Most of us acknowledge, and live with, the critical link between credit and happiness. Lifestyle has become increasingly dependent on leveraging everything from our homes and cars to our small businesses and even future inheritances. Borrowing is okay as long as you can pay your loans back, but as the recent subprime squeeze has illustrated, it’s easy to end up under water and almost as fatal as death by drowning.
How we behave as borrowers is reflected in our credit scores as determined by three national credit bureaus—Equifax, Experian and TransUnion—all of whose models are based on a profile developed by a company called Fair Isaac, which created the FICO score. That score is not a constant but a moving target, influenced almost every time we make a purchase using credit, are late paying our mortgage or Visa bill, or simply take on more debt. Some of us are so obsessed with our credit scores (if you don’t know yours, go to www.myfico.com) that we check our number monthly, and with good reason. Creditors make use of our scores to help make decisions on future loans—your credit limit could be increased or reduced, the rate of interest you are paying could be changed, all while you’re sleeping (literally or metaphorically). Insurance companies, landlords, car dealerships, credit card companies, and even cell phone companies are continually using credit scores to make decisions about consumers.
Scores range between 350 (extremely high risk) and 850 (extremely low risk). A score below 700 generally means you’ll have some difficulties when seeking credit. Below 650, even more resistance. Above 750 is where most of us try to land. The bar graph shows a breakdown of score distribution for Americans in 2003, as supplied by Investopedia (a Forbes media company).
While almost everyone may know his or her FICO score, what is less known is another metric used by institutions to measure your credit—a numerical 0-9 rating scale. Not that we need something new to angst about, but every piece of information makes us smarter consumers. On this numerical scale, each number is preceded by one of two letters—“I” signifies installment credit (such as home or auto financing) and “R” represents revolving credit (like credit cards). According to Investopedia, you might have an R1 rating with Master Card (the highest level credit rating) but an R5 with Visa because you haven’t paid your bill in several months. A blend is taken in determining your overall creditworthiness. Here is how the scale is defined, according to Investopedia:
R(0) or I(0) – You are new to the credit world and have insufficient credit history for making an accurate judgment of your future risk.
R(1) or I(1) You pay your credit back in one month.
R(2) or 1(2) You pay your credit back in two months.
R(3) or I (3) You pay your credit back in three months.
R(4) or I (4) You pay your credit back in four months.
R(5) or I (5) You have not repaid in four months, but you are not a “9” yet.
R(7) or I(7) Your debt payments are made under consolidation.
R(8) or I(8) Debt was cleared by selling the item (repossession).
R(9) or I(9) You officially have bad debt (you’ve defaulted) which usually means it is uncollectible.
Credit rating agencies determine your credit score (whether the numerical scale or FICO) based on five behaviors: 1) your credit performance; 2) your current level of indebtedness; 3) the length of time you’ve had credit; 4) types of credit you use; and 5) how actively your pursue new credit. While all of these determine creditworthiness, they are not given equal weighting. According to Investopedia, the pie chart shows the prime importance of previous credit history and current level of indebtedness.
Coming in our next article…tips to improve or maintain a good credit score. It’s no longer enough to understand the meaning of caveat emptor (buyer beware). It’s now mutuo caveo—borrower beware.
