Finance Definitions: Credit Scores

Once again, guest blogger Mitchell Pauly takes us on a financial definitions ride through his fun, funny and informative take on finance definitions! This week’s def: credit scores.

Credit scores get a lot of press here in the financial world; so much that you would think all of us finance folk are forced to swear an oath to hound every soul we meet about the importance. Not so. Look, credit scores are like butts…we’ve all got one (lamest...joke...ever...). But people tend to obsess about their credit scores, subscribing to (which is not free, by the way), anal-retentively paying their bills on time and fretting over every conceivable incident that could possibly find its way over to FICO. I have a friend who broke up with a girl over her credit score. No joke. So what exactly is a credit score, and how much should we obsess?

What a Credit Score Is

Credit scores are statistical measures of your credit worthiness, which is why lenders such as banks and credit card companies check them almost as religiously as priests check donation plates. They want to minimize bad debt, or the money they lend out that they never see again. When you fall behind in your payments your credit score gets dinged, but when you fall behind on payments with some of the local lenders I grew up around you ended up getting dinged (but I digress…). Lenders use credit scores to determine who qualifies for a loan, which interest rate they merit and what their credit limits will be. So having a good credit score can help you qualify for a loan at a good rate, potentially saving you untold amounts of money.

Behind the Curtain

There are three major credit reporting agencies: Equifax, Experian and TransUnion, which sound like a fax machine, travel agency and money transfer company. But no, they are the three companies which most frequently determine your financial worth in the eyes of lenders. They all use some version of the methods developed by Fair Isaac, a company that, pending which end of the credit score spectrum you are on, either is indeed fair or is the most ironic name for a company ever.

Fair Isaac is the developer of the FICO model, which has a credit number scale of 300-850. What this means to you is that you have three credit scores, one from each agency, but they all use the FICO model and should all be relatively the same. Any differences in score between agencies are due to deferring information and can be corrected with a phone call.

Thick and Thin

Credit scores are unofficially divided into “thick file” and “thin file” categories. A “thick file” score is one with a long history, and a “thin file” score is the one with a short history (like Justin Bieber’s career). This thick and thin division is usually done after a lender looks at your overall score since they likely have minimum credit score cut-offs for applicants. A lender wants a “thick” file, high credit score applicant most.

Most people think that the score is the end all be all; that once a high score is achieved all credit cards should be frozen in a block of ice and put in the freezer**. Not true. In order to build a “thick file” score, you need to use the credit made available to you, at least in part. Fill your car with gas using your credit card and pay the bill off in full every month, for example.

Should you obsess about your credit score like my dog obsesses about his ball? The answer is probably no, unless you have a score below 723 (the median score in America for 2010). Easy ways to ensure you build an excellent credit score include setting up automatic bill payments, disputing anything that may ding your credit score and using a credit card every month (paying it off in full). If you need cash before your score is increased, though, one way to convince a lender to overlook your credit score is to offer a large down payment on any item needing financing.

So credit scores are important but should be viewed as much of finance should be: as a means to an end, a facilitator for the most important aspects of our lives. Fair Isaac doesn’t have an algorithm for that stuff.

**A great strategy for the credit card inclined; freezing your card does not ruin it but gives you plenty of time to think your purchase over while it defrosts. Microwaving ruins the card.

Mitchell Pauly is a Financial Professional with experience working for Fortune 500 companies and small businesses. He enjoys investing and personal finance, comedy and sports. In his spare time he writes for various publications about personal finance, with a mind towards young adults and parents of young adults.

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Financial Definitions - Glossary for Understanding Finances wrote:

Thu, 01/19/2012 - 21:46 Comment #: 1

[...] Bonds C Capital Gains Carrying Costs CDs – Overview CD Ladders Compound Interest Credit vs Debit Credit Scores Current [...]

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