Chapter 1 : What Is a Credit Score?
Thinking about buying a house? That new car you’ve been dreaming about? Opening that coffee shop or bookstore? Big dreams require financial assistance, and in order to get good financial assistance, you need a good credit score.
Unfortunately, there’s a lot of misinformation around about credit scores. Fortunately, we’re here to help you weed out the important info, like the differences between the two main credit scores, from the false, like the belief that unemployment impacts your credit.
In this chapter, we’ll be discussing the credit score’s meaning, how a credit score is calculated, why your credit score is important, and more. Read on to learn all you need to know about credit scores and how to make yours the best possible.
What is a credit score?
If you’ve ever applied for a credit card, tried to rent an apartment, or looked into getting a loan, you’ve probably heard the term “credit score”.
Are you wondering, “What is a credit score?” Your credit score is a number assigned to you based on your financial habits that represents your “creditworthiness”. It’s a universal grading scale that shows how “good” you are at managing your debts. A credit score can range from 850 to 300. The average credit score in the U.S. differs by age and state, but it’s around 675.
You’ll start generating credit when you open your first credit card, but it’s important to know how to build credit so that you can start off on the right foot.
Your starting credit score will be influenced by various factors, such as:
- Your payment history
- Length of credit history
- Credit mix
- Amounts owed
- New credit
Lenders or other entities that expect regular payments will look at your credit score to determine whether you’re likely to pay your payments and to do so on time. This is called your credit reference, and it describes your credit history background and creditworthiness to potential lenders. Your credit score will weigh extremely heavily in their decision to work with you.
You need a high credit score to qualify for things like a lower down payment and a good credit card. If your credit score isn’t exactly where you want it to be– don’t panic. There are many ways you can boost your credit score, which we’ll be discussing later on in the chapter and in more depth in Chapter 8.
How is your credit score calculated?
When it comes to credit scores, there are two main players that major credit bureaus and other lenders look to:
- FICO Score
Each calculates your credit score slightly differently. Let’s review.
The FICO score, named after its developer Fair Isaac Corporation, is the longest running credit score. It was originally invented in 1956 and became the standard for consumer lending in 1989. In order to obtain a FICO Score, you must use credit for at least 6 months.
FICO uses the following factors to calculate your credit score, listed in order of importance:
- Payment history (35% of your credit score): Do you pay your payments on time?
- Amounts owed (30% of your credit score): What is the ratio of your debt to your credit limit?
- Length of credit history (15% of your credit score): How long have you been managing credit?
- New credit (10% of your credit score): How often do you apply for new credits?
- Credit mix (10% of your credit score): How many different types of credit do you have, and how do you handle each?
According to the FICO Score, credit scores are rated as follows:
- 800-850: Exceptional credit, resulting in great rates and terms
- 740-799: Above average credit, resulting in competitive rates and terms
- 670-739: Good credit, resulting in average rates and terms
- 580-669: Fair credit, resulting in worse-than-average interest rates
- 300-579: Poor credit, unlikely to be approved
VantageScore is the newcomer to the scene, originally debuting in 2006. It was introduced in order to better account for changes in technology and borrower behavior.
VantageScore uses the following factors to determine your score:
- Payment history (40% of your score)
- Age and type of credit (21% of your score)
- % of credit limit used (20% of your score)
- Balances (11% of your score)
- Recent credit (5% of your score)
- Available credit (3% of your score)
According to the VantageScore, credit scores are rated as follows:
- 781-850: Superprime, resulting in great rates and terms
- 661-780: Prime, resulting in average rates and terms
- 601-660: Near prime, resulting in worse-than-average interest rates
- 300-600: Subprime
How to improve your credit score
Are you feeling crushed by the weight of a poor credit score? The good news is that, with so many factors that contribute to both scores, there’s also much opportunity to improve it.
The first step to protect your credit is to get a good understanding of where you’re currently at. Request a credit report and examine which factors are most heavily contributing to your current score. This will help you identify areas for improvement. If you notice a credit report error, make sure to dispute it as soon as you see it so you can get the information corrected.
Once you know which issues you need to tackle, it’s time to get to work. There are both short-term and long-term solutions to improving your credit score. Here’s how to solve the most common credit issues.
Pay off as much debt as possible
The first step to improving your credit score is to minimize your debt. Paying off as much debt as possible is one of the best ways to quickly raise your credit score if you’re in a time crunch.
Start by paying off your credit cards every single month. A balance on your credit card that’s carried from month to month is known as revolving debt. Lower this amount or get it to $0 to quickly increase your score. Paying off a loan, whether that be a school loan or an auto loan, is also important so you don’t accumulate debt without even realizing it.
Additionally, make sure you pay all your current debts on time and, if you can, pay more than the minimum monthly payment. This is a sign to creditors that you’re responsible and proactive about paying off your debts. You should also aim to keep your debt-to-credit ratio low, which is the amount of debt you owe compared to your available credit.
Pay your bills on time
This is especially important for your FICO Score. Be sure to pay your bills on the day they’re due every single time, if not a few days early. Even a payment that is only a few days late can have a negative impact on your credit score.
If you can, use an automatic payment system offered by your bank or creditors. This will automate your on-time payments. Remember to check in each month and ensure that your payment went through; it’s still your responsibility to make sure that your automatic payments work.
If you don’t pay your bills, they’ll end up in collections. When a bill goes to collections, the collections agency will contact you directly for payment. But a bill in collections can reflect negatively on your credit report. If you notice you have a bill in collections on your credit, pay it off as soon as possible.
If you didn’t start building a credit score at 18 and therefore have a history of late or missed payments, it’s not too late to get back in good standing. Get current with your payments and pay on time from here on out. Eventually, the on-time payments will outpay the late and they’ll become a thing of the past.
Keep unused credit cards open
Did you finally pay off that credit card that has been plaguing you with revolving debt for years? Before you say, “Sayonara!” for good, think about how closing that card may impact your score. It might not actually be beneficial for you to get rid of closed accounts.
First, closing a credit card will lower your available-credit-to-used-credit ratio, known as your credit usage. Additionally, history is good when it comes to credit. Creditors want to know you have been in the financial management game for a while and closing the account means it may not be visible on your report for them to see.
Note that credit cards should never be opened solely for the purpose of increasing your available credit and improving your credit usage. This practice is an immediate red flag to creditors. Keep an eye on your total accounts.
Minimize “hard inquiries”
When it comes to credit, lenders don’t want too many players in the game. As such, it’s important to keep your new credit applications to a minimum.
You may be wondering, “How would they even know?” When a creditor makes an inquiry in your account, as they do when you apply for a new line of credit, they perform what’s known as a “hard inquiry”. A record of these inquiries remains in your credit history for 2 years, and too many can negatively impact your credit score.
A soft inquiry, such as one that occurs when you pull your own credit score, will not.
Don’t be afraid to seek help
Many people who are in significant debt fear that looking for assistance from their creditors or credit counseling services will only worsen their debt. This assumption is wrong.
Seeking assistance with your credit score doesn’t count against you. If you follow the advice of these counseling services, you’ll begin to see slow but steady improvement. It’s also important to continue to monitor your credit so you can quickly spot any errors that may be hurting your score.
There are a few other ways you can improve your credit score, but the above are the most common. For example, one of the financial benefits of marriage is that it can help you build your credit– but that’s just an added bonus.
Why your credit score matters
So we’ve answered the question of “what are credit scores?”, but what about “why does your credit score matter?”.
Bankers and lenders view your credit score as a direct reflection of your reliability when it comes to repaying debt. A good credit score indicates to a lender that you’re likely to pay your debts back and do so on time, whereas a lower credit score indicates you might be a risk for your lender.
Here are a few instances where your credit score will come into play, as well as potential effects of bad credit:
- When applying for a home or apartment rental, a poor credit score may cause a landlord to reject your application.
- When applying for a home loan, a poor credit score can result in extremely high interest rates or rejection altogether.
- When applying for a new line of credit, a poor credit score may lead to a very low credit limit or rejection.
It’s important to remember, your score in no way defines you. It just gives lenders an indication if they are taking on a big risk in loaning you the money. Unfortunately, a lower score tends to give the lender the upper hand in the transaction.
Boosting your credit score can improve your financial health
Checking your credit score regularly can help you become more aware of your financial health so you can make better financial and credit decisions. It’s also a way to make sure your credit stays in good shape, and if your credit score decreases, you can figure out ways to improve it.
So now that we’ve gone over the credit score definition and basics, you can move onto the next chapter in the series: What credit score do you start with?
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