Thursday, September 12, 2013

The Credit Score: Part 1 of 2

And you thought just because you graduated you were done with grades? Enter the FICO score (aKa your credit score). I'm sure you've heard of it, but I thought I'd do a little mini-series to refresh you on the details. Part 1 is going to cover what it is, why it's important, and how it's calculated. Part 2 is going to cover how to optimize your score and keep an eye on it.

Notebook image from freedigitalphotos.net

The WHAT

What is a credit score? A credit score is essentially a grade you get for how likely you are to pay back your debts. This is super helpful information for lenders who want to know if it's smart or stupid to give you money-- and if they should charge you a higher/lower rate because you're a higher/lower risk.

How is this different from a credit report? A credit report lists all of the components of a credit score (how much debt you have, how long you've had it, if you pay on time, etc.). The credit score consolidates this into one number using a semi-mysterious algorithm.

So why do you keep throwing out the term FICO score when it's just a credit score? The FICO score is sort of a brand name of credit scores, and it's the most commonly used. The name comes from the company's original name-- Fair, Issac and Company. Now it's been renamed to just "FICO."

The WHY

So this FICO score is kind of a big deal. "But I pay cash for everything," you say. "Why do I want a great credit score if I never plan on needing credit?" You may have a point if you plan on paying cash for your house too, but otherwise, I say get on the dang FICO score bandwagon.

It's one of those "big" things we like to talk about on our blog that can wipe out decades of scrimping at the grocery store if you screw it up. How big is it? Well, say you take out a $300,000 mortgage on a home with a FICO mortgage score* of 687 (the national average).  Over the life of the loan, you'd pay about $243,000 of interest (you read that right). But if you Money Hip Mama-ed your score up to 800 or so, you'd pay closer to $218,000 in interest. That's a $25,000 difference. Big stuff. We used this calculator to run our numbers. It's pretty fun to play with if you're bored and into hypotheticals.

The HOW
So by now you probably want to know how they come up with this all-important number. The actual equation they use to calculate it is top-secret, but we do know the basic inputs (all of which come from your credit report) and general weighting of importance.

Remember how I said here Lisa and I kind of have a cake bond? Here's one I made for a roommate's bridal shower. Chocolate ganache is my go-to for the deliciousness factor. 
  • Payment history (~35%): Do you make your credit card/car/mortgage, etc. payments on time?
  • Amounts owed (~30%): This doesn't necessarily mean you need to have $0 balance on your credit card continually to get a high score-- what it does mean is that you know how to use debt without getting up to your eyeballs in it (maybe you should shoot for ankles or lower).
  • Length of credit history (~15%): It takes time to build trust here too.
  • Types of credit (~10%): You'll earn more "street cred" if you have different types of debt (think credit card + car loan) instead of just your cards from Gap, Banana Republic, and Target.
  • New accounts (~10%): Going on a card-opening bonanza can hurt your score. Slow and steady does it.
That adds up to 100%, right? 

Now that you're super intrigued about credit scores, next Thursday we'll talk about how to optimize and monitor them.

*There are different kinds of FICO scores-- generic, bankcard, mortgage, to name a few. But the general principles are the same, so we won't differentiate here. 

Share-- How did you first learn about credit scores?




7 comments:

  1. I hope in the next post you talk about ways to get your credit score. I've heard horror stories about some of the "free" credit score report services that automatically sign you up for some service and start charging your credit card monthly. This is the reason I haven't checked my score in many years because I don't know who to trust! But I know I should check it!

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    1. Good point! I will talk about that. The credit report is pretty straight forward (I give a link), but when you get your credit score, just make sure you are picking the right option to get the one you pay for (it's about $20). It should be fairly clear which one is the "free" report followed by monthly service.

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    2. I'll have to update Part 2 to make it clear how to avoid this trap.

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  2. Love this! I was raised in one of those "avoid debt like the plague" families, so I was shocked when this approach actually hurt me later on in life.

    When I first went to college, I couldn't get a cell phone plan because I didn't have any credit. So, I promptly signed up for a student visa card in order to qualify.

    Over the next 8 years, I paid off that Visa bill on time every month. I supported myself through college debt-free, and didn't incur any additional credit cards. I thought I was doing everything right.

    Fast forward to three years ago when we were buying a house, and I was shocked to learn that I didn't qualify for a mortgage loan. My credit score was excellent, and actually higher than my husband's, who did qualify. After digging a bit deeper, I found out I was denied because I didn't have ENOUGH credit, and the bank didn't think I'd know how to handle debt. Seemed like such a backwards approach, though very common.

    Since then, I've tried to cautiously increase my credit - choosing to incur debt for the interest-free period of the loan.

    The credit agencies are so cryptic, and I personally think that their equations should be made public - why should something that is so important to someone's livelihood be left confidential?

    Great blog, and I look forward to hearing the rest of your advice on this subject!

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    1. Thanks for the comment! It is SUPER annoying that it is often the most responsible people that get penalized! I guess it's a game, and we all have to play along...

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  3. This was super helpful and informative. Thanks for making things so simple for people like me who don't understand all the big finance language and get confused very easily :).

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    1. Thanks for the comment! That makes my day!

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