Establishing and maintaining excellent credit is an essential step of attaining financial security. Even if you’re on top of your month-to-month expenses and have no need for credit now, don’t shy away. Chances are, there will come a time in your life when you’ll need help in paying off large expenses: education, a home, a car, or unexpected emergencies (health expenses not covered by insurance for yourself or a loved one, a pet’s surgery, being laid off (or covering additional expenses in the case of a spouse’s layoff).
In those times, credit lenders will be more likely to lend to someone with good credit, and if they do, will be willing to extend higher lines of credit and, most importantly, at lower interest rates that could save you thousands. Further, your credit score can be used to evaluate your personal accountability by potential employers, lessors deciding whether to place their rental unit in your hands, and cell phone service companies in ascertaining whether they should extend a plan to you.
What Is Credit?
Before getting into the nitty gritty of scores, you should understand what exactly constitutes credit.
There are several types:
1. Secured credit, such as mortgages and auto loans, generally requires you to agree to renounce your home or car the loan is going towards as collateral (pledged as security for the loan’s repayment) to be forfeited in the case of default (failure to repay). You’ve probably heard of foreclosure—the process a mortgage lender must undergo in the event of a default in order to take repossession of the property. Other legalese terms for collateral that you’ll probably encounter are surety, guaranty, and indemnity.
2. Unsecured credit includes accounts that aren’t attached to any form of collateral. Examples include payday loans (usually under $500 and due by the lendee’s next payday, hence the name), cash advances, signature loans, and student loans.
3. Revolving credit products are characterized by having a defined upper limit and allow the consumer to repeatedly withdraw them after repayment indefinitely. Examples include credit cards, home equity lines of credit (secured with the value of your home minus mortgage payments still owed), and overdrafts.
4. Installment credit products have a set amount disbursed in the beginning that is repaid, along with interest, in equal installments and at fixed intervals, typically once per month. Examples include mortgages and auto financing.
How Are Credit Scores and Reports Related?
Credit reports don’t list your credit score, but they include data that scoring models such as FICO Score require, such as your active and closed accounts up to 10 years old and recent credit inquiries. They also contain basic background information drawn from credit accounts (also called trade lines) such as your social security number, addresses you’ve resided at, and employers, which isn’t used to score you; public records related to nonpayment of financial obligations (e.g., bankruptcies, civil judgments, tax liens [possession of one’s property as a last-resort means of getting them to pay taxes owed], wage garnishments [forced debt repayment in the form of salary deductions], and foreclosures [possession of one’s home in the event of failure to continue paying their mortgage]) obtained from county and state courts; and information on delinquent accounts in collections.
Credit Scoring Models
Two scoring models comprise the vast majority of those used: FICO Score and VantageScore. You are likely more familiar with the FICO Score, given that it has been in majority use since 1989. VantageScore, on the other hand, debuted in just 2006.
What Are FICO Scores?
FICO was originally short for Fair, Isaac and Company following the data analytics company’s 1956 founding, which became Fair Isaac Company in 2003, and simplified to FICO in 2009. Lenders began using the score in 1989. Despite VantageScore Solutions’ 2006 entry into the scoring market, it has maintained the lion’s share of top U.S. lenders’ business, in use by about 90% of them.
After reaching the six-month mark of having an open account that has been reported to a credit bureau at least once (with no indication of deceased on your report, which could be pertinent if you share your account with someone who has passed on), you’ll be eligible for a FICO Score, of which there are as many as 65.
While base FICO Scores range from 300–850, industry-specific scores range from 250–900.
The newest (2016) iteration of the FICO Score, FICO 9, is the most predictive yet. Its key differences are that it doesn’t negatively factor paid-off collections, takes into account rental payment history, and is more forgiving with regard to unpaid medical collections.
FICO teamed up with LexisNexis Risk Solutions and Equifax to create FICO XD, introduced in 2015, with a primary objective of tapping the 53 million plus consumers lacking a credit data footprint required to generate a traditional credit bureau score, according to LexisNexis. It has been shown to excel at that goal, enabling more than half of credit applicants formerly invisible to to scored by lenders. LexisNexis explains its key difference is its taking into consideration utility, rent, etc., payments based on data drawn from the National Consumer Telecom and Utilities Exchange (utilities, landline, cell phone, and cable payments) and LexisNexis Risk Solutions (credit bureau data, public records, and property data).
As a temporary solution for unscoreable consumers, it doesn’t affect those with existing traditional FICO scores.
There is often a delay for lenders to upgrade to new scores—FICO Score 8 is still the most widely used score across industries. The most popular versions used depend on their purpose: the FICO Bankcard Score and FICO Score 8 are the most commonly used for credit cards; the FICO Auto Score is the standard for auto financing; FICO Score 8 is chiefly used for student loans, retail credit (financing for big-ticket purchases, often with no minimal or no initial payments, but high interest rates); and base FICO Score versions former to FICO Score 8 are those mainly used in mortgage-related lending decisions.
What Is the VantageScore?
In 2006, the three major credit reporting bureaus—TransUnion, Equifax, and Experian—teamed up to create an algorithm for a score that would be more consistent between them and with improved credit risk prediction capability. It comprises about 10% of the body of scores utilized in lending decisions, while FICO makes up 90%.
The minimum scoring criteria for a VantageScore is simpler than for FICO Scores; all you need is one qualified trade line (i.e., a credit account record that has been submitted to a credit reporting agency) on your account and no indication of deceased on your report.
There have only been three versions of the VantageScore thus far: 1.0, which came out in 2006; 2.0, released in 2010; and 3.0, released in 2013. In fall 2017, VantageScore 4.0 will be made available to lenders and commercial clients and to consumers in 2018.
The hallmark of VantageScore 3.0 (the latest version currently in action) is its ability to score 30–35 million formerly unscoreable consumers. Its updates include a switch from a 501–990 to 300–850 range for greater ease in comparability to FICO Scores; looking 24 months into the past for credit history including utilities, rental, phone service payments to expand access to consumers with little or no credit data; and lifted penalties to those making late payments in the aftermath of a natural disaster.
What Criteria Do FICO Scores and VantageScores Consider? How Do They Differ?
While FICO isn’t forthcoming on their precise scoring methods, they assert that their baseline breakdown for the general population is comprised of 35% payment history, 30% amount owed, 15% length of history, 10% recent credit (number of newly opened accounts and credit inquiries), and 10% credit mix. The weight of each of these categories can vary in response to factors such as an individual’s length of credit history and how their credit report fluctuates.
As with FICO Score, VantageScore is proprietary. While VantageScore Solutions doesn’t divulge their exact metrics for scoring, they provide an approximation of their newest scoring model’s version, whose makeup is similar overall to FICO Score’s. It is comprised of about 40% payment history, 21% credit age and mix, 20% credit utilization, 11% amount owed, 5% recent credit, and 3% available credit. The only factor that VantageScore 3.0 considers that FICO Score doesn’t is how much total available credit someone has; the number of accounts one has doesn’t impact FICO Scores.
Constituting a whopping 35% of base FICO Scores and 40% of VantageScore 3.0, exercising consistent punctuality and dependability when it comes to submitting at least the minimum payment on time is the most effective way to score highly by both models. However, if you slip up once and miss a credit payment by up to 29 days, don’t fret; while you may be slapped with a late payment fee (which stands a good chance of being forgiven if your account has been in good standing otherwise), credit bureaus aren’t notified of late payments until they are overdue by 30 days.
“Amount owed” includes total balances and credit utilization in FICO Score’s breakdown, comprising 30%, while balances and credit utilization each have their own category in VantageScore 3.0’s scoring criteria—20% credit utilization and 11% amount owed—though they come out about equal in weight.
The FICO Score’s credit utilization category is made up of several subparts:
1. Sum of balances (debt) of all accounts;
2. Balances on certain types of accounts;
3. Number of accounts with balances;
4. Absence of a specific type of balance, in some cases;
6. For certain types of installment loans, the proportion of their balance to their original loan amount; and
7. Proportion of balances to total credit limits for certain types of revolving accounts, or your credit utilization ratio.
The credit utilization ratio is considered an important indicator by both models of risk because high can mean overextended. Normally, the ratio is calculated as the ratio of your balance total across all cards to your limit total across all cards (called aggregate utilization), but some scoring models penalize you for having a utilization higher than 30% for any single card (line item utilization), so it’s better to keep tabs on how high it is at all times and pay it off once it approaches the 30% mark.
As an example calculation of your credit utilization ratio, if your credit card balance was $100 while your card’s limit was $1,000, you’d simply divide $100 by $1,000, then multiply the resultant 0.1 by 100 (or move the decimal place two spaces to the right) to convert it into a percentage, ending up with 10%.
Be aware that even if you pay off your full balance off each month—which you should be doing to avoid paying interest—that may not be the one reported to FICO, which is typically the one listed on your statement. Call your issuer to find out when they report the balance to the credit bureaus; if they do so on the first of the month but your due date is on the sixth, for instance, even if you typically pay off the full balance on the third, your utilization rate could appear high. When you are certain of the dates, you could arrange to submit your payments so they precede their reporting dates, or call the issuer to have your due date itself moved.
You can request a credit limit increase from your issuer to reduce your pressure to keep your utilization ratio down, though keep in mind that it could result in a hard inquiry. Another idea to alleviate the worry of a creeping balance is to get into the habit of making a payment twice per month, halving the time it has to accrue.
While we’re on the topic of credit utilization, another thing to keep in mind is the impact of closing a credit card. If you are going to do so, you should make sure you aren’t carrying a balance on any of other credit cards you may have, or at least ensure that the credit usage on the cards you’ll be keeping open is at below 30%; the closure of that card could cause your credit utilization ratio to spike.
Credit Age and Mix
FICO Scores are comprised of 15% length of history and 10% credit mix, while VantageScore 3.0 consolidates these into a single category worth a total of 21%.
Time elapsed since your oldest account’s opening, since the openings of certain types of accounts, and since there has been activity in your accounts are each components of FICO Scores’ length of history category.
Having a rich, extensive credit history is valuable indicator of creditworthiness to lenders.
This is one reason it’s generally wise to keep accounts—especially those with positive payment history—open. Further, your credit card may be closed due to inactivity after a year or so. Note that accounts with positive history remain on your credit report for 10 years, while those with negative marks fall off after seven years.
As for credit mix, ideally, you should have both revolving and installment loan/credit accounts.
FICO Scores are made up of 10% recent credit, and VantageScore 3.0 is made up of 5% recent credit. Recent credit is comprised of newly opened credit accounts and hard inquiries into your credit report.
While hard inquiries require your consent, soft inquiries don’t, as they give lenders just a snapshot of your credit. Lenders perform soft inquiries to identify the most worthwhile recipients for their preapproved credit offers.
Applying for new lines of credit can temporarily lower your credit scores and should be kept to a minimum (once per seven months is a good rule of thumb).
Generally, lenders perform a soft credit inquiry/”pull” to determine initial rates, but if you choose to apply for a loan, a hard inquiry into your credit history is performed. While soft credit pulls don’t affect your credit, hard credit inquiries may decrease your FICO Score score by up to five points, and your VantageScore by 10–20 points, according to Heather Battison, Vice President of Consumer Communications at TransUnion.
While they appear on your credit report for two years, they only impact your score for one year.
This factor is also important to keep in mind when applying to multiple lenders to compare interest rates. FICO and VantageScore Solutions have different techniques of identifying when you’re rate shopping, using scoring formulas that consolidate several loan inquiries performed during a certain time frame into one. While FICO rolls all hard inquiries within a 45-day window into one, VantageScore Solutions only does so for those within a 14-day window according to The Washington Post’s Michelle Singletary, so it’s best to keep rate shopping within the confines of a two-week period to minimize damage to either score.
As mentioned earlier, only VantageScore penalizes you for having many credit lines, though it only accounts for about 3% of the score, so it isn’t something you should be very concerned about. It’s generally better to keep credit cards open (for the sake of a healthy credit utilization ratio and keeping positive account history on your report), provided they don’t have an annual fee.
How to View Your Credit Scores
See Ways to Check Your Credit Score for Free for a list of sites that provide credit scores free of charge.
Additionally, once per year, you are legally entitled to a no-charge credit report from each of the three credit bureaus—Experian, Equifax, and Transunion—officially available at www.annualcreditreport.com. However, note that credit scores are not listed on your credit report.