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The biggest misconception about how credit scores work

They aren't just measuring your overall financial health.

Scrabble pieces over cash
401(K) 2012 via/Flickr

Credit scores can be confusing.

Someone paying off their debt early sees their credit score plummet 100 points.

Another person has no debt and high income, but still has a bad credit score.

And yet another person has several thousands in debt, but their credit is squeaky clean.

How can this be? Why do credit scores sometimes diverge from overall financial condition?

Many people mistakenly assume that a credit score is an assessment of your financial health. This is true – but only to a certain extent.

Once you understand how financial institutions think about credit, you’ll better understand why the three scenarios above happen – and why it actually makes sense.

You’ll also understand how little adjustments – even without changing your fundamental financial situation – can help improve your credit score.

Risk management

From a financial point of view, credit scores are a tool for risk management.

In risk management, the greatest risk is the unknown.

This is key.

This is why having no credit is the equivalent of having bad credit. It is also why someone with a short credit history (say, one year) is harder to assess than someone with 10 years worth of credit history.

Credit scores measure your financial behavior

What credit scores are really trying to gauge is how reliable a particular person is. The more predictable they are, the fewer ‘unknowns’ are plugged into the credit score equation.

This is why it is fully plausible for someone with a net value of -$10,000 to have a higher credit score than someone with $10,000 sitting in their bank account.

If Person A is $10,000 in debt, making on-time payments every month and has been for years, whereas Person B has no debt and money sitting in their bank account, but no credit lines whatsoever, the former’s risk profile is easier to understand.

If both parties make the same income and are applying for a $5,000 personal loan, Person A is more likely to get approved and get a better rate. There is good reason to believe that Person A will continue their well established historical behavior of making good on their financial commitments.

Person B on the other hand, is harder to gauge. Yes, they have the means to pay the loan off. Things could go one of two ways.

If they are approved, they could take on the loan and make payments every month on time. But will they? Up until now, they haven’t had to manage their finances in this way.

On the other hand, they could also take a trip to Vegas and put it all on red, then throw all the past due notices into the trash can, unopened.

Without any context about Person B’s financial behavior, it really could go either way.

Most financial institutions would see Person A are the better risk. Their credit score will reflect that.

Credit scores are governed by algorithms

There is no nerdy accountant out there hunching over a calculator calculating your credit score.

It is all handled by computers and algorithms.

Every credit-related financial action you take is recorded as a data point for the algorithm to factor into your score.

For example, an on-time payment is a positive. A late payment is a negative.

Someone who has hundreds of positive data points in their credit history makes a late payment, they will take a hit on their score.

But for someone with 10 data points in their total credit history, clocking a late payment will be much more damaging. That’s because that same negative data point is a much bigger proportion of their history than it is for the person with a longer and more robust credit history.

For this reason, it is sometimes strategic to make payments – i.e., create more positive data points in your credit score’s calculation – than it is to pay it off all at once. This is particularly true for debt and loans in which the total interest paid on the loan does not change with early payoff. This could be an important consideration if you have several debt obligations and aren’t sure which one to prioritize.

This is also why someone who pays off a long-term loan (e.g., student loans) might actually take a hit in their credit.

When you pay off a loan, oftentimes, the account is closed out. If that particular account was your longest standing, and you spent years paying it off, that account was a good chunks of your credit history with much positive data in it. Closing the account eliminates historical data points that reflect the borrower’s behavior predictability.

With less data, there are more unknowns.

And the biggest risk is the unknown.

Connecting the dots

Someone paying off their debt early sees their credit score plummet 100 points.

Another person has no debt and high income, but still has a bad credit score.

And yet another person has several thousands in debt, but their credit is squeaky clean.

And now, you understand why.

Today, access to many crucial things depends on credit scores. For example, many landlords require minimum credit scores, even if the potential tenant is willing to pay several months in advance. That forces people into opening credit lines, even if they are perfectly financially solvent and simply consistently live within their means.

But such is the society we live in. With credit scores being a make-or-break factor on things like ability to access shelter, understanding how it works can help you better navigate your finances and by extension, open up more options for you in the future.

Check in on it from time to time to avoid any surprises.

Author

  • Tanja Fijalkowski is an award-winning writer, editor, and designer. A North Bay Area native, she has written for various financial, business, history, and science publications. She's a deep-dive researcher with a strong command of data analysis and simplifying complex concepts.

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