If you're a responsible consumer and pay your bills on time, you don't run up exorbitant credit card debt, and you have a healthy credit mix, you probably assume your fabulous credit score of say, 760, is solid and safe. That is, until you go to apply for a home loan, or car loan and see that your credit score is actually more like 720 now. Or, maybe your credit score hasn't changed, but you are now denied a loan that you were able to get a year ago with that same, fabulous score.
So, what happened?
Yuliya Demyanyk, a senior research economist with the Federal Reserve Bank of Cleveland, provides this fascinating finding about credit scores:
Your credit score is not a rating of your credit worthiness, but rather a ranking of your credit worthiness compared to the rest of the U.S. population at a specific point in time.
In other words, when your credit score changes — even if your credit behavior doesn't change — it's because your rank order compared to the rest of the population has shifted. For example, if the rest of your fellow Americans are paying more of their bills faster than you, this will affect your rank and your score. Conversely, if your fellow Americans slip in their payments, your credit score and rank will rise. So, even if you do everything right, you are thrown into the mix with the rest of the population and your score/ranking is affected by what everyone else is doing.
Hidden Data Point — Credit Risk vs. Credit Worthiness
An additional component of your credit score is your credit worthiness. This is a data point that predicts the likeliness that you will pay your bills on time or fall behind in payments. You won't see this number since it's part of a credit-reporting bureau's secret, credit-scoring model, but this is important to lenders who make the assessment of whether to loan you the money. Like it or not, it is an indication of your level of risk to a lender: "What kind of track record does this person have in paying loans on time?"
Another thing to understand is that the relationship between credit score and credit risk is dynamic and changes over time. So the risk associated with a 700 score last year is not the same as the risk with a credit score of 700 this year. And it's risk that the lender fundamentally cares about, not the score.
Also, even though your credit score and credit worthiness might be stable, conditions beyond your control — market conditions, a bad recession — could affect everyone's credit worthiness, not just yours. This is certainly true today in our financial crisis that has affected major aspects of our economy — namely, jobs and housing. So, that fabulous credit score that got you loans in the past may have changed as the "bar" for a good score shifts upwards and out of reach as lenders pull in and loan less.
How Your Credit Score Is Calculated:
For the most part, credit scores are generated from one of three major credit bureaus – Equifax, Experian and TransUnion. Each of these bureaus collects credit information on you and then applies a statistical algorithm to calculate your credit score (the Fair Isaac Corporation was the first to create such a score which is why credit scores are still oftentimes referred to as FICO scores). Each of the bureau's scores will vary slightly because they each have their own proprietary methods to track customer credit behavior and use different methods for collecting data on you. Recently, the three bureaus have gotten together and created a common score call the VantageScore, which is common across the three bureaus.
Factors That Affect Your Credit Score:
35% — Payment history
Lenders look at your payment history on all your accounts; the length of your positive credit history and how long you have gone without a negative item; whether there are any severe unpaid debts like bankruptcies or foreclosures; and the number and severity of delinquencies in your credit history.
30% — Amounts Owed
Too many credit accounts and a high ratio of credit balances to credit limits can affect your score. Also affecting your score is the amount of debt on each account and the level of debt paid off on term accounts.
15% — Length of Credit History
Longer credit histories result in higher scores. Important factors incorporated into credit scores are: length of credit history, length of time specific accounts have been open, and the duration of time since each account was last used.
10% — New Credit
Credit scores track consumers who suddenly take on new debt and potentially overextend themselves, by checking to see when the last time a consumer opened an account and how many accounts were opened and by looking at the number of inquires on the consumer's credit reports.
10% — Types of Credit Used
The type of credit you have plays an important role in determining your credit score. A "healthy mix" of installment loans (mortgage payment, auto loan) and revolving credit from banks is considered better for your score.
What's a good credit score?
Scores may range from around 300 to 900 with the average credit score in America being around 720. Here is an approximate range of how credit scores are judged:
Excellent credit = 720 and above
Good credit = 660 to 719
Fair credit = 620 to 659
Poor/bad credit = 619 and below
For anecdotal evidence of your good credit standing, if you notice you are receiving a lot of zero percent credit card or lines of credit offers, you are probably in pretty good shape.
Summary
In conclusion, having a high credit score is still very important in getting the best mortgage rate, and you should be guided by the factors that make up your credit score. But, since you are ranked against the rest of the population and financial conditions also impact credit worthiness, improving your credit score is not always within your control.
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