Credit Score 101, with Sara Williams
In this episode, I speak to Sara Williams, a debt advisor with over 20 years of experience and the voice behind Debt Carmel since 2013, to help us demystify the world of credit scores.
We discuss whether credit is always good and why we've all become so accustomed to using it. We also explore what a credit score is, the main credit agencies in the UK, and how credit scores are calculated. Plus, we uncover how to check your score for free, ways to improve it and debunk common myths.
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what is a credit score?
A credit score is a number calculated by a credit reference agency that summarizes your recent credit use. The higher the score, the better your use of credit looks to a future lender. This helps lenders decide whether to give you a credit card, increase your credit limit, offer you a loan, or determine the rate for your car finance or mortgage.
Does everyone have a credit score in the UK? Everyone over 18 can have a credit score if they check it. If someone has never checked their credit score, doesn't have credit, and doesn't have a bank account, they might not have one, but this is rare. Newcomers to the country start without a credit score and must build their credit history.
“Another myth is that if you’ve had problems in the past and you pay off a loan, say, which you defaulted on, that will improve your credit score. It won’t. This is bizarre. Nobody thinks this is sensible, but this is the way the system works. If you pay off a defaulted loan, your score is not going to change one little bit.”
credit agencies
There are three main credit reference agencies in the UK: Experian, Equifax, and TransUnion. Although they offer paid reports, you can get free reports from third-party agencies. For Equifax, ClearScore is popular. For TransUnion, Credit Karma is commonly used. Experian offers a free monthly score update but not a detailed free report.
Should we prefer one credit agency over the others? Unfortunately, there is no simple answer. Each agency uses different scores and calculations, and lenders do not report to all three agencies consistently. Major banks will show up on all three, but smaller lenders may not. If you're preparing for a major application, like a mortgage, it's best to check all three reports. For regular monitoring, choose one and check it monthly.
Regulators are considering rules that would require lenders to report to all three major agencies, leading to more uniform data. This change would help avoid discrepancies that could impact applications.
For now, it's a good idea to register with all three agencies, especially since you can get free updates on your score. This way, you can avoid surprises like an unknown CCJ (County Court Judgment) affecting a major application.
It's very easy to check your credit scores online. When you do your financial housekeeping, you can sign up for all three major credit agencies and then just look at one of them each month. You don't have to read them all every month; you can simply have the reports sent to you.
Remember to switch off the option for special offers. Otherwise, you'll get bombarded with ads, usually for expensive loans and credit cards. But you can easily turn these notifications off.
how are they calculated?
In the UK, a credit score is based on your credit history for the last six years as reported by lenders. Let's take Experian as an example. Lenders and utilities send details about your payments. For instance, if you paid your credit card in full this month, that gets reported. If you forgot to pay you mobile phone bill, that also gets reported.
These details go through a complex programme that weighs different factors. In the UK, two main factors count which are credit history and credit utilisation.
Credit History: This includes missed payments and defaults. The older these issues are, the less they impact your score, and they drop off after six years. There's not much you can do to improve this except let time pass.
Credit Utilisation: This refers to how much of your credit limit you're using, especially for credit cards. If you have a £1,000 limit and are using £990, you appear maxed out, signalling potential financial trouble. Using less, like £500 or £150, and paying it off in full every month, is better.
When you have multiple credit cards, each is scored separately and then combined. For example, if your Capital One card has high usage but your Barclay’s card, with a £5,000 limit, has low usage, your overall credit utilisation looks better. However, high usage on one card isn't great.
Improving a Low Credit Score
If you've had major problems like missed payments or defaults, time is your friend. As time passes, these issues become less significant and drop off after six years. You should also pay down your credit card balances. People often hope for a quick fix like getting another credit card, but that usually doesn't work if you already have high utilisation. Instead, look at your budget, cut unnecessary expenses, and stop using your credit cards. Remove them from your purse, Apple Wallet, Google Pay, and Amazon, and start living off your debit cards. Pay more than the minimum on your credit cards to reduce the balance faster. Other boosts include getting on the electoral roll and keeping older credit accounts open as they show a longer credit history.
Overall, the key steps are paying everything on time, waiting for old issues to age, and paying down your credit cards and catalogue balances.
what happens without a credit card?
You can get a credit card and use it in a very limited fashion if you think you've got the willpower to do it. There are things called credit builder cards. These cards have high interest rates and usually come with a low limit, so they are not meant for borrowing money. But if you get a credit builder card and use it to buy something worth £50 once a month and pay it off in full at the end of the month, you won’t pay any interest. This can give the biggest boost to your credit score because it shows low utilisation and full monthly payments. Both of these factors are very favourable in credit score calculations.
If you really don't want to get a credit card because you've had problems in the past and you know you can't be trusted with one, there are other options. Normally, savings don't improve your credit score, but there is an app in the UK called Lockbox that can help. Lockbox sets you up with a sort of loan arrangement. For example, you can decide to save £30 a month for a year. Lockbox sets up a £360 loan for you, but instead of giving you the money upfront, you pay £30 each month. At the end of the year, you've paid £360, and you can get that money back. It’s like using a savings account, but it's reported to the credit reference agencies as though you’re paying off a loan, giving you 12 nice green ticks for monthly payments.
This approach can be particularly useful for young people who don't have much on their credit score or for someone new to the country who is building a credit history. It's an interesting development in financial inclusion, helping more people improve their credit scores without needing a traditional credit card.
the numbers
The three credit reference agencies in the UK have different maximum credit scores. TransUnion’s maximum is 710, Experian’s is 999, and Equifax’s is 1000. So, Experian and Equifax can be considered roughly equivalent.
If someone has a credit score of 600, it’s essential to know which agency it’s from. A score of 600 out of 710 from TransUnion is quite good. However, a score of 600 out of 999 or 1000 from Experian or Equifax is relatively low. Therefore, the interpretation of a credit score depends on the agency that provided it.
Each credit reference agency has bands indicating poor, good, or excellent scores, but these bands are inconsistent across agencies. Even with the same data, each agency might score it differently and place it into different bands, making the labels somewhat meaningless. Generally, for TransUnion, a score over 550 is good. For Experian or Equifax, a score over 800-850 is good, though not excellent.
Checking Credit scores
There’s a misconception that checking a credit score will negatively impact it. This is not true. Credit scores can be checked as often as desired without affecting them. Regularly checking one’s credit score is a good practice for monitoring financial health.
The best methods for checking credit scores include using free services provided by third parties associated with the main credit reference agencies. For Equifax, ClearScore is popular. For TransUnion, Credit Karma is commonly used. Experian offers a free monthly score update. These services allow individuals to keep track of their scores without any cost or impact on their credit ratings.
Regularly checking your credit score is pretty pointless in terms of impacting it positively or negatively. It won't make your score look better or worse if you do it. The only time it affects your score is when you sign up to get credit and the lender asks for your address and previous addresses to piece together your history, especially if you've moved around a lot. Having your current address on file means your creditors can see where you live, which may not be ideal if you're trying to hide from them.
But, apart from that minor exception, checking your credit score as much as you want is not a problem. However, keep in mind that credit scores don't change very quickly. It's usually suggested to check your score every month. Pick one report you like and stick to checking that one regularly. If something seems off, you can then look at reports from other credit reference agencies.
The only time you might want to check more often is when you're nearing a significant credit application, like a mortgage, and you're feeling a bit paranoid. However, it's advisable never to pay for a credit score. Instead, sign up directly with the credit reference agencies. They can provide you with a real-time report that you can check multiple times a day if you want to see what's changed.
lenders
The extent to which your credit score matters to lenders varies. While credit scores are important, they aren't the sole factor considered in credit applications, despite the myth suggesting otherwise.
Many lenders use credit scores initially to screen applicants. Subsequently, they conduct affordability checks to ensure borrowers can repay loans. These checks, along with credit record assessments, influence the amount lent and the interest rate offered.
Some lenders offer preferential rates to certain individuals based on their credit scores, while others have fixed rates for everyone. This applies to both loans and credit cards, determining the credit limits and interest rates assigned.
In essence, a good credit score makes borrowing cheaper and easier, potentially allowing for higher loan amounts. However, having a perfect credit score doesn't guarantee approval for loans, as lenders consider other factors such as existing debt.
Debunking Myths
One prevalent myth is that your credit score determines whether you'll be lent money, especially for significant loans like mortgages. However, lenders are more concerned with your payment history and whether you've missed payments or defaulted on loans rather than your credit score's specific number.
Another myth is that running a balance on a credit card and paying interest on it improves your credit score. This is false. The most significant boost to your credit score comes from clearing your credit card balance in full every month via direct debit. Paying interest does not enhance your credit score and can harm your financial situation.
There's also a misconception that paying off a defaulted loan will improve your credit score. Unfortunately, this isn't the case. While paying off defaulted loans may make lenders more willing to lend to you, it won't change your credit score.
Lastly, there's the myth that having a payment arrangement is better for your credit score than having a default. While this may be true in the short run, defaults drop off your credit record after six years, whereas payment arrangements can stay on your record for the same duration after the debt is paid off. Therefore, defaults may be preferable in the long term.
challenging your credit score
Can you question your credit score?
Yes, you can, but you're not challenging the calculations; you're challenging the data that goes into the score. If you believe there's incorrect information on your credit report, such as a missed payment that you actually made, you should contact the lender responsible for reporting that information and ask them to correct it.
For women, particularly, lower credit scores can impact their access to credit. While credit scoring itself isn't biased, women may face challenges due to factors such as the gender pay gap and being more likely to be single parents. Financial difficulties, such as defaults, can be harder to overcome for women, affecting their ability to access credit and achieve financial equality.
differences in credit scores across countries
Defaults vary in duration across countries. For instance, in the UK, they linger for six years, while in America, they endure for seven years. In Australia, they drop off after five years. These disparities can significantly impact your credit standing. In America, having a diverse range of credit types is more critical for scoring than in the UK. In Ireland, credit cards with limits of 250 euros or less might not even be reported to credit reference agencies.
As for individuals relocating to new countries, their credit scores don't transfer with them. Each country has its own credit reference agencies, requiring individuals to rebuild their credit history. Joining expat groups and seeking advice from those who have been in similar situations can be helpful in navigating these transitions.
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