What is credit? I’m sure you’ve heard of it. People talk about it all the time. Good credit, bad credit. Credit cards, credit scores, credit karma, etc. But what does it all mean? Now for the accountants in the room, a credit is the opposite of a debit, obviously. But I’m assuming most of the people reading this aren’t accountants and will never be as fascinated as I am with double entry bookkeeping.
In short, credit means debt. The only reason you need credit is if you want to spend money you do not have.
For the average consumer, the only times you really need to use credit is for large purchases you intend to pay off over time, ideally a car or a house. But here’s a secret. You don’t have to use credit to buy these things. The last time I bought a car, I paid “cash.” Now by cash, I simply mean I used money in my bank account. I didn’t show up with $12,000 in a duffle bag, although that would have been a pretty baller move. See last week’s article for my full rant on the definition of cash.
But my landlord says I need a credit score!
Yes, okay fine. In today’s society, it’s easier to function if you have an established credit score. But WTF is a credit score? Storytime!
Once upon a guy, five guys named Joe were all going through hard times. They went to the bank and asked for a loan of $5,000 each. The bank only had $20,000 to loan out. How do they decide who gets the money? Should they split it evenly? Give 10k to each of the first two Joe’s and call it a day? Give it all to Joe #5?
Banks make their money by loaning out money and getting it back, plus interest. If only they had a way to determine who the most likely person to pay back the money was. If only there could determine someone’s credit worthiness. If only they had, say, a credit SCORE! Now, someone’s credit score has become an overarching measure of how responsible they are, and how much risk you’re taking on by loaning them money, leasing them an apartment, or even hiring them for a job.
Great idea, in theory. But I personally hate credit scores, for the primary reason that I don’t think they achieve their purpose – to measure someone’s ability and likelihood to repay debt. Instead, I’d argue they’re designed to measure how much money the person is likely to make the bank. Furthermore, credit scores aren’t standardized. In the US, there’s three main credit scores with similar secret recipes for determining your credit. However the algorithm is slightly different for all 3, so you don’t have one credit score at any point in time.
These are the six factors in a credit score, what they’re intended to measure, and why I have a problem with them. They’re not weighted equally, so I’ve indicated what weight they hold in a FICO score¹.
- Payment History- 35%
- Credit Usage – 30%
- Average age of credit – 15%
- Credit Mix – 10%
- New Credit – 10%
1. Payment History – 35%
35% of your credit score comes from your history of on-time payments. Banks want to make sure that if they give you money, you’ll give it back (plus their interest). A single late payment will stay on your credit history for seven years. My practical advice to managing credit cards is to make sure you have auto-pay set up for at least the minimum payment. I like to go in twice a month, when I get paid, and pay off my credit card balance. Sometimes though I get busy or I’m travelling and I forget. Keeping auto-pay on will make sure that when I forget, a payment still goes through. If I’ve already made a payment that month, the auto-pay automatically reverts to $0, I didn’t have to set that up.
2. Credit Usage – 30%
Credit scores are a snapshot taken at a moment in time. Your credit usage means, when they took the snapshot, how much of your available credit had you taken out? Let’s say you have one credit card for $3000, and you have a balance of $1,500 when they take the snapshot. That’s a 50% utilization rate. Now, it’s bad for the banks if this is $0, because the more debt you have in total the more you owe other banks, and the less likely this bank is to get your interest money. Most banks & financial blogs like to see a “healthy” credit utilization rate of 30% or less.
If you have a credit card, the balance on it is always changing. You build it up, you pay it off. Looking at a trend of credit utilization might have some merit, but I don’t think a point in time figure is worth 30% of your value as a human being.
3. Average Age of Credit – 15%
This factor gives the banks a history of your credit. It’s the average age of how long you’ve had each of your credit items – credit cards, car loan, etc. A higher number, more time, is better.
My problem is that Joe #4 is a responsible adult. He’s never lived beyond his means or borrowed money. Because of that, he’s negatively impacted by this factor. When he opens his first credit card, this factor will drag his score down. I don’t think that’s fair.
Also, when you close out a credit item, say by paying off your car or student loans, this factor can be negatively impacted. Tell me who that’s good for besides the banks.
4. Credit Mix – 10%
As we were saying earlier, Joe #4 is a responsible adult. He finally opens up his first credit card. His credit mix, well, isn’t a mix, because he only has one credit item. That will be bad for his credit score. Unfortunately, this factor will be weighed even higher for Joe #4, because he doesn’t have payment history or a high age of credit to review.
Joe #3 has a mortgage, car payment, and five or six credit cards. The banks love his credit mix, because it’s diversified. He has all different types of debt! Again, who is this good for besides the banks?
5. New Credit – 10%
Joe #4 decides that in order to help his credit score, he needs to open a couple more credit cards. Unfortunately this also isn’t good for him, because now the banks see a lot of “new credit” all at once, and might start to be less inclined to loan Joe money.
There’s a couple of other factors that aren’t on the list, but also impact your credit2. One of these is called credit inquiries. Everytime you go to open a new account, and someone runs a full report to check your credit score, it dings your score. The good news is that no one can check your credit score without your consent and social security number. (Yes, this means you need a social security number to have a credit score). You are allowed to check your own credit score at any time without it impacting your score. If you set up an account with Mint.com, you can authorize MInt to pull in your credit score for you so you can view it that way. You can also check your score directly with one of the credit bureaus.
Well my friends, hopefully you now have a better understanding of what credit is and how credit scores work.
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