We spend a lot of time worrying about our credit score. Credit repair is a billion-dollar industry. Having a poor credit score can cost us tens of thousands of dollars over the life of a mortgage or deny us a personal loan just when we need it most. Credit scores are important, so it’s no surprise that we would do everything we can to get and maintain a “good” or “excellent” credit score. But, what does a credit score really measure? What does that number represent and what does it say about you? When a lender looks at your credit score, what does that number tell them?
What do credit scores measure? What does a poor credit score mean? Today, we’re going to explain what that three-digit number really means. What does it tell a lender?
What does your credit score say about your character?
I have spoken with people who say that the credit score represents their integrity or their trustworthiness as a person. It shows other people that they will pay back their obligations. In short, these folks think a credit score is an estimation of them as people.
This is just not true. And it’s kind of disturbing, actually. To think that you as a person could be defined by a three digit number. So, if a credit score isn’t an accurate reflection of your character, what is it? Maybe it’s simply a measure of your likelihood to pay back a loan.
That might be a bit closer to the truth, but–believe it or not–that’s not right, either. The credit scoring models are actually meant to quantify the percentage of people who are likely to default on at least one credit account within the next 24 months. That sounds a little convoluted, so let me give you an example that will hopefully make it a bit more clear.
Example of default rates by credit score band
Imagine a large group of people who all have an 810 credit score, which is functionally a perfect credit score. Yes, the maximum score is 850 in most cases. In this hypothetical case, 0.2% or 2 out of every 1,000 people with a “perfect” credit score will default on a loan in the coming 24 months. People who have a credit score 40 points lower, a 770, will default at twice the rate: 0.4%, or 4 out of every 1,000. It doubles again for every 40 point drop. So, 0.8% of people with a 730 will default and 1.6% of people with a 690 will default. These, of course, are low numbers, which explains why a credit score above 700 is considered “prime” or “good” credit.
But the doubling really impacts lower scores. 3.2% or 32 out of every 1,000 of people with a 650 will default. The doubling continues so that 6.4% or 64 out of every 1,000 of people with a 610. Almost 13% of people with a 570. And nearly 26% of people with a 530 credit score will default on a loan within the next 24 months.
Why a bank denies people loans
This explains a lot, doesn’t it. If a bank charges 6% interest on a mortgage, you can see why they would be hesitant to lend money to a group of people where even 2% of them are expected to have trouble paying bills within a couple of years. It’s hard to make money when there are some out there who can’t pay back the principal, much less pay the interest.
But, here’s another way to look at it. A vast majority of people with a 530 credit score will still meet their obligations in the coming 24 months. If you have a “poor” credit score, it doesn’t actually say you won’t pay back your obligations, it merely says that a percentage of people with similar credit histories to yours will struggle. And, let’s remember, struggling to pay those bills may not have anything to do with “irresponsibility.” People can struggle to pay their bills because of losing a job, medical problems, or other unexpected expenses.
Credit scores are a collective measure
Credit scores are a way to group similar credit histories. Lenders estimate the percentage of people in the groups that are likely to default. Most of the people won’t default, even those with lower scores. While lenders look at the score and have a good idea of what their groups’ default rate is, they can’t know whether Jill, or Tom, or Sophie, or Frank will be the one to default.
Focus on what you can control
Finally, remember that credit scores are rear-view mirror metrics. They are looking at what has happened in the past. It makes sense that credit scoring agencies are looking at things like late payments, accounts in collections, utilization rate, and similar values. Those things are likely to predict whether someone will struggle with a future bill.
So, if you are working on your credit score, focus on the things that will show the credit scoring agencies that you are a low credit risk: make on-time payments and don’t max out your credit.
Your credit score DOES NOT measure you as a person, your integrity, character, or responsibility. Credit scores are cold, impersonal numbers that are merely meant to give lenders an idea of how many people might default on a loan in the next 2 years.