Mainstream personal financial advice is to get a credit card and build your credit. Investopedia explains that a credit score is used to determine to lenders if you are likely to pay your debt to obtain additional loans.
How Credit Scores are Calculated (FICO Explained and Exposed!)
- 35% your payment history
- 30% amount owed
- 15% length of credit history
- 10% new credit
- 10% Types of credits used
Credit scores range from 300-850, with 850 being the best possible score. However, having a high credit score does not paint a clear financial picture of what is going on financially. Here are four factors that are not measured in calculating your credit score, but vital to financial success.
1. Net Worth
Personal net worth can be calculated by taking the total of your assets (everything you own: your savings, investments/ retirement account, and home value) minus your liabilities (everything that you owe: car loan, student loan, credit cards, or any other debt). Someone who has a net worth of zero or ten million could have the exact same credit score.
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Your credit score doesn’t factor in your income. Whether you are unemployed, making minimum wage, or bringing home a six-figure salary this isn’t evaluated in your credit score. If you get a promotion or pay raise your credit score is not impacted in any way, but your financial situation does vary greatly as your income fluctuates.
3. Monthly Budget
Your credit score does not examine your income in comparison to your non-debt related expenses. For example, you could have a take-home pay of $2,500 and be paying $1,500 on rent each month. This would be a very bad situation having 60% of your take-home pay going towards rent. A good rule of thumb is that your rent or mortgage should be 25% or less of your take-home pay. Your credit score does not measure your cash flow or how you spend money on any other items except for debt.
CNBC reported that 30% of workers earning six-figures are living paycheck to paycheck and still under financial stress.
Would you rather have a high credit score and owe $100,000 in student loans or no credit history and be completely debt-free? Or, who is more financially savvy, someone who goes into a car dealership with a high credit score, no down payment, and buys a car with a 72-month loan, or someone who saves and buys a car with cash? Someone who currently has no debt obligations is in a more stable and desirable financial position than someone who is paying off loans.
That’s how credit scores are calculated and how FICO doesn’t show the whole financial picture.