The Importance of Your Credit Score
With almost every major financial decision in your life, your credit score plays a big part. Your ability to qualify for a car loan, mortgage, or credit card ó it all comes down to that three-digit number. A credit score is not just an indicator of how much of a financial risk you are, either. Increasingly, it’s being used to determine how much of a risk you pose as a potential consumer, renter, or employee. So the more you know about your credit score, the better off you’ll be.
The premise is pretty simple ó the higher the score, the less likely of a risk you are to a loaner. On the other hand, the lower the score, the more likely of a risk you are to a loaner. There are many instances where your credit score will come into play, so you’ll want to know where yours falls on the spectrum. If you have a good credit score, you are more likely to have applications for credit cards, mortgage loans, or car loans approved. You also are more likely to receive high credit limits on credit cards, competitive rates from lenders, and get loans faster. A bad credit score, meanwhile, could mean higher rates ó and, as a result, higher monthly payments on loans ó or being denied loans altogether.
Nowadays, it’s not just banks and credit card companies that want to know your credit score, either. According to the Federal Trade Commission, many other types of businesses, including insurance companies and phone companies, are using credit scores to determine whether a potential customer qualifies for a service and on what terms. The Consumer Federation of America further notes that companies may purchase consumer credit reports to help them make such decisions as providing or pricing insurance, renting an apartment, and even employment, if you let them look at your consumer report. The logic goes that a good credit score can be seen as an indicator of how responsible of a person you are.
Whether or not you’re applying for a loan or mortgage in the imminent future, you monitor your financial health regularly. That means you should check your credit score and report on a yearly basis to make sure your information is correct, as well as before you apply for any loans or credit cards. That way, if there is any false information due to human error or identity fraud, you’ll know about it before it’s too late.
Breaking Down Your Credit Score
A credit score is the result of a mathematical formula based on information in your credit report ó the record of your financial history. Lenders have access to several different formulas when determining your credit score, though the most commonly used scoring system is the FICO score, developed by the Fair Isaac Corporation. It is the standard for measuring credit risk, as about 90% of financial institutions use your FICO score in making lending decisions, according to MyFICO, the consumer information website of FICO. To have a FICO score, you must have at least one account that has been open for six months or more and at least one account that has updated in the past six months.
Components of a Credit Score
Your credit score is calculated based on the information included in your credit report, which provides an objective snapshot of your financial health in comparison with other credit holders. These standard components are listed below in order of decreasing relevance, with percentages provided by the Consumer Federation of America (though keep in mind that the exact weight of each factor may vary from person to person, depending on credit history):
- Payment history: This includes the account payment information on credit cards, as well as installment loans, finance company accounts, mortgages, and any public records, such as bankruptcy, judgments, suits, liens, wage attachments, etc. It generally accounts for 35% of a FICO score.
- Amounts owed: This is the amount owed on all accounts, including balances, installment loans, and credit lines used. It generally accounts for 30% of a FICO score.
- Length of credit history: This is the time since you have opened your first account. It generally accounts for 15% of your FICO score.
- New credit: This is the number of recently opened accounts and recent credit inquiries. It generally accounts for 10% of your FICO score.
- Types of credit used: This is the number of types of accounts, such as credit cards, retail accounts, installment loans, mortgage, and consumer finance accounts. It generally accounts for 10% of your FICO score.
Factors not taken into consideration for your FICO credit score include race, color, religion, national origin, sex, and marital status; age; salary, occupation, title, employer, date employed, or employment history; where you live; any interest rate being charged on a credit card or account; items reported as child/family support obligations or rental agreements; and consumer-initiated inquiries. Keep in mind, though, that lenders may still consider some of these factors, such as age or salary, in addition to your credit score.
The Credit Score Gatekeepers
Consumers should be wary of blindly searching the Internet in order to purchase their credit scores. Since so many shady credit score companies are out there looking to make a buck, finding your actual credit score can be a confusing process. The best place to start is MyFICO. From the MyFICO website, you can view your credit score and credit report at no charge through a free trial, as well as sign up for a credit monitoring service for a fee if you so desire.
From there, you also may want to check out AnnualCreditReport.com. This site allows you to request a free credit report every year from each of three main credit reporting companies ó Experian, TransUnion, and Equifax ó under the Fair Credit Reporting Act. That way you can check that the information on your credit report is accurate at no charge.
Credit scores are not available for free through these credit bureaus. If you do decide to purchase yours, keep in mind that Equifax sells FICO scores, while both TransUnion and Equifax do not. Instead, the latter use different scoring systems to determine your credit score (sometimes derogatorily called FAKO scores). This number most likely isn’t identical to your FICO score or to each other’s, so you could wind up with three different credit scores from all three credit agencies. Because there is a chance that lenders and companies will seek your credit score through either of these credit bureaus, the Consumer Financial Protection Bureau advises that it is more important to review your credit report for any errors than it is to buy your credit score. That way, regardless of where a lender is pulling your credit score, you can at least know the information is an accurate reflection of your finances.
Credit Score Ranges
Your credit score is derived from all the data included in your credit report ó your payment history, amounts owed, length of credit history, new credit, and types of credit. Different mathematical formulas are used to arrive at this number, though the most common one used by lenders is the FICO score, developed by the Fair Isaac Corporation, which ranges from 300 to 850. As a rule, the higher the score, the better, whether it’s from independent companies, credit reporting agencies, or lenders.
Good vs. Bad Credit Scores
What exactly constitutes a good credit score will often vary from lender to lender, though generally, a FICO score in the 700s would put you in good standing, according to the U.S. government. At that level, you are not seen as a credit risk and are more likely to have credit card and mortgage loan applications approved, be offered competitive rates from lenders and high credit limits, and get loans faster. Anything below 600, however, and you’ll be seen as a high risk, which could lead to higher rates or being turned down for loans altogether.
According to MyFICO, the consumer information website of the Fair Isaac Corporation, the best interest rates on a mortgage go to those with credit scores between 760 and 850, while the lowest go to those with a credit score between 620 and 630. For comparison’s sake, let’s consider a couple that’s looking to take out a 30-year fixed mortgage based on some recent APR percentages. Someone with a FICO score between 760 and 850 can get a 3.224% APR ($1,301 monthly payment), while someone with a score of 620-639 can get a 4.834% APR ($1,580 monthly payment). That’s a nearly $300 a month difference in the end.
For an idea of where your credit score might fall in the spectrum, MyFICO uses these ranges in comparing interest rates among different credit scores:
- 760-850 (lower interest rate)
- 620-639 (higher interest rate)
For a general look at what constitutes a “good” or “bad” credit score, Rob Berger at Dough Roller further breaks down credit scores with these ranges:
- Excellent: 750-850
- Good: 700-749
- Fair: 625-699
- Poor: 550-624
- Bad: 300-549
What Impacts Your Credit Score?
If you check your credit score on a Tuesday, it may not be the same score on Wednesday. That’s because as your financial information changes at the credit reporting agency, so does your score. This can be good news for those looking to improve their number, and an encouraging sign to those with a respectable score to keep doing what they’re doing. But it should help to know what exactly causes it to go up or down.
All factors that are included in your credit report influence your credit score. So that means if you make a late payment, add a credit line, or, in extreme cases, file for bankruptcy or foreclosure, you can expect your score to reflect that.
Here are some actions that can negatively affect your credit score:
- Making a late payment (this includes minor late payments, such as a 30-day delinquency, as well as foreclosures, repossessions, and public record items such as tax liens, bankruptcies, and judgments)
- Owing more than your credit limit
- Having multiple inquiries into your credit
Here are some actions that can positively affect your credit score:
- Making payments on time
- Keeping a low credit usage (meaning the ratio of balances to credit limits is low)
- Having a long credit history
- Recently using your credit card
- Having a mix of different types of credit
So by paying your bills on time, only applying for credit that you need, and not using too much of the credit that is available to you, you can keep a good credit score, according to the Consumer Financial Protection Bureau. It’s also important to check your credit report for any inaccuracies. If your report lists missed payments on a loan you never took out, it’ll negatively affect your credit score, regardless of whether you took out that loan, until you fix it.
Maintaining Your Credit Score
After years of responsibly managing your credit, you’re rewarded with a good credit score. What that number is will vary by lender, though USA.gov notes that a FICO score in the 700s and higher will put you in good standing. At that level, you can enjoy low interest rates, high credit limits, and are likely to be approved for credit card and loan applications.
Once you’ve reached a point where you want to maintain your credit score, or even bring it higher, there are several things you should keep in mind to stay favorable with lenders:
Check Your Report
If you have a good credit score, that doesn’t mean you should stop monitoring it. It’s important to regularly check it throughout the year for any inaccuracies or signs of identity fraud. You can request a free credit report each year from the three main credit bureaus ó TransUnion, Experian, and Equifax. In addition, sites like MyFico.com, the consumer information website of the Fair Isaac Corporation, also provides a credit report summary of factors that are positively and negatively affecting your credit, so you can know what to keep doing to maintain your score, and where to improve to bring it even higher.
Know Your Credit Scoring Models
The majority of lenders use your FICO score, but it’s not the only credit scoring model out there. Some may use newer scoring models, like the credit reporting company’s VantageScore, or a scoring model of their own. It can be confusing, so to know exactly where you stand, Privacy Rights Clearinghouse recommends asking your lender what scoring model it uses. You can also check your credit score with each of the three credit reporting companies to know where you stand in case a lender or company looks there. It’s not a free service, but if you don’t want to pay, you can still request your report for free and check your data to ensure your credit score is at least accurate.
Make Payments On Time
Payment history comprises the bulk of your credit score compared to other data on your credit report. Chances are, you’re already making credit card and loan payments online consistently, but it’s important to maintain this practice, as even being only a few days late can have a negative impact on your FICO score.
Don’t Rack Up Debt
Another major component of your credit score is amounts owed ó essentially, any balance on your accounts. Not owing a lot and staying well within your credit limit helps to maintain or improve your credit score. Even if you charge close to your limit and pay off your card in full each month, lenders may see a reliance on credit a risk and that could negatively affect your score. A good credit balance to limit ratio to maintain is under 30%, note experts on CNN Money. In other words, if your credit limit is $1,000, you shouldn’t charge more than $300 a month.
Don’t Move Your Debt Around
It may be tempting to consolidate your debt onto one card to make for easy payments, but this may negatively affect your score. MyFico.com notes that owing the same amount but having fewer open accounts may lower your score.
Keep Credit Open
If you pay off an old credit card, don’t close the account. Another factor used to determine your credit score is the length of credit history. The longer the credit history, the better, but if you close an old account, that would shorten the life of your credit history. It’s also important to use your credit cards, even frequently, as recent use can help your credit score.