Am I Obsessing About My Credit Score?

If you are asking that question then you probably already know the answer…

Do credit scores predict whether I’ll pay or not? Let’s be clear about what a credit score is.  At its heart a score is a mathematical algorithm that predicts based on past information the likelihood that you’ll pay better or worse than the next guy (or gal). It will not predict whether you’ll pay a specific debt.  A score is most often an expression of odds of repayment for people who have that specific score. So for example a certain score may indicate that out of 100 people 1 of them won’t repay.  Will you be the one?  There’s no way to tell.  Lenders may or may not want to take that chance.  Lenders assess the risk they’re taking by weighing the odds in the aggregate (a whole bunch of loans together).

Does a high credit score make me a better person? Let’s not get carried away.  Sure it’s an indication that you pay or bills on time and manage you’re debt responsibly.  But that’s only one aspect of who you are.  I’m not trying to get philosophical about this.  Lenders used to talk about the 3 C’s of credit, capacity, collateral and character. Capacity is whether you have the wherewithal to repay what you’re asking for.  Do you have an income? Is what you’re asking for in line with what you can afford?  Collateral doesn’t necessarily have to be pledged to the loan but an assessment of whether there are other sources of funds if things go bad.  But how do you measure character?  Whether lenders think the person will repay because it’s the right thing to do?   You could argue that a credit score is at least some measure of character since it’s based on past behavior but it’s not really what it’s designed to do.

I guess I shouldn’t rest until my score is 850, right? While it’s true that the higher your score the lower risk you represent  to lenders, there’s a point above which you become so low risk that there’s really no point in obsessing over it.  What is that score?  As you’d expect there’s no clear cut answer for at least two reasons – 1) each lender will have differing approaches to the market and will be more or less willing to take scores  above a given threshold and 2) it’s a moving target.  There was a time when a 720 would allow you to pretty much pick your lender.  Today because consumer risk profiles have shifted, that’s more like 760. It’s doubtful you’ll get a roomful of lenders to agree on a number but if you have an 825 it’s probably not worth sweating the last 25 points.  I just wrote about this for Mint.  Read the article here and you can see WHY you’ll never hit 850.

Will increasing my credit score 20 points dramatically reduce my borrowing costs? Maybe.  There are two things at play here.  The first is that scores aren’t linear, in other words 20 points at one place on the scale isn’t the same as 20 points at a different place.  As mentioned above scores are a representation of odds of repayment.  Typically scores are scaled so that as the score moves up a certain number of points, the odds double (moving down the same number halves the odds).  What this means is if you already have a high score and you go up 20 points you simply move from a really good risk to a ridiculously good risk.   Or if you’re staring at a low score you’ll simply move from awful to marginal. The other important factor is where lenders are making make or break decisions – usually in the mid range say between 680 and 760. 20 points here could mean getting a loan or not or getting better terms.

Understanding what credit scores are designed to do and how lenders are actually using them to make decisions will help put your score in context and help you make more reasonable informed decisions.

John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a Contributor for the National Foundation for Credit Counseling.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry.  Follow him on Twitter here.

Categorised in: Credit Cards, Credit Report, Credit Score, Debt, Getting Credit, Improving Credit, Money & Identity

This post was written by John Ulzheimer