Ch. 19:  Credit Scores

19.0 Introduction

            In this chapter, I will spend significant time explaining why this chapter is not important.  Funny, right?  When I first started teaching personal finance, I was shocked by how often students mentioned credit scores or worried how an action, such as applying for a credit card, might adversely impact their credit score.  Financially savvy people need only a passing knowledge of credit scores because their scores will be adequately high without exerting much effort.  I’m going to do my best to keep this short and sweet; this isn’t so important!

19.1 What is a Credit Score?

            Back in 1989, the first industry-wide credit score was created by an organization that is now known as FICO.  This “FICO score” was designed to provide a simple snapshot of an individual’s risk as a borrower.  It is imperfect and simple but provides lenders an easy starting point for determining whether an individual is suitable for a loan. 

            Credit scores don’t inherently take income and many other factors into consideration.  This is frustrating to many Americans who don’t really understand how a credit score is used in the loan process.  These people seem to mistakenly think that since income is not a part of the credit score calculation, it must not matter in the loan process.  That’s just wrong.  Income, and other factors like employment status, employment history, and assets absolutely do impact one’s ability to attain a loan, they just aren’t included in credit scores.  When a lender is considering whether to give you a loan, these factors (along with your credit score) will be given significant weight in assessing your application. 

            Today, there are three U.S. credit bureaus that provide FICO scores—Experian, Equifax, and TransUnion.  These agencies have slightly different information about their subjects. Thus, everyone with an open credit history (meaning they currently are borrowing money) has three credit scores, which vary slightly by bureau.  There are places to view at least one credit score online for free, or you may pay and see all three.  There is usually no significant value in viewing more than one score, but it’s a good idea to keep an eye on at least one, to monitor unexpected changes.[1]  I personally have an account at Experian.com, which allows me to view my Experian FICO Score for free, which I do every couple of months. 

19.2 Starting your Credit History

            If you have no extant credit record, then you will have no credit score—an individual in this circumstance is credit invisible.  This can be a significant problem.  Back in 2014, my wife and I embarked on becoming first-time homebuyers.  Although our financial situation was strong, my wife had no credit score—she was credit invisible.  While she had a credit card and student loans in the past, she had fully paid off all debt and closed her cards.  Thus, the credit bureaus had no current record of her borrowing history. 

  To avoid this dilemma, you will need to have some ongoing debt or something similar on your record.  I would never encourage you to go take out a student loan or a bank loan to start your credit score—that’s the tail wagging the dog.  But you can easily start and maintain your score by getting a credit card.   Credit cards are decidedly not for everyone and the misuse of one can trigger a lifelong financial battle.  But, if you get a credit card (and use it at least once/month or so), you will initiate your credit score.[2]  If you keep this card the rest of your life, you never have to worry about becoming credit invisible.  Since you may keep that first card for your entire life, you should certainly choose one that has no fees and is issued by a reputable firm.  Discover cards are a good option (see Chapter 20 for more discussion).  If you do eventually close your first credit card, that’s no problem so long as you have another form of debt (e.g. another credit card) currently to your name.

19.3 What does a score mean?

            If you visit Experian.com or another reputable credit report site, you can quickly find your credit score and should be able to see how it has changed over time.  Maybe you have a 715 score… what does this mean?  Well, credit scores range from 300 to 850.  A score below 600 usually indicates that the individual made at least one significant financial mistake (e.g. declared bankruptcy or failed to make debt payments for many months).  Usually, such individuals should worry about fixing these mistakes rather than improving their credit score.  I occasionally see posts on social media from individuals with 560 credit scores that want to know what they can do to increase their score so that they can qualify for a mortgage.  If you have a 560 score, forget about the mortgage.  That’s the least of your problems (and would only make your problems worse).  Fix whatever caused you to have such a horrific score and then get back to me.

            If you are young, have made good financial choices, and have no significant red flags in your financial history, your credit score will likely be in the high-600s or 700s.  This is a good starting point for a financially literate person, and you will find that your score will slowly rise over time without concerted efforts on your part.  Make good financial decisions and your score will take care of itself. 

  There are various categorizations of credit scores to help folks interpret their credit score.  Here is a pretty standard one from Nerdwallet:

Higher is better, but there is a threshold at which point increasing one’s score has no practical value.  For example, imagine you and your friend work for the same firm, earning the same salary.  If you have a score of 803 and your friend has a 790, there is no advantage to your higher score.  Both of you will be able to attain a loan for a house or car (or something else) at industry-low interest rates, assuming the rest of your financial picture is sound.  While it’s hard to put a number, anecdotal evidence indicates that a score of 780 or higher will qualify you for the best possible mortgage rates.  For other loans (e.g. car loans) a score of 750 or so is high enough.

            While there is no advantage to attaining a very high credit score, there are plenty of maniacal perfectionists seeking the elusive 850.  I guess everyone has their hobbies, but this seems like a colossal waste of time.  I mean, I play golf.  Some would say this sport, err… game is a waste of time but at least I’m getting some exercise.  Come to think of it, golf is basically an antonym for credit score pumping.  In golf, just about everyone that is above average still sucks at the sport.[3]  Meanwhile, anyone with an above-average credit score has basically beaten the game… there’s no point in trying to get “better”.  At the moment, my credit score is a 763 and my handicap is a 9.8 (update in late-2024:  I'm down to a 3.8 handicap... don't act like you're not impressed).  I don’t give a rat’s ass about my credit score, but that handicap is driving me crazy!  I sincerely hope and fully expect that you will get to this point too.  I don’t mean to sound like a jerk, but caring about credit score is the kind of thing that irresponsible people living paycheck-to-paycheck do.  If you live a financially sound life, you too will stop caring about your score, which will allow you to spend more time thinking about how much you suck at your hobbies.

            If you have a lower score (less than 750), then I have some recommendations for you at the end of the chapter.  But please, remember that your score will be just fine if you make good financial decisions.  You don’t need to game the system.

19.4 Factors that Determine a Credit Score

  So, what determines a credit score?  I really don’t think there’s much reason to be too specific, but let’s at least get an idea.  Here are the determining factors, and the respective weights, for each category.  For example, “payment history” makes up about 35% of your credit score.  These percentages and explanations are imperfect.  FICO and the credit bureaus do not fully reveal the methodology used to assign scores.

1.       Payment History (35%):  You will receive positive marks if you have (a) many debt payments required with (b) no missed payments.  Emphasis is placed on your payment history with recent and larger required payments.  Make your payments in full and you’ll be just fine. 

2.       Amounts Owed (30%):  Generally speaking, having more debt will hurt you in this category (but could help you in the other categories).  In addition to considering one’s total debt, this category also factors in your credit utilization rate, which is the percentage of possible debt that you have used, typically with credit cards.  For example, if you have a credit card with a $20,000 credit limit, but have only borrowed $1,000, then you have a 5% credit utilization rate for this card.  A lower credit utilization rate will improve your credit score and is one of the factors that you can control.  In the long run, having more credit cards and higher credit limits will lead to a higher credit score, all else equal.

3.       Duration of Credit History (15%):  Generally speaking, one’s credit score is higher the longer they have had credit.  All else equal, someone who has no problems (e.g. unpaid debt) on their account with a 20-year payment history is a safer borrower than someone with no problems but only has a 5 year payment history.  As a result, it’s typically easier to have a higher score as you age, assuming you avoid mistakes.  This category considers both your total duration (years of having a score) and the average length of each instance of credit on your account.

4.       Credit Mix (10%):  It seems that FICO scores are highest when a person has a variety of debt.  A person with several types of debt will usually have a higher score than someone with only, say, a mortgage.  Of course, this is controlling for other factors.  If you have a variety of debts and regularly miss payments, then your score will be low.

5.       New Credit (10%):  Suppose someone has applied for three credit cards in the last 30 days.  We might take this as a sign that this borrower is about to go on a risky spending spree, right?  As such, someone with lots of new accounts or attempts to start new accounts (e.g. applying for a credit card and getting rejected) will have a relatively low score.  Sometimes, this category causes folks to believe that getting a new credit card will sink their score—this is not a serious concern.  Applying for a new credit card only drops one’s score by a few points and these few points are re-awarded to the person’s account after a year.[1]

Folks are often frustrated by the realization that having debt generally improves one score.  If you pay off a debt balance in full, your payment history will end.  If you close a credit card, your utilization rate will rise and your credit score will fall.  I can see why this might be frustrating but remember that a credit score is just an imperfect snapshot of your ability to repay debt.  You need not focus on minor details.  Make good financial choices and live your life.

19.5 Conclusions

  Ultimately, I hope you learn to care very little about your credit score since financially skilled individuals that make good choices will automatically have solid scores.  But if you are young and hoping to buy a house soon, I can see why you want to learn about the FICO system to improve your score.  So, here are some ways to attain a high score:

Tips and Tricks

1.       If you are credit invisible, get a credit card now.  Choose one with no annual fee so that you can keep it the rest of your life without bearing a cost.  Use this card at least once per month.  Payoff the statement balance each month.  Even if you have no plans to apply for a loan in the near future, this is a useful practice.  If you get your first card now, this will improve your credit duration for the rest of your life.

2.       If you are more than 12 months away from borrowing money, feel free to apply for a second (or third) credit card.  The impact of multiple cards is unclear (applying for a card now will shorten your average credit duration, but reduce your credit utilization rate), but shouldn’t substantially impact your score one way or the other.

3.       If you are offered the opportunity to increase your credit limit on a card, go for it.  This will reduce your credit utilization rate and increase your score.

4.       Pay off debts as appropriate.  Having an active student loan debt may improve your score, but it’s stupid to pay unnecessary interest in the interest of achieving a high score.

5.       Do not apply for any new credit cards in the final 12 months before applying for a mortgage (or seeking a car loan).  Applying for a new card drops your score for 12 months.

Beyond these suggestions, the most important advice I can offer is to simply never borrow more than you can afford and avoid making boneheaded mistakes.  Back in 2021, I unknowingly held a credit card that had a $49 annual fee.  When my annual fee was posted to my account, I was unaware, and I had four months of unpaid debt on my card.  This was a non-issue for me financially; in fact, the credit card agency ultimately closed my account and didn’t even require me to pay the $49!  Nonetheless, my credit score dropped about 142 points during those five months.  See:

I didn’t really care that my score dropped so sharply.  I didn’t need to borrow anytime soon, so who cares?  But what a costly mistake this could have been!  Note that my score still hasn’t bounced back from this silly mistake.  Don’t be like me.  Make good decisions and stay organized! 

End Notes

[1] Some financial gurus advocate that you determine your score from all three bureaus.  When you apply for a loan, you can then target banks that use the bureau that gives you the highest score.  I can’t totally dismiss this recommendation, but I really hope you are financially stable and don’t need to play the credit score maximization game. 

[2] You can use it more, of course.  But not everyone wants to take-on the risk of frequently using a credit card.  If you use it sparingly (less than once per month), you run the risk that the issuing bank will close your account, which may push you back to the shadow realm of credit invisibility.

[3] I shot a 77 last week.  That’s pretty good I guess, but I still would get annihilated by anyone with actual talent.

[4] Applying for a credit limit increase will also reduce one’s score for 12 months.  But the specifics on this are tricky.  If you apply for a credit limit increase, this triggers a “hard pull”, reducing your score.  But if you are offered a credit limit increase without inquiring, this usually does not trigger a reduction in your score 

Key Terms

Credit Invisible:  A person that does not have a credit score is credit invisible.  This happens because the person has no active debt record, so they don’t have any data from which to pull.  A credit invisible person will have a hard time borrowing money to buy a house or car.

Credit Utilization Rate:  Typically relevant for credit cards only, credit utilization rate refers to the percent of available credit one has used.  A lower credit utilization rate leads to a higher score, all else equal.

Equifax:  One of the three credit bureaus that provides a FICO score.

Experian:  One of the three credit bureaus that provides a FICO score.

FICO score:  The standard credit score used in the United States.  Three credit bureaus—Equifax, Experian, and TransUnion—provide slightly different credit scores to lending agencies.

TransUnsion:  One of the three credit bureaus that provides a FICO score.

Practice Problems

1. Jason and Alex are both applying for a mortgage.  Their financial situations are very similar but Jason has a 822 credit score while Alex’s is only 793.  Will Jason have an easier time getting a mortgage loan?  Explain.

2. Mason currently has a 744 credit score.  He applies for a credit score today and is approved.  He plans to keep the card for a long period of time..  How will this impact his score today?  In two years?

3. You have a car loan with a 12.5% interest rate.  You could pay it off now, but you’re afraid that doing so will reduce your score since it will reduce your credit mix, reduce your duration of credit history, etc.  Should you pay it off?

4. Alyssa has an 850 score.  Should I throw her a party?

5. Valerie has a 681 credit score.  Should she be worried about her ability to get a car loan?  How can I help her?

6. Sungme is a really strong college student and plans to buy a house after graduation via a mortgage.  She brags to you, “I don’t have any debt so I should have no trouble getting a loan!”  What should you tell her?

Solutions

1. Jason and Alex are both applying for a mortgage.  Their financial situations are very similar but Jason has a 822 credit score while Alex’s is only 793.  Will Jason have an easier time getting a mortgage loan?  Explain.

Almost certainly not.  Jason and Alex will likely have equal capabilities to obtain a low-interest loan.  Once a score reaches the high-700s, there is no practical value to increasing it further.

2. Mason currently has a 744 credit score.  He applies for a credit card today and is approved.  He plans to keep the card for a long period of time.  How will this impact his score today?  In two years?

His score will drop a few points as a result.  This reduction will only last 12 months.  After this period, it’s unclear how it will impact his score.  All else equal, his credit utilization rate will fall (good), but his length of credit history will fall (bad).  If this is only his first or second card, then his credit mix will broaden (good).  AARRGGHHHHH… who cares!  This is such a non-issue.  A couple of points her or there doesn’t matter!

3. You have a car loan with a 12.5% interest rate.  You could pay it off now, but you’re afraid that doing so will reduce your score since it will reduce your credit mix, reduce your duration of credit history, etc.  Should you pay it off?

Don’t be a Donny Dumbass.  This might hurt your score, but keeping this high interest loan on your books when you could pay it off is far more important than your score.

4. Alyssa has an 850 score.  Should I throw her a party?

Don’t throw her a party, throw something at her instead for wasting her time achieving a pointless goal.

5. Valerie has a 681 credit score.  Should she be worried about her ability to get a car loan?  How can I help her?

Yeah, that’s low enough to be a serious concern.  If I was helping her out, I would first try to determine why her score is so low.  Her low score may be a symptom of some grave financial mistakes that she has made.  Worrying about her score while ignoring why her score is low is like treating someone for headaches without investigating the cause. 

If it appears that all is in order, I encourage her to implement the recommendations made in this book and to be patient.  It can take some time to increase a score.

6. Sungme is a really strong college student and plans to buy a house after graduation via a mortgage.  She brags to you, “I don’t have any debt so I should have no trouble getting a loan!”  What should you tell her?

Sounds like she is credit invisible!  She will have a very hard time getting a mortgage and needs to immediately find a way to start her credit history (likely by getting a credit card).