of it you’re using. This includes revolving credit and installment loans.

4. Recent credit/Hard Inquiries 11%: Each time you apply for credit, or someone checks your credit, a hard inquiry is placed on your credit report. VantageScore combines all hard inquiries made in a 14-day period as a single inquiry for credit-scoring purposes.

5. Account balances - 6%: The total amount you owe on all of your credit accounts.

6. Available credit - 2%: The total available credit you have on revolving credit accounts.

These two scoring models use different formulas to weigh the information on your credit report. Hence, you’ve likely noticed that your credit scores are different when compared - case in point, to Credit Karma. Suppose you use Credit Karma and other credit monitoring services that pull your FICO score. In that case, you more than likely noticed that your Credit Karma score is different (sometimes way different) than your FICO score. That is because Credit Karma’s credit scores are calculated using the VantageScore model, not FICO.

It’s also worth noting that dozens of credit score versions such as FICO Score 8 and VantageScore 4.0 play a factor in why your credit scores are different.

Understanding FICO Credit Score Ranges:

• Poor (300-579): Limited credit history or significant negative factors like missed payments or bankruptcies.
• Fair (580-669): Some credit history but may have past credit issues or high credit utilization.
• Good (670-739): Demonstrates responsible credit behavior with a history of on-time payments and low credit utilization.
• Very Good (740-799): Strong credit management skills, low credit utilization, and a longer credit history.
• Exceptional (800-850): Exceptional credit management, minimal credit risk, and favorable terms from lenders.

Your credit report must contain enough (recent) information for a credit score to be calculated. Generally, that means you must have at least one account that has been open for six months or longer, and at least one account that has been reported to the credit bureau within the last six months.

Understanding VantageScore Credit Score Ranges:

• Very Poor (300-499)
• Poor (500-600)
• Fair (601-660)
• Good (661-780)
• Excellent (781-850)

It's important to note that although FICO and VantageScore has a separate scoring model, lenders have their own criteria for what they consider to be a good credit score. They may consider other factors, such as your income, debt-to-income ratio and more. As such, there's no guarantee that you'll qualify for a loan or credit card if you have good credit by FICO and VantageScore's standards. Always check with the lender to see what you need to qualify with them.

Why do you have different credit scores?

The 3 major credit reporting agencies (Equifax, TransUnion, and Experian) are all different entities, meaning that each one could have different information on file about you. Your creditors that you do business with decide who they report your account activity to. Some can report your account activity to one, two or even all three credit reporting agencies, thus making your credit scores different for each of the three credit reporting agencies. As the information on your credit reports changes, so will your credit scores so, your credit scores today are more than likely different than what your scores were in previous months.

Tips to Improve Your Credit Score:

1. Pay Bills on Time: Set up automatic payments or reminders to ensure you never miss a payment. Make all future payments on time to demonstrate responsible credit behavior and build a positive payment history.
2. Reduce Credit Card Balances: Aim to keep your credit card balances below 10% of your credit limits to improve your credit utilization ratio. Yes, I know you’ve heard to keep it under 30% but that’s still too high. Individuals with exceptional credit scores use less than 10% of their available credit. We strive for excellence over here 😁!
3. Pay Off Outstanding Debts: Focus on paying off outstanding debts, especially past due accounts. Consider negotiating settlements or payment plans with creditors if needed.
4. Avoid Opening Too Many Accounts: Limit new credit applications to avoid multiple inquiries that can lower your score.
5. Monitor Your Credit Report: Regularly check your credit report for errors or inaccuracies that could impact your score.
6. Maintain a Mix of Credit: Having a variety of credit accounts (e.g., credit cards, loans) can positively impact your score.
7. Keep Old Accounts Open: Closing old accounts can shorten your credit history, potentially lowering your score.
8. Limit Credit Inquiries: Only apply for credit when necessary to minimize the impact on your score.
9. Use Credit Wisely: Use credit for essential purchases and avoid maxing out credit cards or taking on excessive debt.
10. Repair what is broken: Credit repair may be necessary if you have negative items reporting on your credit report such as late payments, collections, charge offs or bankruptcy.

Steps to Repair Your Credit:

1. Check Your Credit Report: Obtain a free copy of your credit report from each of the major credit bureaus (Equifax, Experian, TransUnion) through AnnualCreditReport.com. Review it for errors or discrepancies.
2. Dispute Errors: If you find inaccuracies, dispute them with the credit bureaus by mailing in a dispute letter with supporting documentation. They're required to investigate and correct any errors.
3. Bring Past-due Accounts Current
4. Build new/positive credit: If you don't have any credit cards, apply for one and use a small amount monthly to show positive activity on your credit report.
5. Get a Credit-Builder Loan: Credit-builder loans are designed to help build or rebuild your credit score. Credit-builder loans work a bit differently than traditional loans because the money you borrow is kept in a savings account or certificate of deposit while you repay the loan in fixed monthly payments. The loan amount is usually $1,000 or less with repayment terms between six and 24 months.
6. Monitor Your Credit: This allows you to keep track of your progress and to see what new activity is being reported.

There is no magic button to repair your credit. It takes time, patience, knowledge, and persistence. The process of repairing credit involves identifying and addressing negative items, improving payment history, and demonstrating responsible credit management. It's a gradual process that requires patience and persistence. As you take steps to repair your credit, monitor your progress by checking your credit report regularly and tracking changes in your credit score.

Final Thoughts:

By understanding your credit report, identifying areas for improvement, and implementing healthy credit habits, you can take control of your credit health and work towards achieving a stronger financial future. Repairing your credit is a proactive step towards financial stability and improved creditworthiness. It takes time and effort, but the benefits of improved credit are well worth it.

Implement these smart credit habits so you can take control of your credit health, build a solid credit foundation and work towards achieving and maintaining an excellent credit score with confidence.

**Please note that the information provided in this blog post was accurate and true at the time of publishing. However, credit scoring models and regulations may change over time, so it's always recommended to do your own research and/or consult with a credit expert for the most up-to-date information and personalized guidance regarding your credit management.*