600, 700, 800, we’re all familiar with credit scores but have you ever wondered exactly what all of those numbers mean? They have to mean something, right? Every other number we see means something so why would credit scores be any different?
The signs that say 55MPH mean we’re not supposed to go past 55 miles per hour (yeah, right). The sign that says $5.00 means that whatever we are buying is going to cost us 500 pennies. If our report card says that we’ve gotten straight A’s then that means that we’ve earned an average of 90 (or more) of the points available during the school quarter or semester.
So what do those pesky little credit score numbers mean? Have you ever thought about it?
We all know that a higher score is better. But, according to whom?
According to lenders and insurance companies, that’s who.
Any time you ask someone other than a lender or insurance company (or me ☺) “is my score good?” or “what’s a good score?” The answer should always be prefaced with…”according to the companies that use credit scores…”
Anyone who isn’t a lender or insurance company really can’t answer either of those questions with 100% certainty.
Here’s an example…
“John, is 725 a good score?”
I think we all recognize that a 725 isn’t a bad score but is it really a good score? It might surprise you to know that it’s no better than average compared to your peers.
If you asked a lender if a 725 is a good score then they may or may not say “yes.”
Here’s how I would define a good score…
“Any score that gets you approved at the best terms that the lender or insurance company has to offer.”
Other than that it really doesn’t matter. As long as you get what you want at the best price available…that’s what matters.
If, in order to get the best terms, I need a 725 then yes, it’s a good score.
But lenders and insurance companies (and any other company that uses credit scores as a component of making a decision) don’t all use the same minimum score requirements.
You should familiarize yourself with the term “score cutoff.” Score cutoff is a term used in the lending and insurance industries. It’s essentially whatever minimum score they will require of you in order for them to give you credit or insurance. Simple enough.
Most score users have several cutoffs for each of their products. Let’s make up an example. We’ll use a fictitious product from a fictitious bank. In this case we’ll use a platinum card from John’s Bank.
Here are the terms for the John’s Bank Platinum Credit Card, which are based on several score cutoffs.
750 or higher – no annual fee, 7.9% APR and a $25,000 credit limit
700-749 – no annual fee, 8.9% APR and a $20,000 credit limit
675-699 – $25 annual fee, 12.9% APR and a $15,000 credit limit
650-674 – $40 annual fee, 15.9% APR and a $10,000 credit limit
649 or below – Application declined
Ok, so what we’ve just done was to create a set of score cutoffs and terms specifically for the John’s Bank Platinum Card.
In this example is 725 a good score? If you used my definition from earlier then you’d have to answer “no.” No, because you wouldn’t have gotten the best deal.
Not all lenders will use the same cutoffs as John’s Bank so a good score will vary from lender to lender and product to product.
So back to my original question…what do all of those numbers mean?
In order for any lender or insurance company to create a successful score cutoff table they have to have a very solid understanding of what each of those numbers mean.
It’s certainly not arbitrary to set credit terms based on random cutoffs.
There’s a significant amount of research (and money) that goes into creating a table like the one above.
Here’s the deal…
Each of those scores represent the odds of you going delinquent. The higher your score the better your odds of not going delinquent on your accounts. The lower your score, the better your odds of going delinquent.
That’s why John’s Bank is willing to give you better terms the higher your scores are. They feel comfortable about your credit risk. They feel comfortable that you will make your payments on time so much that they’re willing to give you availability to more unsecured credit.
Think of the trust involved here. If I qualified for any of those platinum cards I could get the card, activate it, use up the entire credit limit and never pay John’s Bank back.
And since you can’t repossess dinners or vacations it’s likely that John’s Bank is never going to recover everything owed.
That’s an incredible amount of trust to give, in part, to a single number. Think about that for a moment. My 750 equated to $25,000. Would you ever be comfortable letting me borrow that kind of money simply because some number says that I’m good for it?