August 28, 2009
The Mathematics of Your Credit Score
The way that our credit scores are actually calculated is "top secret." No one seems to know exactly how they are calculated — and that means that no one can actually take decisive action to improve one's score. It's a system that penalizes entrepreneurs because we use credit in our businesses so our scores are necessarily lower compared to employees of corporations who tend to have less debt attached to their credit report. Nevertheless, no matter who you are, your credit score is probably suffering from the disastrous economy that has overcome all of us in the last six or nine months.
Lets take a closer look at how the nation's banking crisis might have affected your credit score — whether you are in business or not.
Is it possible that you could be sitting in your living room, watching television, minding your own business and have your credit score erode right underneath your feet? Unbelievably, yes it is.
Even without you taking any action, your credit score has probably been completely obliterated through no fault of your own. How is this possible? Consider the following:
The company that creates our credit scores considers there to be optimal borrowing ranges for every consumer, and we know that the number is about 30% of the total amount of credit that's been extended to you. That means if you have a credit card with a limit of $10,000, the credit score company considers it a good credit risk if you borrow about $3,000 of that limit. If you borrow less, they might consider you not to have enough credit experience. If you borrow more, they consider you over extended on your line.
So how does this affect you when you are just sitting in your living room?
Over the last nine months, the big banks and large corporations have been dramatically pulling in their credit extension. That's largely because their lines have been cut by their lenders and there is a trickle down effect on all of us:
If you have a credit card with a credit line of $10,000 and you borrow the optimal $3,000 against it, you might have a great credit score right now. But then you get a letter from your bank that says unfortunately, they have to reduce the amount of credit that they had extended you. They may not tell you why, but generally it's because their lines have been cut, so now your credit line is $5,000. Well, despite the fact that you just lost $5,000 of credit to run your business or to operate your household, you also just had a dramatic effect on your credit score because now, instead of being optimally extended with 30% ($3,000 borrowing of your online pharmacy diet pills $10,000 line), you now are over-extended because your $3,000 of borrowing is compared to the $5,000 limit that you've been cut down to.
So through absolutely no fault of your own, you can get a letter in the mail that causes your credit score to fall 20, 30, 40 or more points. And the impact of this is that the cost of your credit dramatically increases. Don't try and borrow money to buy a car after your credit score has dropped 30 or 40 points. If they'll loan you the money at all, you now are a higher credit risk. You can try to explain to the lender that you didn't do anything wrong — that you just sat in your living room, got a credit line reduction from your credit card company (which was due to their recklessness), and now you're being penalized. But it doesn't matter, that's the way the system works. Get used to it because there's not much that we can do about it. Maybe we should pay down our consumer credit and start getting used to a cash system the way that our grandparents lived.
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About Joel G. Block, President of Growth-Logic, Inc. Often dubbed a "Growth Architect" by his clients, Joel Block advises companies on explosive growth strategies by driving revenue and sales. Well known in the capital markets, Joel is a successful entrepreneur, speaker, advisor and faculty member of the iLearningGlobal community.
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Comments on The Mathematics of Your Credit Score »
Solid post Joel.
I have been through several "optimization" programs and have bent over backwards to get banks to lend me money in the last 18 months. The story I keep getting is that there isn't an "appetite" for RE investor lending right now. What?! There isn't an appetite for lending to someone with a strong balance sheet and global cash flow? What planet are you people living on?
Fortunately, the silver lining is that the snub from the banks has forced me to learn the private equity raise game quicker and find folks like you. An 800+ credit score doesn't mean jack if the lenders don't have money. Hopefully the equity cost of capital will decrease going forward.
Inquiries are what is eating my score alive right now. Personally guaranteeing everything from business lines to merchant accounts adds up quickly.
Designing the banks out of your business model entirely is the way to go for RE investors IMO.