Your credit score is like your financial report card in today’s financial world. A three-digit number can open doors to better loan terms and lower interest rates, even extending to job opportunities. But for many, credit scores remain a mystery. What exactly is a credit score? How is it calculated? Most importantly, how does one improve it?
This post will explain everything about credit scores, simplifying what may seem complex to grasp into simple concepts. For the beginning finance or student of finance, for more critical outlooks on credit scores, some useful information can be found within this article.
What is a Credit Score?
Definition and Purpose
It is a numeric representation indicating your creditworthiness. It’s like a grade given to you to depict how likely you will repay your borrowed money. The higher your score, the more reliable you look to potential lenders.
Credit scores range from 300 to 850 commonly. The higher the score, the better the credit. Here’s a general breakdown:
Excellent: 800-850
Very Good: 740-799
Good: 670-739
Fair: 580-669
Poor: 300-579
These scores are used by lenders to decide whether to approve your loan applications and what interest rates they will offer you. It is not just the lenders that pay much attention to your credit score. To whatever purpose it may serve, your landlord, your insurance company, and even some of your potential employers may want to check your credit score.
History of Credit Scores
Credit scores have not always been the same, even though credit decisions have been carried out since time immemorial. Prior to their invention, credit decisions were often subjective and could be influenced by personal biases.
Fair Isaac Corporation, now known as FICO, developed the modern credit scoring system in 1989. The FICO score introduced objectivity and consistency into credit decisions. It allowed lenders to assess credit risk quickly without manually reviewing each credit application. In turn, it made credit available to more consumers over a wider range. It provided the consumer with a fast, uniform way to get credit.
How Credit Scores Are Calculated
Knowing how credit scores are calculated is the key to managing and improving your credit. Though the algorithms for credit scoring are proprietary, we do know the main factors driving your score.
The Five Key Factors
- Payment History (35%): Your payment history is the leading cause of your credit score. It indicates whether you paid past credit accounts on time. Many missed or late payments and accounts sent to collections will substantially lower the score.
- Credit Utilization (30%): The percentage of available credit used. For example, if you have one credit card with a $10,000 limit and you have charged $3,000 on the card, then 30% of your credit is being utilized. As a rule of thumb, that percentage should be below 30%.
- Length of Credit History (15%): This factor considers how long you have kept credit accounts open. The longer your credit history, the better your score will be because more information about your borrowing habits exists.
- Credit Mix (10%): This considers all the various types of credit you have assumed, such as credit cards, retail accounts, installment loans, and mortgages. It may be beneficial to have a mix of different types.
- New Credit (10%): This factor considers how many new credit accounts you have recently opened. Opening many new accounts quickly can signal higher risk and might lower your score.
FICO vs. VantageScore
Though FICO is the most popular credit scoring model, it is not the only one. VantageScore is another popular model developed by three major credit bureaus: Equifax, Experian, and TransUnion.
VantageScore does, however, use a similar 300-850 range but weights them slightly differently:
Payment History: 40%
Credit Age and Mix: 21%
Credit Utilization: 20%
Balances: 11%
Recent Credit: 5%
Available Credit: 3%
This will better help you understand these differences, enabling you to interpret your credit scores more accurately, particularly in cases where you may monitor your credit across multiple platforms.
The Importance of a Good Credit Score
A good credit score is not just a number; it may translate to real-life impacts on your financial life and beyond.
Financial Benefits
- Better Loan Terms: A high credit score can help you qualify for lower mortgage, auto, and personal interest rates. Even a small difference in interest rates can save you thousands of dollars over the life of a loan.
- Higher Credit Limits: With a good credit score, your lender will likely be better positioned to approve a higher credit limit. This, in turn, would provide you with more financial leeway and help you maintain a decent credit utilization ratio.
- Better Credit Card Offers: You stand a better chance of getting credit cards offering rewards programs, cashback offers, and lower interest rates with a good credit score.
- Insurance Discounts: Most states allow insurance companies to use credit-based insurance scores when calculating premiums. If one has a good credit score, this may result in lower insurance rates.
Non-Financial Benefits
- Rental Applications: Several landlords request credit scores when considering rental applications. A good score will make you an attractive tenant.
- Employment Opportunities: Some employers check credit reports, not scores directly, for certain positions, especially financial. In these scenarios, a good credit history may be an advantage.
- Reduced Stress: Knowing that you have good credit can provide some level of peace of mind. You will most likely be approved in any instance where you need credit, giving you a type of financial safety net.
Factors That Do Not Affect Your Credit Score
It’s also important to learn what does not affect your credit score. Common myths include:
- Income: Although lenders consider your income, it is not part of your credit score.
- Checking Your Own Credit: This is called a “soft inquiry,” and it does not affect your score when you access your credit report or score yourself.
- Race, Religion, National Origin, Gender, or Marital Status cannot legally be considered in credit scoring.
- Age: Though the age of your credit history is a factor, your actual age does not count in your credit score.
- Geographic Location: Your address doesn’t determine your credit score but is likely to be used to verify your identity.
Understanding what isn’t considered will help you understand what really matters when striving to improve your credit score.
How to Check Your Credit Score
Knowing your score is the first step in managing and improving it. Thankfully, most people have several ways to check their scores. Some popular options include:
Credit Karma
Credit Sesame
Discover Credit Scorecard (even if you are not a customer)
Most services are free, come with VantageScore 3.0 or FICO scores, and are updated monthly.
Credit Card Issuers
Many credit card companies provide free FICO scores to their customers. Check with your credit card issuer to see if it’s available.
Annual Credit Reports
While not a score per se, you are entitled to a free credit report once annually from each of the three main credit bureaus through AnnualCreditReport.com. This will be useful to you to understand what’s affecting your score and to catch any errors.
Remember, though, that your credit score can vary depending on which of several scoring models is used and also depending on which credit bureau’s report is pulled.
Boosting Your Credit Score
Whether your credit score needs an extreme makeover or just a minor touch-up, there are some things you can do to improve it.
Short-Term Strategies
- Pay Down Credit Card Balances: Reducing your credit utilization can positively impact your score fairly quickly.
- Become an Authorized User: If any of your family members or friends have a credit card with a long history of timely payments, ask them to include you as an authorized user. Their good credit behavior might just increase your score.
- Request a Credit Limit Increase: If approved, this could reduce your credit utilization ratio and may improve your score.
Long-Term Strategies
- Pay All Bills on Time: Make use of the automatic pay or reminders so that you will never be late for due dates.
- Keep Old Credit Accounts Open: The length of the credit history, therefore, comes into effect-one should not close the old accounts one doesn’t use regularly.
- Limit New Credit Applications: Each hard inquiry can slightly lower your score; hence, apply for new credit sparingly.
- Make Your Credit Mix More Diverse: If you currently only have credit cards, you may want to add an installment loan to your credit profile.
- Monitor Your Credit on a Regular Basis: Be regularly informed about any changes in your credit report and score and dispute errors as soon as possible.
Addressing Negative Items
If your credit report does list negative items, you can address them as follows:
- Negotiate with Creditors: For accounts in collections, try negotiating a “pay for delete” agreement where the creditor removes the negative item in exchange for payment.
- Write Goodwill Letters: If you have a generally good payment history with a creditor but had a one-time late payment, a goodwill letter may persuade them to remove the negative mark.
- Wait It Out: Negative items generally disappear from your credit report after 7 years, while bankruptcy takes 10 years.
Keep in mind that good things take time, and patience is a virtue when trying to improve your credit score. There’s no such thing as an overnight fix, but consistently good habits will pay off in due time.
Common Credit Score Myths Debunked
There is a lot of bad information about credit scores floating around. Let’s clear some common misconceptions up for good:
- Myth: When you check your own credit score, you lower it.
Fact: Checking your own score is a “soft inquiry” and has absolutely no effect on your score. - Myth: You have but one credit score.
Fact: You actually have many scores based on various scoring models and different information from different credit bureaus. - Myth: Closing old credit cards improves your score.
Truth: It can actually hurt your score by reducing your available credit and shrinking your credit history. - Myth: You must carry a credit card balance to build credit.
Truth: Paying your full balance monthly is the best thing for good credit; that way, you avoid interest charges altogether. - Myth: Your credit score takes a hit when you get married.
Truth: Marriage in and of itself does not affect your credit score. You and your spouse have individual credit reports and individual credit scores.
Knowing these myths will help you make more informed decisions on how to handle your credit.
The Future of Credit Scoring
As technology in society changes, so does credit scoring. Below are listed some ways that the concept of credit scores is changing:
Alternative Data
Traditional credit scores are very dependent on histories related to loans and credit cards. Recently, an increasingly loud drumbeat has been heard to commence integrating alternative data, like rent payments, utility bills, and even social media activity, into credit scores. This can help people with thin credit files develop scores more quickly.
AI and Machine Learning
AI/ML is already being used to analyze vast reams of data to make more sophisticated credit risk analyses possible. This may enable a more accurate creditworthiness prediction than has been possible.
Open Banking
Open banking- the ability of consumers to decide if and with whom they share their banking data radically changes the face of credit scoring. Open banking might just allow a more complete view of a person’s financial habits and responsibilities.
Financial Inclusion
There is a growing interest in developing more inclusive scoring models designed to offer better service to populations traditionally underserved by the financial system. This may expand the population with access to credit and other financial services.
As these trends continue to unfold, it will be exciting to learn how credit scoring changes and how it may impact your financial life.
Conclusion
Your first step towards taking control of your financial health is understanding your credit score. Besides being a number, a credit score may be the key that opens better opportunities in life.
It is not like you wake up one day and find yourself with good credit; rather, it’s something groomed through time and repetition of responsible handling of your finances. A proper understanding of how credit scores work, frequent checking of your credit score, and techniques for improvement can help in the development and maintenance of good credit scores.
Whether you’re just getting started with building credit or you’d like to improve an already good score, the core concepts remain the same: pay your bills on time, keep utilization low, maintain a long credit history, and be judicious about how many new accounts you open.
Remember that your credit score is just one piece of your overall financial big picture as you go along. While important, this is not the only focus that should be made. Add good credit habits to sound budgeting, saving, and investing practices for a well-rounded approach toward good financial health.
Keep yourself informed about the changes in credit scoring models and other new financial products that may impact your credit score. Knowledge and continued effort shall help you navigate the realms of credit scores and confidently unlock the doors of better financial opportunities.
