Investment Glossary – Credit Score
Let’s be really clear on what a credit score is and what a credit score isn’t.
A credit score is a numerical measure of how well you have used credit in the past, based on criteria set by credit bureaus that develop formulas to measure your score. I like to compare a credit score to how skilled a person is at any particular specialization within a field. Here’s an example – let’s say that you are a pastry chef. You bake really, really good pies, cakes, and all kinds of other desserts. You’ve been written up in Pastries Quarterly (which I hope exists), and have all kinds of accolades. If you walked into any restaurant in the country, you could get a job making pastries.
But you probably couldn’t get a job cooking steaks. Why? Because you haven’t been playing the steak game.
What the heck does this have to do with your credit score?
If you aren’t involved in using the credit system, you represent an unknown risk, and as such, it’s more difficult for lenders to get a handle on your ability to repay debt over time. Credit scores are supposed to represent one part of the puzzle as lenders sort through whether or not they want to lend you their money.
So credit scores have five major factors that help lenders to figure this out:
- Payment History
- Amount Owed
- Length of Credit History
- New Credit
- Types of Credit
So if you show up at a bank asking for a loan, one of the first things that bank is going to do is run your credit report. It helps to give them an overview of how much debt you have outstanding, how consistently you pay your debts, and how long your track record is with paying back debt.
Now, if you’re just opening up a new credit card with a low credit limit, a lack of credit history and a low credit score isn’t going to hurt you very much. If a bank extends you a $500 line of credit on a card and you don’t pay them back, they aren’t going out of business – at least not if they run the rest of their business well. But if you show up to the same bank and want a mortgage for a $700,000 home, and you have no credit history, underwriting the loan is obviously going to be a lot harder. That’s a much bigger problem to swallow for the bank if they loan you all that money and then you don’t pay them back. They don’t want to be in the business of selling foreclosed houses.
There are things that lenders can do to make loans to you if you have a lack of credit history. They can look at your income, other assets you may own, and other financial information. And in some cases, they will even underwrite loans using this information, provided it is strong enough to offset your lack of standing in the credit system. But this takes us back to the beginning – if you want to be able to gain access to larger amounts of credit in the future, you have to participate in that system. You can do so in ways that don’t change your spending habits, such as paying off your credit card every month, but you have to participate in some way for your score to start moving in the right direction. And there are a ton of ways you can look to boost your score as you start to navigate how credit works.
So think of a credit score as your reputation for paying back your loans to banks and other institutions that have lent you money. One small mistake isn’t going to be held against you forever, but it’s nearly impossible to have a good score if you don’t have a track record to begin with. However, bigger issues such as bankruptcies can affect that reputation at a deeper level for a longer period of time. So in addition to earning a good, consistent wage, responsibly participating in the credit system on your own terms is key to starting to build the history needed to borrow money effectively.