It is common knowledge that credit scores play a significant role in many of our financial decisions these days and can impact your payments on a variety of different things. From obtaining a mortgage to buying insurance, credit scores do not tell a lender if you can afford to pay a debt but they do look at credit scores as one indicator of the possibility that might not repay a debt.
Of course, credit scores are determined by many, many factors, but there are some common myths and misunderstandings that can create confusion and will sometimes even lead people to take actions that are not in their self-interest. Here are two of the most common confusions and the facts to clear them up.
There are hundreds, maybe thousands, of credit scoring models.
With the proliferation of companies and websites that will now allow you to review or monitor your credit report and credit scores, there are now many, many different algorithms being used to calculate scores in varying ranges. So, while the characteristics of your accounts and histories that show up on multiple credit reports may all be the same, these systems may weigh these characteristics differently, which results in different credit scores.
The reality is it does not matter what scores you see when you check your credit online because different industries and even different companies within those industries will use different algorithms. For example, each of the three main credit repositories used by mortgage lenders (Experian, Equifax, and Trans Union) have a handful of different scoring models that are acceptable within the industry and those models can provide considerably different scores for the same credit report than models used by, say, a car loan lender.
The point here is this: do not pull up a credit report online, look at the score, and assume that will be the credit score that a lender (any lender) will be looking at as well. Use online tools to review the creditor and account information for accuracy. That is the true benefit of monitoring your credit report, not any scores those services may offer.
Credit Usage is a Big Deal
While it is possible to have too much available credit in the view of a credit scoring algorithm, that is not as common a factor as what percentage of your available credit is being used. This applies only to revolving credit like credit cards, home equity lines-of-credit, retail store accounts, etc. Closed-end loans that cannot be reused do not apply.
If you are using a high percentage of your available credit you will likely receive a significant penalty to your credit score. The less you use, the lower the penalty. This is calculated in the aggregate, so not account-by-account but as a total. Of course, it is always a great idea to carry as little debt as possible, but one of the significant thresholds in this case is 50 percent. If the balances you are carrying equal more than 50 percent of your available credit, the penalty is relatively high and only gets higher as that percentage increases.
Please do not rush out and get a bunch of new credit based off this blog post! Each situation is different and the preferred method is to pay down the balances on your credit cards. That being said, one tactic to reduce the impact of high usage is to increase your available credit. This could open you up to other hits on your credit score. Any new credit typically results in a temporary, small negative adjustment to your credit score and there could be other consequences as well.
Your credit is an important part of your financial situation. It is imperative that you check your credit every so often to ensure that the information reported is accurate. By Federal Government mandate, all Americans are entitled to a free annual credit report from each of the three main credit reporting agencies. If you have not already done so in the previous twelve months, you can obtain your free report at https://www.annualcreditreport.com.
As always, if you have any questions or if there is anything I can do for you, please do not hesitate to contact me at your convenience.