If you were born somewhere between the end of the baby boom generation and prior to Generation X, you're probably well acquainted with the idea of the credit score. People in our demographic remember our parents drilling into us in our late teens and early 20s the importance of maintaining a good credit score if we ever hoped to buy a house. The credit score was held over our heads as the goose that laid the golden egg of our future. They were partly right, but they were also partly wrong.
By the time most of us hit our financial strides in the late 1980s and early 90s, banks were freely loaning money to just about anyone who wanted it. Back in the "good old days" you could have a credit score well below 600 and still qualify for an FHA mortgage backed by Fannie Mae or Freddie Mac. Unfortunately, such loose lending practices played a huge role in the inflation of real estate prices and the ensuing burst of the housing bubble in 2008.
The resulting economic crash that has been felt around the globe has changed the world of credit and returned us to the days our parents were warning us about. Today the credit score is highly important not only to purchase houses, but also to get car loans, credit cards, revolving lines of credit at department stores, and so on. The importance of your individual credit score and how to make sure it stays within an acceptable range cannot be understated.
Multiple Credit Scores
Most people don't know that there are multiple credit scoring systems utilized by lending institutions and other creditors around the world. In the United States, the most common system is known as FICO. This system was developed decades ago by an engineer and mathematician who were trying to determine whether or not it was possible to predict whether certain types of individuals were more likely to default on their financial obligations.
Their formula proved successful but didn't have a lot of takers until the Fair Isaac Corporation got a hold of it and introduced it to the federal government. Once Fannie Mae and Freddie Mac were on board FICO became the standard for mortgages in the United States. It is now used by more creditors in the U.S. than any other system.
Under the FICO system scores range from 300-850; other systems use other ranges. In 2010 the average FICO score for Americans was just over 720. That has no doubt changed as unemployment has risen and the credit crunch has tightened in both major cities and rural towns alike.
Regardless, a score above 700 is considered excellent by most lending institutions. Anything below 640 is considered sub-prime with 500 likely being the bailout point where most lenders will not grant loans except in extenuating circumstances. People who do manage to get credit with a score below 500 are subject to very strict terms and extremely high interest rates.
How the Credit Score Is Applied
Exactly how a credit score is interpreted and applied depends on the institution making the loan and the purpose behind the loan. For example, mortgage lenders typically look for a higher score because they stand to lose a lot more money than a bank making a car loan. This is especially true now, as real estate prices in most parts of the country have fallen drastically over the last few years. Banks are very wary of making mortgages to begin with, let alone working with someone who has a sub-prime credit rating.
On the other hand, a company financing an auto or personal loan won't have such high requirements for credit scores. If they see that consumers have a fairly low debt load and a good debt-to-limit ratio, they're more willing than the mortgage lender to offer credit. A score below 700 will probably mean higher interest rates and larger down payments (where applicable), but it shouldn't be hard to secure credit if your score is in the 600s.
Regardless of how a particular bank interprets your credit score, they're trying to determine the likelihood that you will default on your payments. According to the original FICO formula, the threshold for default is 90 days. In other words, the credit score measures how likely you are to fall more than 90 days behind on your payments from the date that the score is calculated. At that 90-day threshold creditors generally assume you either don't have the resources to make your payments or you simply have no intention of doing so.
The Building Blocks of Your Credit Score
When your credit score is calculated reporting agencies are looking at several things:
- your payment history over the life of your credit
- the size of your current debt load
- the type of credit you currently have (secured and non-secured)
- the amount of your current debt as supposed to what your credit limits are (debt-to-limit ratio)
- how often you apply for credit
- recently opened and closed accounts
- whether or not you tend to pay off your credit early
All of the factors listed above go into a complicated formula which determines your score. Since not all of them are weighted equally, there are some factors that are more important than others. The three most important are your current debt load, your debt-to-limit ratio, and your past payment history. For a better explanation we'll deal with them one at a time.
Current Debt Load - Before anyone will loan you significant amounts of money they want to know what your current debt load is in relation to your income. For example, the standard rule of thumb for mortgages is that a homeowner be able to make his payment with no more than 25% of his monthly income. Lenders want to know your total debt load in order to see whether or not you have the financial resources to make your payments.
Debt-to-Limit Ratio - As you're probably aware, lines of unsecured credit are often capped with certain limits. This includes credit cards and revolving lines of credit like home equity loans. This ratio is important because it tells lenders how likely you are to run your limits up to their maximum. Consumers who regularly max out their credit lines are more likely to default within that 90-day period because they do not spend wisely. On the other hand, a low debt-to-limit ratio demonstrates not only that you pay your bills, but that you can resist the temptation of abusing credit even with high limits.
Payment History - While it is possible to turn over a new leaf, it is generally accepted within the financial industry that a person with a history of late and missed payments will continue that behavior into the future unless there is some evidence on a credit report that such behavior has been corrected. As a general rule, late payment histories that show up within one year of the credit score inquiry will put doubt in the mind of the lender.
Keeping Your Credit Score High
As the economy continues to contract and credit remains tight, keeping your credit score as high as possible is of utmost importance. Doing so will make credit available for those times when you really need it. It could end up being your lifeline should you face some sort of emergency situation where a credit-based purchase is your only option.
Keeping your credit score high assumes that it's already fairly good to begin with. If not, you'll be practicing credit repair before you can engage in behavior that will keep your score above 700. That said, some of the easier things you can do to maintain a good credit score include:
- applying for new credit sparingly
- keeping your debt-to-limit ratio low
- making sure you always pay your bills on time
- limiting the number of credit inquiries by anyone other than yourself
If you need to repair your credit there are plenty of strategies you can employ to do so. We would suggest you utilize the services of a professional credit repair agency if you don't know the best way to do it yourself. Attempting to repair your credit using dealer-financed car loans, rent-to-own contracts, and secured credit cards could backfire if you don't know how to control your spending. Under the advice of a professional credit counselor you stand a much better chance of repairing your credit and raising your score above 700.