Does Your Income Affect Your Credit Score?
Although some experts state that your income doesn't affect your credit score, it's only half the truth. Your earnings may not have a direct impact on your FICO rating as they are not a component that determines it. However, income creates favorable conditions for making it better or worse. Let's find out whether there is a clear correlation between your income and credit score.
What Is a Credit Score?
A credit score is a three-digit indicator of your financial behavior that helps lenders predict your credit risks. People with bad credit are considered risky as they already demonstrate some financial mistakes, for example, late and missed payments, or shown suspicious activity, such as applying for multiple loans within a short timeframe. There are several factors that determine your credit score:
- Payment history. This indicator shows how you handle your bills and other debt payment obligations. Your credit score is 35% made up of your payment history;
- Credit utilization. This ratio shows how much of the available credit limit you use. You need to keep it low to maintain good credit. Experts recommend keeping credit utilization below 30%;
- Length of credit history. The longer your credit history, the better. This way, a lender will be able to track your financial behavior over time;
- Credit mix. Your credit mix is a diversity of credit accounts you have open. If you can show that you're good at managing various types of loans, a lender will consider you more reliable;
- New credit. If you demonstrate high financial activity by applying for many loans within a short period, it may indicate financial problems. This way, lenders may treat you cautiously.
Depending on the scale, your credit score can be between 300 and 850. Each of the three major credit bureaus (Experian, Equifax, and TransUnion) have their ranges, but in general, credit scores are grouped as follows:
- 300-579 - Bad credit;
- 580-669 - Fair credit;
- 670-739 - Good credit;
- 740-799 - Very good credit;
- 800-850 - Excellent or exceptional credit.
Why Is a Credit Score Important?
Credit scores are crucial elements of people's financial life. They affect their ability to get a loan, rent a house, and sometimes get a job in a sphere of finance. Individuals with higher credit scores tend to have easier access to financial products and always get more favorable terms. At the same time, borrowers with bad to poor credit often experience challenges when it comes to borrowing. This way, you may find it difficult to qualify for a mortgage, purchase a car, or even get a small personal loan when you find yourself in an emergency.
Average Credit Score by Income
According to the results of the New York Fed's analysis, people with lower incomes tend to have lower credit scores. Below is a table.
| Income | Average Credit Score |
|---|---|
| Low Income | 658 |
| Moderate Income | 692 |
| Middle Income | 735 |
| High Income | 774 |
Correlation Between Income and Credit Score
This is a complicated issue that some recent research argues about. Thus, Albanesi, De Giorgi, and Nosal (2017) state that income is one of the most important factors, going right after age, that is closely related to an individual's credit score. This is because our income has a strong impact on the way we behave, affecting consumer credit risks.
At the same time, your income is never a factor that is used in credit scoring models. Statistical analysis made by the Federal Reserve shows that having a high income doesn't automatically result in a good credit score. The same goes for people who are low-income earners, as they do not necessarily have bad credit. Thus, we can speak only about a moderate correlation. There are only some potential risks of credit score damage if a person unexpectedly loses a job or experiences other financial difficulties.
Why Do People with Low Income Tend to Have Lower Credit Scores?
Let's take a look at two potential ways in which income can affect your credit score. First is when your income is a component that is used by a credit scoring model when calculating your credit rating. However, neither FICO nor Vantage models base their calculations on an individual's earnings. This leads us to another way how income can affect your credit score, which is by reducing your solvency.
Suppose that you already have multiple credit accounts and use a huge portion of your income to cover existing debts. This way, financial issues may result in late payments or bankruptcy, leading to credit score damage. This may also happen if you don't have loans or active credit cards but find it difficult to pay rent or utility bills. Keep in mind that your whole payment history makes up 35% of your credit score.
What Are the Consequences of a Low Credit Score?
A low credit score can have a significant impact on your financial life. First of all, it may limit your ability to access credit and borrowing on favorable terms. Lenders often view low credit scores as a sign of higher credit risk. This could lead to higher interest rates and fees, making borrowing more expensive. However, there are loans for people with a low credit score, for example, a personal loan for 500 credit score.
Additionally, a low credit score can impact your ability to rent a property. It's no secret that landlords often use credit scores to evaluate potential tenants. It can also hinder access to certain job opportunities, as some employers check credit reports as part of the hiring process. This is especially true for positions that involve financial responsibility. In the long run, a bad credit score can hinder efforts to buy a home, finance a car, or even get insurance at reasonable rates. Therefore, maintaining a healthy credit score is essential for financial stability and access to various opportunities in life.
Conclusion
Although your earnings are not used in credit scoring models, there's still a moderate correlation between your income and credit score. People with a lower income have less ability to manage their debts and other financial obligations properly, while households with above-average incomes, all else being equal, are typically more solvent. However, having lower income doesn't automatically make your credit score bad. It just shows the potential risks of its damage caused by your further financial behavior.
If your income unexpectedly decreases, try to refrain from getting new loans to solve your problems. This can make the situation even worse. If you find it difficult to manage your existing debts due to financial problems, contact your lender and ask about available options. Lenders are often willing to help and may offer you an extended payment plan.