My bank said that I couldn’t quality for the lowest rate on my new car loan because I had a low credit score. What does that mean and how do they calculate my credit score? For that matter, what can I do to improve it?
Until relatively recently, “credit” was what your neighbors would extend to you when you were having a tough harvest, a way to ensure that you could feed the family even as the corn in the back forty rotted due to the heavy rains. Now it’s all about big banks, big math, and how much you owe, to whom, versus how much you earn. Credit is big business.
Your bank also didn’t actually calculate your credit score because there are actually three companies –Experian, Equifax and TransUnion — that track all your loans, debt, payments and earnings and each offers its own version of the credit score. Different organizations prefer one over the other in terms of reports and background data.
I know this first-hand as I also just purchased a car a few weeks ago and financed about 75% of the cost. That meant I had to go to my credit union and apply for a loan, a process that relies on credit scores. If you have a good score — a high number — then you will indeed pay a lower interest rate and therefore pay less money in the lifetime of the loan than if you have a lower score.
It makes sense from the bank’s perspective because their calculation is all about risk. What are the chances that you will default on the loan, won’t be able to pay it off, or will bail part way? High risk produces high interest rates, while very low risk yields the best possible rates.
Experian, for example, generates both FICO and VantageScores with a range from 300-850. Anything 700 or better is considered good and if you’re above 800? You’re a personal money management star. Below 550 and you’ll find that you won’t be able to qualify for most loans and might even have credit card companies yank your cards or charge you 21% interest or higher.
Government data suggests that 50% of American adults have a credit score of 700 or higher, while only 13% exceed 800 and 7% are below 550. Heck, US News reported earlier this year that credit scores are actually increasing, of all things!
But how is that FICO score calculated? Here’s a handy graphic from Cafe Credit to consider:
Payment history answers the question: do you pay your bills on time? If you’re seeing late fees then that by itself can be adversely impacting your score. The other big factor is how much money you owe, in particular versus your income. Not only that, pay attention to the available credit on your credit cards too: If you have a $5,000 credit limit and owe $4,300, you’re in worse shape than if you had a $15,000 limit and owed $5,900. Zero balance cards are your friend in this instance too.
How long you’ve had credit and how well you’ve managed it are also factors, which means if you’re just entering adulthood, it would be smart to get a credit card and practice paying it off every month. A modest loan for a used car that you can consistently pay when due will also help grow your credit worthiness.
Like it or not, that FICO credit score is going to continue to affect your life, whether it’s a credit card application, a car loan or a house mortgage. Now’s the time to find out what your score is, check your reports at Equifax, Experian and Transunion, disputing anything that’s inaccurate, and start growing your score. You’ll thank me in a few years!