Financial planning is one of the most important parts of life. It gives you the ability to set firm goals and progress toward them at a predictable pace. But it’s not always easy to make sense of the data needed to create solid financial plans. Credit scores in particular can seem intimidating at first and understanding the various types will help ensure that you’re able to properly understand where your finances are now and how to use them to plan for the future.
Credit Reports and Credit Scores
Understanding the types of credit scores begins by looking at how their data is sourced. Credit scores are generally calculated through information provided by credit reports. Credit reporting agencies compile information such as your account balances, existing money owing on credit cards, personal loans, student loans, history of paying bills on time, and many other factors to determine your credit risk. The end result is a report which can be used by credit-scoring companies to generate credit scores through the use of many different mathematical models.
Unraveling the Complex Threads of Credit Scores
You’ll typically discover a number of surprises when you look into your credit scores for the first time. One of the biggest shocks to most people simply stems from the fact that they have more than one credit score. Credit discussions often frame the subject around the idea of a single stable number that’s applied to every individual.
In reality, any given individual can have hundreds of credit scores. And any of them can change on a fairly regular basis. Things get even more confusing when you start comparing your various scores. It often seems like different credit scores aren’t even related to each other. You might seem like a huge risk when looking at one of your credit scores, but seem stable when looking at another. The concept runs contrary to most people’s assumptions about economics. After all, aren’t the scores created by impartial mathematical formula?
The answer to all of these questions can be found by considering why credit scores are compiled in the first place. The scores are created as a predictive metric to help lenders determine the risk factors for any given transaction. Every industry is going to have a different view of any given individual’s financial risk factors and those lenders put different weighting to different aspects of the score which can mean those scores vary significantly from lender to lender. This touches on one of the main points that people often overlook about the credit scoring industry.
Most of the credit scoring industry doesn’t see someone looking into their personal score as a primary customer. Their customers are the companies operating in a lending capacity. And credit scores will almost always be targeted at lenders rather than individuals. But with that in mind, you do have a primary generalized credit score. Though even that number is highly variable depending on which company you’re working with and myriad other factors which might impact things on a day-to-day basis.
How Do Credit Scores Work?
All of these factors center around one specific point. Credit score calculations are done through specific formulas. And much of the data used in those formulas is shared between the various companies performing those calculations. This data can include your history of bill payments, the amount you currently owe in loans, your current credit limit, the size of credit lines, and any other data from your credit report.
These criteria are often quite counter-intuitive as well. For example, imagine that you were making some big changes in your life. You apply for a new credit card, mortgage loan, and start to consider pool loan options for your new home. It’d be natural to start wondering if there’d been any changes in your credit scores during this process. Especially since you might want to take changing circumstances into account when planning out new loans and payment plans.
But when you check your credit scores you might notice a trend and wonder why has my credit score dropped. Drops when researching your financial status can actually happen as a result of loan inquiries and applications. These changes touch on the distinction between soft vs hard credit inquiries. A financial institution is performing a hard check when it checks your credit history before approving or denying a loan. And when you authorize a company to check your credit on your behalf you’re creating a soft check.
The counterintuitive aspect of this process stems from the fact that a hard credit check can actually lower your credit score. One of the more difficult aspects of credit scores is how interlinked various aspects are. This is why it’s important to carefully consider tips to improve your credit score for potential problems. For example, using frequent hard checks from loan applications can pose significant problems. As such, it’s always best to go with soft credit checks when possible.
Credit checks are just one example of how many unexpected pitfalls are out there. And things are made even more difficult by the fact that the exact formulas used by the larger credit industry are often hidden behind closed doors. You can see much of the data going into a company’s system. But how they use those variables is often a mystery.
Types Of Credit Scores – VantageScore and FICO
While this can all seem disheartening, it’s important to keep in mind that while some formulas are secret others are more open to examination. VantageScore and FICO are two of the most popular examples. Each uses a different formula to calculate their credit scores. These methods, also known as a credit scoring model, are synonymous with the companies that created them.
VantageScore was established in 2006 by Equifax, TransUnion, and Experian. VantageScore has stated that its scoring model was the first to incorporate data sources from all of the major credit bureaus. And they also maintain that in doing so they’ve been able to create a more accurate and consistent model which provides a higher level of predictability. The company’s credit scoring models are also known as VantageScore. Though this is more of a banner term that encompasses a large number of additional variations. For example, the company uses both VantageScore 3.0 and 4.0. And each can produce different results.
VantageScore puts special focus on a few different metrics. This includes:
- Credit utilization ratio
- Credit mix (account type)
- Payment history
- Age of credit accounts
In FICO 8, payment history is easily the most important variable. Payment history can account for 35% of a FICO 8 score.
FICO was originally created as the Fair Isaac Corporation. FICO’s credit formula, also known as FICO, is largely recognized as the first example of a credit scoring model. This original creation dates back to 1989. As with VantageScore, there are multiple versions of FICO. All of them incorporate the same data points. This includes:
- Payment history
- Total debt
- Length of credit history,
- Credit mix (account types)
- New credit
Each of these items and related metrics can be weighted differently. This is largely dependent on specific versions or types of scores.
FICO also uses industry-specific models. The banking and auto industry each have their own version of FICO. And different industries also tend to use different base versions of FICO. For example, mortgage lenders use one of the older versions of FICO. This means that mortgage scores are often particularly out of line with credit scores issued for different industries.
The Tip of the Credit Iceberg
FICO and VantageScore are particularly notable for their popularity and history. However, it’s important to keep in mind that they’re still just one of many different credit models currently in use throughout the world. Even the credit bureaus themselves will sometimes offer credit scores using their own custom models.
It’s also important to keep in mind just how often credit scores change. Even the same model might produce different results when run on a different day. And two variants on the same model, run from within the same company, might produce very different results from each other. Even seemingly small changes in a credit report can make a big impact on calculations if a particular model stresses them. And the chance of that happening typically increases with the number of models in use. The end result is that there will always be an element of the unknown within credit scores. But you can still obtain a general idea of where you stand by keeping the points covered so far in mind.
Joining Everything Together with Real-World Situations and Solutions
One of the most important points to keep in mind is that credit scores are ultimately mutable. Different companies and situations will always produce different scores. And you should never feel like you’ve been branded by bad credit. The different types of credit scores mean that you have multiple options which can always be used to improve your overall rating.