Does a Credit Score Indicate Responsibility or Profitability?
Your credit report provides banks and lenders with a snapshot of how you have managed credit in the past. If you are someone who has at least one credit card, a car loan, or a mortgage on a house, your credit score indicates to potential creditors on whether you have been reliable in making payments on time and for the full amount. Your credit report also informs creditors about your total outstanding debt and the available credit you can utilize.
Individuals with a FICO credit score above 750 typically enjoy lower interest rates, saving them a considerable amount of money over the course of their loans. A higher credit score suggests that you have been responsible in your past debt payments and are likely to remain so in the future.
The Evolution and Calculation of Credit Scores
The concept of the FICO score was introduced in 1956 by engineer William Fair and mathematician Earl Isaac through the company Fair Isaac and Company. While there are numerous variations of the FICO score, all operate similarly by assessing a consumer's past performance and part of their current financial condition to determine their creditworthiness.
The most critical factor is the payment history, which accounts for approximately 35% of the score. A single 30-day late payment can decrease your score by around 25-35 points. However, the impact of a single delinquent payment diminishes over time. After two years, the influence of a single late payment becomes negligible provided other factors remain constant.
Impact of Low Credit Scores
Individuals with a low credit score, generally below 620, often exhibit a recent history of delinquent payments within the past two years. As a prospective creditor, seeing several 30-day late payments in the past two years would cause significant concern. This pattern suggests that future late payments are statistically likely, and thus, I would be reluctant to extend credit to you.
Understanding Credit Utilization
The amounts owed or credit utilization, which makes up 30% of the FICO score, refers to your credit card balances as a percentage of your credit limit. Having a credit card used near its limit can lead to a decrease in your score by 50-75 points. Managing your credit utilization effectively is crucial since it can indicate whether the consumer is financially overextended.
How Long You've Had Credit
The average age of accounts (AAoA), which represents 15% of your score, reflects how well you have managed your accounts over an extended period. Keeping older accounts up-to-date demonstrates a long-term history of responsible borrowing. The misconception that a FICO score is an "I-love-debt" score is inaccurate. High scores can be achieved by consistently using credit cards instead of cash without incurring interest.
High FICO Scores and Lender Profits
One might wonder if a high FICO score signifies how profitable a borrower can potentially be. Indeed, since consumers who receive credit in the form of a credit card, car loan, or mortgage and make their payments as agreed, generate more profit for the lender. The cost of dealing with delinquent borrowers is significant, as reflected in the credit score system.
Addressing Unfairness in Credit Scoring
Many people express dissatisfaction with the credit scoring system, often citing it as unfair. However, in my 30 years of experience in finance, all such complaints have come from individuals with low scores due to a history of delinquent payments. Fortunately, low credit scores are not permanent. Anyone can start improving their scores today. Late payments from a few months ago will still appear on your credit report for up to seven years but their impact becomes minimal after two years—assuming there are no new delinquencies during that period.
I hope this provides a comprehensive understanding of how credit scores work and their role in both indicating responsibility and influencing profitability for lenders.