If a friend asked to borrow $100 from you, would you do it?
You’re probably thinking, “That depends on the friend.
Are they trustworthy?
Have they borrowed money from me before, and if so, did they pay it back?”
Borrowing money is as old as civilization itself, and for a long time, it was based
on personal relationships and recommendations.
The only way for a lender to know whether they could trust someone to pay them back
was by knowing them personally, or if someone else they already trusted vouched for them.
But when credit became big business, lending companies needed a more efficient way to decide
which borrowers they could trust.
So, in 1956 a data analytics firm called Fair Issac and Company started creating mathematical
models that used a borrower’s history to measure their risk, and in 1989 they debuted
the first industry-standard algorithm: the FICO score.
This formula was soon adopted by the “big three” credit reporting bureaus: Equifax,
Experian and Transunion.
Your FICO score is a three-digit number between 300 and 850 that indicates to a lender how
safe it is to lend money to you.
[show meter with more specific categories like fair, exceptional, etc.]
A high score tells a lender that you’ll probably pay the money back on time, so they’re
more likely to give you a loan with good terms.
A low score signifies that you might not be able to pay the money back, so if they’re
willing to offer you credit at all, they’ll want to be compensated for the risk by charging
more interest.
But it’s important to remember, this number doesn’t represent who you are as a person,
or even whether you are financially responsible.
There are people with high credit scores who live paycheck to paycheck, and people with
low credit scores who save like little chipmunks.
Your credit score only reflects your past relationship to debt.
Every time you borrow or repay money--like taking out a credit card or making a student
loan payment--the lender reports that activity to the credit bureau where it goes into the
math machine.
But not all data is judged equally!
The largest percentage of your FICO score is based on your payment history.
So missing a payment is one of the worst things you can do.
But thankfully, late payment dings are like broken bones.
They may hurt for a while, but they eventually heal, as long as you don’t break that same
bone again!
A close second is your credit to debt ratio.
If you have a $1000 limit on your credit card with a balance of $750, you’re using 75%
of your available credit.
Hovering close to your limit is like driving on empty--which looks risky to credit bureaus,
so you’ll want to keep that ratio under 25%.
That’s why paying down debt can really help your score.
The length of your credit history makes up 15% of your score.
It’s based on the ages of your various accounts, and it’s why older people often have higher
scores than younger people.
It’s also why getting a credit card early--but using it conservatively!--can help you have
a higher score later in life.
10% of your score is based on credit diversity, There are three main types of credit: revolving
(aka credit cards), installment, like student loans and car loans, and mortgages.
An ideal credit report has a mix of all three.
The last 10% comes from new lines of credit and credit checks, or “pulls.”
If you apply for a bunch of new credit cards in a short period of time, or if many different
lenders have to check your score, that can be a red flag.
Though there are exceptions: if you’re shopping for a car loan or a mortgage, you’ll usually
have a window of one or two months in which multiple credit pulls won’t affect your
score much.
Also, this only refers to pulls done by potential creditors, called “hard” pulls.
“Soft” pulls, by insurance companies or employers won’t count against you.
The FICO model is the main way your score is calculated.
But there are many variations depending on what the lender
wants to know about you.
And remember, your credit score is not the be-all end-all of financial health--but there
are life goals that a good credit score can make a lot easier to achieve, like owning
a house or starting a business.
If you want to know what your score looks like, many credit card and auto loan companies
provide it on your monthly statement.
Alternately, the big three credit bureaus are required by law to provide you with a
free credit report once a year--but they’ll only calculate a score for a fee.
And don’t worry, that’s considered a “soft pull” and won’t hurt your score.
It may seem a bit creepy that these faceless organizations are monitoring your activities
in order to pass judgment on you, but it’s really just our modern version of having a
good borrowing reputation.
In which case, the same old rules still apply: try to borrow as little as possible, and pay
it back on time.
And that’s our two cents!