The Credit Score Demystified

The credit score.  How does thing work and how important is it?  You may know what it is, but do you know what it’s not?  This week I’m going to break down for you exactly how this sacred cow of finance works, how to understand it, and also challenge a few assumptions you might have about it’s importance.

Hate The Game, Not The Player

It seems like everyone these days is living under the shadow of their credit score.  They’re playing a balancing act trying desperately to keep their score good, and even if it’s good they are trying to make it better!  It’s a never ending cycle.  We’ve been told in our society that you can’t live without a good credit score and you are unfortunately stuck in this never ending battle, but how important is the score really?  To understand this we need to first understand how it works.

Knowing Is Half The Battle

The credit score is generated by a company called FICO which stands for Fair Isaac & Company.  They are an agency independent of the credit reporting agencies (Experian, Equifax, and Trans Union) that take the activity reported by them and generate a score based on that activity.

From FICO’s own website here’s exactly how the score is calculated.  It breaks down to 5 factors:

  1. Payment History – 35%
    Paying on time, late, 6o days late, in collections, etc?  This is the most important factor.
  2. Amounts Owed – 30%
    How much balance are you carrying on all these debts?  That’s the second most important factor.
  3. Length of Credit History – 15%
    Only 15% of your score has to do with how long you’ve been interacting with credit.  Contrary to popular belief the fact that you are new to the game is not as big of a factor as it’s hyped up to be.  This gives new perspective to the arguments about getting a job, a first apartment, etc.
  4. Type of Credit – 10%
    Is your debt a student loan, car, credit cards, etc?  It only matters for 1/10th of your score.
  5. New Amount of Credit – 10%
    Racking up new credit fast?  It can hurt your score, but not that much.  Probably because they want you to keep taking more…

It’s important to understand that just like any score this is only a reflection of your activity not your actual understanding or strength areas.  You are not a math machine and this score doesn’t factor in your behavior just the results of your behavior.

Remember cramming for a test in school?  Getting a good score showed you got the answers right but it can’t prove you actually know and understand the material.  Likewise, paying your bills on time doesn’t mean you are responsible with money.  It only shows you are good at paying bills on time.

What’s Missing

Now that you see how the score is calculated and what it represents can you tell what’s missing?  That’s right… anything that’s not debt!  See, we have been told that this credit score is a financial score and if you don’t have a good one you aren’t good with money.  I’m here to tell you that is a bold face lie sold to you by those who want to sell you credit.  Credit is a product.  It’s simply other people’s money.

Guess what, if grandpa dies and leaves you money, if you get a raise, or if you manage to save some money….  NONE of that affects your score one single point.  You can be a multi-millionaire or a bum on the street and have absolutely no score (note: not zero but non-existent) unless you choose to interact with debt.

So, I’ve got good news for you… Your days of living under the shadow of your credit score can be over.  I have been debt free coming up on 10 years.  I haven’t had a single open credit account.  No cards, no car loans, nothing.  I’m doing just fine!  Great even!  Debt is not worth the risk.

I don’t live in a hole and only come out on triple coupon Thursdays.  I interact with everything that everyone else does: flying on planes, renting cars, having insurance, owning a cell phone etc. etc. all without a credit score.

 

So, I leave you with this last thought. How much simpler would life be if your finances were streamlined and you didn’t owe anyone a single cent?  The grass truly is greener on the other side.  I hope you decide to join me.

For more thoughts and information on this topic read my other post “Is Your Credit Score Deceiving You?” here.

 

Question: What would it feel like to live without the weight of your credit score?  Share in the comments below!