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Understanding Credit Scores

December 03, 2008

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As the economy continues down its volatile path, keeping a watchful eye on your credit score is more important than ever. But simply watching your credit score isn't enough. You have to understand how credit scores work and how using your credit can affect them. This is easier said than done.

Understanding how credit scores work is complicated. When you apply for credit, increase a credit line or make a late payment—all these things can affect your score. And to make it even more complicated, these actions have different effects on lower credit scores than they do on higher ones.

To better illustrate the point, let's look at some actual credit scores* and see how "credit events" affect each differently. For obvious reasons of privacy, let's just call them "Jane and John Doe." Jane has always been great with her money and how she uses credit. Her score is 793. John, on the other hand, has had some trouble in the past with how he deals with money. His score is only 576.

Getting a New Credit Card — Jane 793 to 791, -2 points. John 576 to 557, -19 points.
Let's start by looking at what happens to the Does' credit when they add a new card with a $15,000 limit to what they already have. In Jane's case, she already has several credit cards and adding a new one barely changes her score, but not so for poor John. If John could even qualify for a new card, it will cost him19 points against his credit.

Increase Credit Limit of Credit Cards by $10,000 —Jane 793 no change. John 576 to 612, +36 points.
Jane already has several credit card accounts, so increasing her credit limit by $10,000 doesn't change her score because her credit card utilization is already 0%. As for John, the extra $10,000 in credit line lowers his credit card utilization significantly and therefore boosts his score by 36 points!

Closing Oldest Account — Jane 793 no change. John 576 to 558, -18 points.
Established credit accounts are great for showing credit history and adding numbers to your score. For Jane, who has a long line of established credit, closing an old account has little or no effect. But for John the results are damaging. Closing his oldest account costs him 18 points because he loses any good credit attached to it. And it doesn't work both ways. If you close an account with a mediocre history... that history stays with your credit score.

Paying Off All Credit Card Debt — Jane 793 no change. John 576 to 615, +39 points.
Jane always, always pays off her credit card debt and carries no balance on her cards. This doesn't change a thing for her. But for John, it's a big benefit. Paying off all of his credit card debt raises his score by 39 big points and goes a long way to establishing good credit.

Increase Credit Card Debt by $10,000 — Jane 793 to 769, -24. John 576 to 556, -20 points.
This is where Jane's good habits actually hurt her score more than John's. By increasing her credit card debt by $10,000, her score drops more than John's because she had no debt prior to the $10,000, whereas John has some preexisting debt.

Allow 1 Monthly Account To Become 30 Day Past Due — Jane 793 to 759, -34. John 576 to 558, -18 points.
Poor Jane, she's had a bad month or two and misses her first monthly payment. For John, this is old school. This will hurt Jane more than John because a 30-day delinquency for someone with no prior problems is an early warning of default risk and changes her score by -34 points, almost double the points that John will lose.

Have On-Time Credit History for 24 Months — Jane 793 no change. John 576 to 595, +19 points.
This is John's moment to shine. By paying his bills on time for 24 months he can increase his credit score by 19 points. Paying bills on time for 24 months does not affect Jane's score because she has paid her bills on time for over 10 years, establishing a great credit rating.

Credit and credit scores have always been cryptic and difficult for consumers to understand. Whether you're like Jane or John Doe, it's important to get control of your credit, especially in these days of economic uncertainty. Hopefully by demystifying the information, you can see how using credit wisely can go a long way toward building your financial health.

The credit score changes in this article are based on Credit Karma's personalized credit simulator.

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I filed bankruptcy in February 2010 after job issues and struggling to pay the bills. I have a new car loan (June 2010) and a credit card with a limit of $500 also new. I put an occasional lunch on the credit card and pay it off each month. I have a credit score on this website of 623. My question is...I filed against my current mortgage so will have to vacate the premises sometime next spring. I have been saving for a down payment on a new residence. What are the chances of me getting a new mortgage as early as next spring?

pfishpop 10 months ago

Based on feedback from some mortgage brokers, the answer is unlikely.

CK Moderator

I have two questions. First (and less important one here). I actually ordered my credit score from Transunion. The page said I would be given a "personal score" and this score may not be the one used by lenders. This seems to be an understatement worthy of the hall of fame. It gave me a score of 843(!!) whereas my score here is 704. It ranked me in the 65th percentile, which is close to what creditkarma reports which is 63rd percentile. But, what value is this score of 843??? Is it actually used by anyone?

yirgster 10 months ago

That score of 843 sounds like a Vantage score (range up to 990). What you have to understand is that lenders decide which score to use and there are dozens of scores in the marketplace. As a result, no one can guarantee the score they provide will be the one used by the creditor. With that said, you should take comfort in the relative changes. As you pointed out, you are in the 65th percentile of one score and the 63rd of another. Very close and should have the same meaning to a lender regardless of the model.

CK Moderator

Second question. I have 3 credit cards. My credit card utilization is 22%. Two of the cards have a combined balance of $29,000. The other card carries a limit of $33,500 but its reported on my credit report as 0. I called up the card company, Citibank, and they said this was because a feature of the card is that it has no preset limit since I can exceed the $33,500 without being it being reported to the credit agencies. And, according to them, this is why it shows as $0 on the credit reports. But, they said, the credit agencies understand this. (I find this hard to believe.)

The service rep said if I wanted a to have a limit reported I would have to cancel this card and open a new one. But, I've had this card for 17 years and an absolutely clean history on it.

So, my questions: (1) is it true that the credit agencies "understand" a $0 limit on a revolving card?

(2) If not, what can I do about this that won't adversely affect my credit score. (The simulator said that if I opened a new card with a $5000 limit my score would drop 2 points.)

Thanks!

yirgster 10 months ago

Different credit models account for "no-limit" cards differently. Right now, there shouldn't be an adverse affect unless you are at 30-50% of your limit. Add a new credit card with a limit may be the best thing in the long run even if it drops your score a few points in the near term.

CK Moderator

Yet another question. Would or could removing hard inquiries that shouldn't be there help my score. One inquiry was actually made but shouldn't have been. The other I'm completely puzzled by.

Here are the circumstances for the first: we were looking to buy a house in 2008 (just before the crash, naturally) and from 03/06/2008 through 10/21/2008 the loan broker pulled credit 4 times. (I didn't realize what this would do.) However, the last time was over a month after we closed!!

So could it help--even a couple of points--to have this removed. Transunion reports 6 hard inquiries and equifax 7, the 7th one is completely unknown to me.

yirgster 10 months ago

It is wrong you should look into it. As for the score, there probably won't be much of a difference between 6 and 7.

CK Moderator

Mr/Ms CK Moderator: Thank you for your very informative (and quick!) replies!!!

They are very much appreciated!

yirgster 10 months ago

I would like to add a comment from my personal experience with credit scores and trying to refinance our home. I'm not saying this is true for everyone or even for most. But it's been true for us. It was also true for our original loan.

(1) In every case the loan originator has pulled the scores from all three big agencies for both my wife and I.

(2) In every case, the score used to determine what loan/interest rate we qualify for is based on the one LOWEST score of the six. There is NO averaging, etc.

(3) The lenders--at least the folks we deal with--are super rigidly strict with respect to the score needed to qualify for a specific loan. So, you can't say (we've tried): "But look at my other scores. Look how unreasonably I've been treated by this agency."

The consequence of this as I see it is: a SMALL difference in your credit score can make a HUGE difference in what mortgage you qualify for from a particular lender.

Here's a real life example: my FICO pulled directly from equifax is 679. (Equifax says this is "poor".) But a 680 is needed to qualify for mid-tier mortgage pricing for the loan amount we would need from Wells Fargo. Low tier pricing doesn't help us. We were told in no short terms that there was no possibility of making an exception. (Sure, if you're friends with the VP of mortgages I'm sure you'd get an exception made. But somehow none of our friends have made it into that august category. I better speak to them and tell 'em to get going!)

ONE point we're talking about!!! (Yeah, we're going to see what other lenders have.)

yirgster 10 months ago

I am also apply for mortgage to purchase a home. I checked with HSBC, TD BANK, Chase, and some local community banks like FIRST AMERICAN INTERNATIONAL BANK, Atlantic Stewardship Bank, etc. Our findings show that Wells Fargo has the strictest criteria to approve a mortgage. That's why they would not average out the credit score from all 3 agencies but use the lowest score to make the customer paying the highest interest rate. The loan officers that give me info are supposed to base on their understanding of the underwriter's guidelines. Even making friends with the president of a bank should not has any help for the underwriter to approve your mortgage application.

I heard that the local and smaller community banks and credit union would be more flexible in the process of mortgage application.

Don't forget that whatever quoted to you by the loan officers of either a broker firm or by a lender would provide no gurrantee. They are just sales persons lure people to pay the application fee and start the application process. They are not responsible nor care if you can be approved or not because they can easily blame of the underwriter who actually process and approve/deny your application.

Just be careful with what these loan officers said to you before making them put the info down in writing.

wonwon 10 months ago

I have a lot of closed charge accounts on my credit report. Should I have them removed? Can I have them removed?

jbaxter7 10 months ago

If they are accurate, then can not and should not be removed.

CK Moderator

Thanks very much to unfold the mystery of credit score. Great article with good examples. I have asked around for 2 years about this kind of info from bankers, friends and internet but not very successful.

Question 1: How would the credit score be affected if I consolidate 2 credit cards and combined the credit lines into one card? That means I would have fewer number of cards but same credit line. Would that help to increase my score at all? I need to have higher score to get the best mortgage interest rate ASAP. If that wouldn't help, what else can I do? I already used your websites Tools and calculators and tested on the credit simulator.

Just for my background: I got 791 from CreditKarma and 685 from Quizzle.com (a big difference that is unexpectedly more than 50). In Aug 2008， I had 14 credit cards (on my name) and an additional of 5 credit cards (Joint account with my spouse) and the total credit line for all 19 cards were $320K. At that time, my FICO score was 734 (free from the Juniper Credit card）.

However, after the economic tsunami, the bank of america suddenly slash 50% (value of $110K) of my credit line of the 5 credit cards with them even though I have paid on time and paid off balance every month for years. They use ridiculous excuse by saying that I don't seem need the large credit line because my average spending was only a hundred or two each month even though every year I had intentionally accepting their 0% balance transfer money into my savings account (varies around $50K to $90K each）and paid them off in a few months just to create some activities. Never late and never spend over limit.

Question 2: Recently I have decreased the number of credit accounts into half by closing some accounts on my own request. I now have only 12 credit card accounts (7 individual credit cards and 5 joint cards) with $280K credit line. I only have $50K balance on one card now. Am I considered low or high credit card utilization rate? (should I divide $50K by $280K to get the utilization rate? Is it 17.8%??)

wonwon 10 months ago

Lots to answer with these questions. We will try to group them into our Q&A section.

CK Moderator

What is a score of 661 considered?

emigar20 10 months ago

I'm not sure what a score of 661 means? The report says that my score is fair. How can I obtain an higher score. Maybe having a credit-card will improve my score rating yes are no?

smoochies 9 months ago