For some, credit scores are these mysterious, powerful numbers that determine whether or not you can get a loan for a car, house, or just about anything else. Most people don’t understand how credit scores actually work. You may not have checked your score in a while (or ever), but it is important to know and understand it to ensure a healthy financial future.
Let’s demystify the ever-important credit score:
What is a credit score?
A credit score typically refers to your FICO score, a formula developed by the Fair Isaac Corporation. Your FICO score is determined by taking into consideration all of your credit accounts, from credit cards to mortgages, as well as your payment history.
A good way to look at your credit score is as a grade, like what you might get on a test. Instead of a score from 1-100, though, it is graded on a range from 300-850. To grade your credit history, Fair Isaac uses three credit reporting agencies: Experian, Equifax, and TransUnion. Because of the three different reporting agencies, each person technically has numerous credit scores, all of which will vary slightly. If you are rated “excellent” in one score, however, you should always be rated excellent in the others.
Your credit score determines how much money you can borrow and how much you’ll pay for the loan. Generally speaking, the higher your credit score, the more money you can borrow and the smaller your interest rate will be.
How is your credit score calculated?
There are five key factors that you should pay attention to in order to maintain a good credit score:
- Payment history: How often do you pay your bills or fines on time? To keep a high credit score, you should always make on-time payments. One late payment won’t destroy your credit, though, so don’t fret! Credit card companies don’t typically report late payments until you are 30 days late. Medical bills and parking tickets can appear here as well.
- Open credit card utilization: This is how much you owe each of your creditors in comparison to your total credit available to you or to your loan amount. That means if you are maxing out your credit cards, you are likely damaging your credit score. Ideally, you should keep your credit balances under 30% of you total credit card limit in order to build good credit. This and your payment history are the two most heavily weighted factors in your credit score.
- Derogatory marks: These negative marks include accounts that have gone to collections, bankruptcies, foreclosures, or tax liens. Most derogatory marks take 7-10 years to clear from your credit history.
- Average age of open credit accounts and total number of accounts: Having fewer and older accounts in good standing can help build positive credit. Conversely, having many new accounts can hurt your credit.
- Types of credit: Having both installment debts (like a mortgage with fixed payments each month) and revolving debt (like a credit card) show that you know how to manage different types of credit.
There isn’t an exact known number that determines a good credit score from a bad one, because each lender or creditor has their own ranges, but here is a generally accepted guideline:
- Excellent: 720 and up.
- Good: high 600s to low 700s.
- Fair: mid 500s to mid 600s.
- Poor: 300 to low 500s.
Why is your credit score important?
Lenders look at your credit score and credit report to see a record of credit history. They use this as an indication of whether or not you will repay the loan you are applying for. To put it even more simply, a good credit score can get you approved for a loan while a bad score can get you denied.
Lenders also use your credit score to determine the terms of your accounts, as in interest rates, credit limits, down payments, etc. Insurance companies will also look at your credit history to assess risk and to set premiums. Even some employers check credit reports during the employment screening process.
A good score is important if you plan to apply for a student loan, a car loan, or a mortgage. It can cause you to save money down the road or get blocked from getting that dream house. Remember that your credit score is a test of your overall history, so there is never a good time to make a mistake that could hurt your future. Take the time to check out your credit score and be sure to monitor it each year so you can be aware of how creditworthy you are.