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Understanding Credit Part 1: How do credit scores work?

Knowing what credit is and how it affects you might be the most important thing you can do for your financial well-being. Sal Khan and a panel of credit experts explain credit, how your credit score is determined and the impact that score has on your finances.

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SAL KHAN
What, at a very high level, what defines credit?

FARNOOSH TORABI
Really good question. So there’s probably a lot of ways to define credit, but to keep it really, really simple, I think the best way to explain it is that it’s a measure of how trustworthy of a borrower you are, and, um, it’s, it’s from the eyes of people like, um, loan officers, banks, even as you said earlier, um, potentially your landlord; uh, these are the people in this, in, uh, in, in the industry who want to know if they’re going to need to give you a loan, or, um, give you a lease, that you will be good for that money. And your credit, which comprises of a score and your report, two separate things, reflect ultimately, um, you know, how again, how trustworthy you are as a borrower to pay that money back.

SAL KHAN
I see. It’s kind of like your financial reputation?

FARNOOSH TORABI
Exactly.

SAL KHAN
I see. And, and just, and, and just following up on this, this is from Carolina from Massachusetts, and Kevin from Arizona, and we’ll, we’ll throw this question over to Ian. They ask, “What goes into a credit score? How is it calculated?”

IAN COHEN
Great. So, um, very common question. The credit score is a measure, a numerical measure of a consumer’s ability and willingness to pay their bills, and it’s measured according to five, um, areas that all make some, some sense once you hear what they are. So 35 percent of your score is, um, uh, based on your payment history. If you pay your bills on time, you’re going to get full credit for 35 percent of your score. Uh, 30 percent of your score is based on how much debt you’re utilizing. So if you have a credit card that has $1,000 of balance on it, or limit, rather, and you run $100 of revolving balance every month, you have a 10 percent utilization, fantastic. Um, from there, it’s the age of your credit, how long your credit has been active. Um, next is mix of credit, and finally, it’s called “inquiries,” which measures how often do you apply for credit. So, um, excuse me ... and so that’s, that’s, uh, uh, a quick overview of your score. And in general, um, I, I think that to Farnoosh’s earlier comment, it is a numerical resume for consumers, and it’s not the entire picture that lenders look at, but a very important part of what lenders look at.

SAL KHAN
And, and just to dig one, one layer deeper there, out of those metrics I’d assume for the, your payment history, the more you’ve paid on time, the better. For, uh, things like, uh, for p-, for the length of credit, uh, the longer that you’ve had credit, the better, but what about things like utilization? What ... is, is there an optimal? Is it good to have zero utilization, is it good to have full utilization, or is it something in between?

IAN COHEN
So the people with the best credit scores, or the average credit score in the country, uh, is 696, and the median credit score is 732. Most of those people, uh, are utilizing 10 percent or less of their total credit limits. In general, that’s pretty ambitious, though. So what we recommend to consumers is that try to stay below 25 percent. That’s a good, safe place to be.

SAL KHAN
And so in general it is good to use your credit, but stay maybe roughly below the 25 percent threshold?

IAN COHEN
That’s correct. If you don’t use your credit at all, um, you’re going to have no credit history, and if you don’t use your credit cards at all, they’re going to likely get cancelled eventually. So even if you don’t use your credit cards often, take them out for an occasional test drive, uh, just don’t spend too much money on them.

SAL KHAN
Right, right. And that, uh, and you already, you addressed some of the questions ... this came from Candi (?) from Brunswick, Georgia, uh, Beatrice (inaudible) from North Carolina, “What is a good credit score?” You, you already touched on that idea, is that you really want to get as close to the kind of high 700s, low 800s as you can?

IAN COHEN
Yeah, so to (inaudible) what’s a good credit score, so the very best rates you’re going to get on a loan or a credit card, um, generally happened when you, when you reach a credit score of 750 or higher. And that’s the very best rates. That said, 680 to 720 is absolutely a good score. Um, you know, the higher the better, but, uh, you know, depending on where you’re at, uh, you, you can only do so much, and 680 to 720 is a perfectly reasonable score, and puts you in the average for the United States.

SAL KHAN
I see. And just following up on that, I’ll, I’ll hand this question over to Farnoosh. This is Jeannette (?) from Tampa, Florida, and she’s asking, “Why, why, why having ... why is a good credit history a great, a good credit score valuable? How, how does it actually impact us in the long-term?”

FARNOOSH TORABI
Great question. So a good, a great credit score equates to saving money. And here’s why. As Ian pointed out, when you have the best score, and he said 750 or higher, now you’re in business to really negotiate the best rates possible on, uh, products like students loans, private loans, um, car loans, mortgages, et cetera. And so think about it, if you can have a great score that can earn you a low interest rate at ... then every year you’re going to be saving money, compared to somebody who has maybe a lower score, gets a higher interest rate, they’re going to have to pay more interest over the life of that loan. So, uh, a great score, in short, is money saved.

SAL KHAN
And then not only ... and, and those, you know, few percentage points might not seem like a lot, but that could be a, a significant amount in terms of ... dollar terms, especially on something like a mortgage.

FARNOOSH TORABI
Exactly. Especially since a mortgage, as you pointed out, is 30 years. So it does add up.

SAL KHAN
Right. And it’s not always either a good score versus a bad score, sometimes it’s whether you’re getting the loan at all.

FARNOOSH TORABI
Exactly, yeah.

SAL KHAN
(Laughs)

FARNOOSH TORABI
I mean, some banks don’t want to be in business with you, you know, if you don’t have at least a certain score.

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