In almost anything related to your personal finance, your credit score is one of the biggest indicators of how worthy you are to banks and other lenders. The issue there is that the FICO scoring system is inherently flawed for consumers. Here’s why.
Whether just starting out or working on rebuilding a credit score, you’ll have to borrow money in some form in order to build a decent credit score. Most companies don’t report to the credit agencies, so paying for your regular, non-debt expenses like utilities or rent on time often doesn’t impact your score, though it does show your willingness and ability to meet financial obligations.
It also seems kind of silly to have to say, “You know what the perfect way to rebuild my credit after taking on too much debt would be? To take on a little more debt but be more responsible this time!”
In that sense, you sort of have to sacrifice your shot financial freedom in order to have a good FICO score, and that just doesn’t seem right. If you’ve done the work to become debt free and no longer reliant on loans, whether they be in the form of installment loans like a mortgage or car payments or in the form of credit cards, it seems like it should follow that banks would see you as financially responsible and therefore you’d have a high credit score.
That’s not necessarily the case, though. It’s true that a good payment history goes a long way. However, paying off debt could jeopardize your credit mix, which is responsible for 10% of your score.
One would think that one of the biggest indicators of overall personal financial success would be the assets that a person holds, but that actually has no bearing at all on a FICO score. They don’t care whether you’ve got the finances now to pay back a loan; they only care whether you’ve paid back loans in the past.
This means that even if you’ve got money to your name in the form of non-liquid assets, you may have trouble getting access to them. For example, home equity can be tough to get your hands on without either selling your home and uprooting your life or building a positive credit history so that you can take out a HELOC or other equity release loan.
Say you’ve paid off all your debt and now you’re financially free. That’s great, except for the fact that you may need to leave credit accounts open in order to maintain them on your credit report so that your credit score doesn’t suffer. More than that, you may have to pay fees to keep those accounts open. That seems a little like the banks that report credit score could potentially profit off the FICO scoring system.