What Your Credit Score Actually Measures

We frequently encounter clients who are disappointed because their credit score isn’t as high as they would like it to be. This happens especially with business owners and entrepreneurs, who tend to have lower credit scores than employees, for various reasons. We’re here to tell you that you should not take it personally, because your credit score is NOT a measure of your ability to make income, or of financial success.

In order to understand this, you have to understand what a credit score is and what it actually measures

What is a credit score?

A credit score is a number assigned to a person that is meant to be an estimation of that person’s creditworthiness (how likely they are to repay a loan). It is important to understand that the credit scoring system is not a public utility but a set of privately owned systems that were commercially developed for the use of banks and other lenders. Credit scores do not exist as a service to the public; they exist as a service to lenders, providing them with information about specific individuals.

The original credit score was developed by a company called FICO® (Fair, Isaac & Company), and this is still the main credit score system in use today. The score is calculated according to a proprietary method, the exact formulas of which are kept secret. However, the FICO company has disclosed that the following elements play a role in the calculation:

Payment history—lack of late payments or derogatory remarks
Debt burden—including debt to credit limit ratio, number of accounts with balances, and other factors
Length of credit history—including the average age of all the accounts combined, and the age of the oldest account
Types of credit used—what different types of credit a person has been given access to, such as mortgages, car loans and credit cards
Credit inquiries—inquiries into the person’s credit report by lenders at the time when a borrower applies for credit with them

Today, there are a number of different credit scoring variations provided by FICO for lenders to choose from (these all use slightly different scoring methods and are known as FICO2, FICO4, FICO5, etc). Lenders can also opt to use credit scoring systems from a few different FICO competitors. Some lending institutions, such as credit unions, may also choose to factor in their own internal credit scoring systems when making lending decisions, using calculations that are based on the customer’s history with that specific institution in place of or in addition to the FICO score. It’s all up to each individual lender.

In the rest of this article, when we talk about “credit score” we will mean credit scoring system as provided by FICO, which is the system primarily used in the mortgage industry today.

How credit scores came about

The first FICO credit score was developed by electrical engineer Bill Fair and mathematician Earl Judson Isaac in 1956. Prior to this time, banks employed what is called “relationship banking”—the bank manager knew you personally and had a personal relationship with you. He knew about your financial history with the bank, and he knew how your business was doing because he would talk to you regularly, and he could also verify the flows of funds going in and out of your bank accounts.

Unlike today, when banks often resell a mortgage to another bank almost immediately after closing, banks historically usually kept the mortgage within their own portfolio, collecting the payments as years went by, thereby increasing the assets of the bank. The mortgage was made with funds of their own depositors, and the bank had a direct stake in the mortgage being repaid. They therefore took considerable care to only make loans that they had confidence in. They not only looked at your income and your history with the bank, they could also ask around at businesses in the community (which usually extended credit to their customers) if you were reliable in repaying what you owed. Your reputation and personal relationships played a large part in you being able to obtain a loan with this more social-based approach.

How credit scores changed the lending industry

The use of computer-calculated credit scores had the effect of turning lending decisions into a semi-automated process. In mainstream lending, mortgage applications are first run through automated computer processes, and if they pass those, they are then reviewed by a human evaluator called an “underwriter” who evaluates the application using certain specific rules.

Use of an automated system made the process of loan evaluation and approval faster and required less skilled manpower, making it cheaper for lenders to run their businesses and allowing them to expand. The credit score system enabled lenders to issue mortgages on a much larger scale, helping to grow the real estate industry and the number of home owners exponentially. Proponents additionally say that credit scores standardized evaluations of creditworthiness and removed discrimination by relying solely on facts and calculations that are the same for everyone.

However, there is also widespread criticism of the current credit scoring system. Among the criticisms are statements that:

the methods developed for credit scoring are arbitrary (i.e. they are just based on whatever the original developers thought would a good idea), and because they are partly kept secret, they cannot be subjected to independent third-party research or verification.
whereas the credit scoring system is stated to have been developed to help lenders assess the risk of making loans to specific borrowers, in practice it does not do a good job of assessing that risk.
a credit score does not take into account a person’s income or their ability to make payments based on that income.
people can have trouble correcting inaccuracies on their credit report, as credit reporting agencies are not accountable for incorrect data and there are no penalties for not investigating disputes.

It is important to understand that “consumers” are not the actual clients of the credit scoring system. Lenders are the real clients of companies who provide credit scores. In recent years, credit reporting agencies have been making credit scores and credit reports available to consumers for a fee, but this was more of a sideline activity and not the main purpose for which the system was developed.

What your credit score actually measures

Your credit score does not measure your ability to make income, your ability to manage money, your ability as an entrepreneur, or your financial success in any manner. It measures your ability to manage debt, within very narrowly defined criteria.

Since the credit scoring system was developed for the use of large corporate lenders, these narrowly defined criteria were likely developed with the desires of corporate lenders in mind. In another way of saying it, your credit score measures how closely you’ve been adhering to paying your debts to large corporate lenders in the manner that they like to see it (for their own maximum profitability).

As an example, corporate lenders like to see people pay their debts little by little over a long period of time. This allows them to charge more interest over time and thus make the loan more profitable. In the eyes of a mainstream lending institution, characteristics of the “ideal borrower” include:

only occasionally asks to borrow money
never uses more than 50 percent of their credit limit
keeps their loans for at least 2 years and 1 month (and paying it off slowly; if you pay it off quickly it doesn’t contribute or can actually even hurt your credit score)
has three credit cards, one car loan and one mortgage

Another thing to know is that the credit scoring system is mostly geared toward and most accurate in evaluating employed borrowers. This is the type of borrower that mainstream lenders are the most interested in, because:

they make up the majority of borrowers
due to the relative regularity of their income patterns and spending behavior, they are easiest to evaluate using automated systems. This saves the lending institution money, because they do not have to hire as many skilled humans to manually evaluate what is going on in a person’s financial life, as they used to before the invention of credit scores. They can rely largely on computer calculations.

No element of the credit scoring system takes into account the person’s income. A person’s credit score also does not reflect how many loans they have successfully paid off in the past.

If you are an employee and you have a top-rated credit score, you may be able to get a good mortgage without too much trouble at your local bank or credit union. If you are not sure about how you rate, if you are on the borderline, if you are having trouble getting approved or if you simply don’t want to risk impacting your credit score by submitting random mortgage applications without first knowing where you stand (a very smart thing to do), then find out how we help employees get great mortgages by doing a thorough evaluation of their financial picture and using our “The Qualifier”® in-house pre-qualification method.

Credit scores and the business owner/entrepreneur

As you can see, the credit scoring system has been useful in increasing the number of mortgages that can be provided on a daily basis, especially in the employee segment of borrowers. In 2018, lenders in the United States alone provided over 21,000 mortgages per day.

However, for entrepreneurs, it’s a different story. If there are already some problems with the credit scoring system in terms of accurately evaluating the creditworthiness of employees, then it is even far less accurate when it comes to evaluating entrepreneurs.

First of all, entrepreneurs are by definition people who create their own systems of doing business and who create their own income streams, rather than fitting into a predefined system. Each entrepreneur tends to have a relatively unique pattern of income and expenses that is relatively simple to understand as a skilled financial professional, but difficult to understand for a computerized system. Additionally, the narrowly defined criteria used by the system tend to reward the regular patterns in financial behavior of employees.

Entrepreneurs tend to have lower credit scores than employees because:

entrepreneurs borrow when they see an opportunity for a good deal—they expect to multiply their money using the borrowed funds. If they see many good opportunities, they may try to get loans frequently (and credit score is negatively impacted by frequent inquiries)
entrepreneurs tend to take more risk in order to achieve financial goals. They move large amounts of money, and things may happen that are unexpected. They may sometimes need to delay making payments for a month or so while they solve a problem or move some funds around. (Certain financial companies are onto this, allowing their high-profile clients to skip a certain amount of payments with no questions asked)
entrepreneurs tend to utilize the maximum of their loan amounts at times, or even go over the limit, because they are juggling funds, deals and projects. They may need all the funds they can get in certain months to then make a great profit and pay off the whole loan a few months later
the attention of the entrepreneur tends to be on making income. He may simply forget to make a payment on time because he was busy with something else

Additionally, if an entrepreneur has a low credit score but needs money for a project, he may be tempted to accept subprime loans. This does not impact his credit score but reflects badly on his credit report (and it looks bad to lenders).

Factors that entrepreneurs are not being credited for

Factors that entrepreneurs are not being credited (but should be) include:

experienced entrepreneurs are good at making income. An employee could potentially loses his job at any moment and would then depend on finding another job. An entrepreneur who has been in business for a while tends to be resilient even in down economies; he can pivot his business into new markets when needed, or he can create a new business from scratch if necessary. Entrepreneurs tend to be resourceful at making things go right income-wise. Currently, a person’s income volume is not a factor in determining their credit score.
entrepreneurs tend to pay off their debts. Reputation and creditworthiness is an important part of doing business. They may not always do it exactly according to the monthly schedule, but if at all possible, they will pay off their debts so they can borrow again
for the most part, entrepreneurs who have been in business for a while know how much debt they can take on. They have a good estimation of how much income they can expect from their projects and activities, and they do not overextend themselves with debt. As part of running their business, they are forced to evaluate risk on a continuous basis, and they tend to know what they are doing when it comes to debt

Strange scenarios in credit scoring we have seen over the years include one instance where we had a long-time successful entrepreneur and real estate investor (client A) and a recent entrepreneur (client B). Client A had recently sold a share in a business and had a considerable amount of money in his bank account. He owned multiple investment properties, and his credit report showed that over the years he had obtained and paid off over 40 mortgages on single-family residences. Client B had never had a mortgage, but she had three credit cards that she barely utilized. Client B had a near-perfect credit score; client A still had a decent credit score, but not top-tier, and 100 points lower than client A.

If you have a low credit score—don’t freak out

Having even a slightly lower credit score than perfect can prevent you from getting the mortgage you want from a mainstream lender, even when you can afford the payments. This is often shocking to people, as they have been with a bank for a long number of years and the bank can easily verify how much money they have in their accounts, and the exact flow of income and expenses that have been going through their accounts. Sadly, with most banks, the era of “relationship banking” is over, unless you are an exceptionally high-profile client.

An entrepreneur’s credit score is often lower than what he or she expects, and this can be very disappointing. But don’t take it personally, because it’s not any kind of measure of your ability to make income, your ability to create wealth, or your success as a business person.

And the good news is: you can still get a great mortgage. There are specialized lenders who specifically cater to the needs to entrepreneurs, business owners and self-employed professionals. They understand that being an entrepreneur comes with certain financial realities, and they offer mortgage programs that take this into account:

it’s ok to have a lower than perfect credit score
you can show bank statements to prove your income instead of tax returns
or the loan can be based on your assets instead of your income
competitive rates and fair fees—better than you will get at a mainstream lender

As a mortgage broker, we can provide you with access to these specialized programs and help you select the most suitable one for you after a thorough evaluating of your specific financial situation.

Call us at 310-294-9417 for a free consultation.

“I am a very busy person and Alejandro handled everything for me. I have refinanced two homes and bought two homes with him.”

— Janice, Client