Are Credit Scores a Sham? It Might Feel That Way

If you search the topic of credit scores online, you’ll find plenty of complaints and allegations that the system is substantially flawed.

Since buying a home a few years ago, I learned a lot about credit scores. Joining a service like Credit Karma boosted how much I know about them. But there are times when the more I learn, the more I question how they score one’s credit.

You may know the credit score by its more official name: the FICO Score. FICO is named for the Fair Isaac Corporation, which helped create the process for calculating the scores.

Here’s how they figure your credit score

When computing FICO scores, creditors consider five factors:

Your payment history poses the biggest impact on your score. So pay on time every time. Late payments can drop your credit score. Your payment history counts for 35% of your score. TransUnion’s scale indicates they want near perfection here. One bad mark drops you from “excellent” to “fair.” Two or more and you’re a problem child.

The second factor is the amount owed. It accounts for 30% of your score. Owe too much and your score drops. What’s too much? TransUnion says owing less than 10% of your available credit ranks you “excellent.” Owing 10 to 29% is good, owing 30 to 49% is fair and owing 50% or more is considered a “danger zone.” They figure credit card use among each individual card as well as the average across all cards.

The third factor is the length of credit history. It accounts for 15% of your score. Creditors want to see that you have a long history of accounts. How long? They like to see accounts that are more than nine years old. That shows more stability. If you’re just starting out, there’s nothing you can do about this one except wait. But keep things in good shape by paying your bills on time!

The fourth is new credit. This one examines the number of recent inquiries on your credit report, which suggests someone opening new credit accounts. If you have one or two inquiries over the nine months to a year, that drops you from excellent to good. Three or four drops you to fair. Five or more might mean trouble. Your score should bounce back though within a few months. This makes up 10% of your score.

Then there’s “Credit Mix.” That refers to the kinds of accounts — credit cards, mortgage, car loans, etc. — you have and how many of them there are. This also accounts for 10%.

Some things about calculating credit scores make sense

Prioritizing your payment history definitely makes sense. Creditors want to see that people who borrow money aren’t late and actually pay their bills. You wouldn’t want to lend money to someone who appears to be a deadbeat, after all.

The credit use factor also makes sense — at least, to a degree. Why is 30% the threshold between “excellent” and “good”? Well, I suppose they had to pick some kind of number. Given how expensive things have gotten, though, 35% might be a bit more helpful to consumers.

I don’t dispute the potential value of looking at the age of one’s accounts. But because I’m in my 50s, my oldest credit card is almost 35 years old. So I score just fine when you look at the age of my accounts. Even having some “young-uns” in the mix among credit cards doesn’t have much effect when I have old-timers that date back three decades or more.

I certainly understand that a creditor would like to see that someone can maintain accounts for that long and have a positive payment history to boot. That shows responsibility, one might suggest.

Looking at the number of hard inquiries on someone’s credit report also makes sense. Anyone who opens — or tries to open — a lot of accounts at once might look like someone who’s about to go on a spending spree. That could be a red flag.

But some things don’t make a lot of sense

Even if we stick with the 30%, some borrowers might face a snag if the report looks at use percentages of individual cards as well as overall.

Imagine that you have balances across six credit cards. A seventh then offers a great consolidation option with zero or lower interest than you’re currently paying. If you take advantage of the offer to consolidate all of that credit onto that one card, you might drive that individual card’s use percentage well above 30%.

Sure, everything else would be zero, assuming you don’t charge them back up. But in moving the debt to lower interest to pay it off sooner, you might get dinged in the short-term. That somehow seems a bit off if the report doesn’t look at the consolidiation in context.

A relative, meanwhile, has a major beef with age of accounts. She managed to achieve an 850 credit score, the highest possible! About a year later, she made the last payment on her car. When she paid off her car loan, her perfect credit score dropped by 19 points!

The reason? Paying off the car loan closed that account. Closing accounts can hurt credit scores. Why is it almost 20 points worth of negative? No one can explain that one.

She never missed a payment. She never made a late payment. In terms of her commitment to the loan she took out, she did everything she was supposed to do. She was a model borrower. Yet she dropped that much because she paid off the loan when she was supposed to. She still hasn’t gotten over that slight.

Then, how many accounts is too many? More than 20 accounts is considered “excellent.” Between 11 and 20 is considered fair and 10 or fewer is in the red zone. I can understand creditors wanting to see several accounts, all with a good payment history. But why does anyone actually need more than 20 accounts? Why should 21 or more accounts be even a small benchmark for better credit scores?

The old joke about getting a loan

When you try to get a bank loan, an old joke suggests you must first prove you have enough assets that you wouldn’t need one. It definitely feels that way sometimes.

Improving credit scores begins to feel the same way. They want you to have many credit accounts that you rarely use and carry few balances on. If you have more than 20 accounts with little to no balances, and can afford to pay off everything that you buy every month, why would you need any more credit?

On the other hand, if you don’t meet all of these benchmarks and you actually need a new line of credit, your score is likely to be lower. That allows creditors to potentially charge you higher interest rates.

The way the financial industry is now, I don’t see a real solution that would deemphasize credit scores. But I can’t help but think we need one. The way it is now, it feels like a money grab to me.

Still, to play the game, we have to follow their rules. It’s just important that we know and understand what those rules actually are. Even if they seem unfair — and some of them do — following them can still save you a great deal of money in otherwise-unnecessary interest.