Understanding Your Credit Score

Your credit score can determine how likely you are to secure loans, rent apartments, and even find job opportunities. But how is it calculated and what can you do to improve it? 

What is it?

Your credit score lets someone see how dependable you are at managing and paying back your debt. This three-digit number, ranging from 300-850, was created as a way for lenders to understand how likely their borrowers were to pay them back. The higher the score you have, the more creditworthy you’ll appear.

Why is it important?

Your credit score is the most valuable when it comes to creditors determining your eligibility for loans, credit cards, and other forms of credit. Having a higher credit score increases the likelihood of a lender qualifying you for loans with lower interest rates, which can save you thousands over time.

Because of their online accessibility, a lot of people other than creditors check credit scores too. Landlords and utility companies use scores to assess your reliability, affecting your ability to rent a home or set up essential services without large deposits. Some employers even check credit scores during the hiring process to get a snapshot of how financially stable and diligent you’ve been in the past.

How is it calculated?

Your credit score is calculated by credit reporting agencies that collect your credit history and give you a score based on popular scoring models. Here’s how the score is weighted:

• Payment History (35%): How timely do you pay your payments?
• Amounts Owed (30%): How much credit do you use compared to how much you’ve been allowed to use?
• Length of Credit History (15%): What is the average age of all your credit accounts?
• Credit Mix (10%): Do you have multiple types of credit (credit cards, car loans, mortgage loans)?
• New Credit (10%): How often are you opening new accounts and applying for credit?

It’s important to note that since there are two different popular scoring models, FICO and VantageScore, and because there are three other major reporting agencies (Equifax, Experian, TransUnion), you have not just one score, but multiple. However, they all use similar information and algorithms to attempt to keep scoring standardized across the board.

What’s a good score?

The average FICO credit score in the US is 715, here is the generic breakdown of how to gauge whether your score is in great shape or needs to be improved:

Excellent: 800 – 850

Very Good: 740 – 799

Good: 670 – 739

Fair: 580 – 669

Poor: 300 – 579

The average mortgage lender looks at many different factors to approve you for a mortgage, with one being your credit score. The credit score you need to get approved can vary dramatically based on the type of mortgage you’re looking to get, as well as with which bank you are working with. However, here are some general rules of thumb to follow when getting approved for a mortgage (FICO scores):

760 – 850: Likely to qualify for the best interest rate and terms.

720 – 759: Should still qualify for favorable rates, but not as good as those with excellent credit.

680 – 719: Considered a solid credit score for mortgage approval, but rates may be higher.

620 – 679: May still qualify for a mortgage, but interest rates could be higher and approval may require additional compensating factors (such as a larger down payment).

How to Check Your Credit Score

Your credit score is constantly moving up and down depending on the factors listed in the previous section. The three main ways to see your credit score are through credit card issuers and banks, major credit reporting agencies, and credit score monitoring services.

Common Myths

Checking your score frequently will cause it to drop: This is not true. Checking your score is considered a soft inquiry and has no impact on your overall rating. The only time accessing your credit score would drop your score is when you apply for credit, considered a hard inquiry.

If I have a perfect credit score, I’m in great shape for any loan: Having a perfect score does help your odds of getting approved for a loan with a great rate, however, this is just one of the many pieces of your financial picture that lenders look at. They also look at your income, employment history, debt-to-income ratio, savings and assets, and existing debts when determining whether you’ll be approved.

I must always strive for a perfect credit score: While having a great credit score does reflect a level of diligence over how you’ve been able to manage your debt, a perfect score is only useful in a handful of scenarios. As mentioned before, it is the most beneficial when you are applying for major loans. If you aren’t planning on doing so in the coming future, there is no reason to obsess over having a high score because it does very little for you.

Steps to Improve Your Credit Score

So, if you want a higher credit score for more favorable rates on a future loan. Here are some practical steps to bump your score:

1. Make Payments on Time, Every Time: Set up reminders or automatic payments to ensure you don’t miss any payments on your credit cards, loans, or other bills.
2. Reduce Credit Card Balances: Try and only use up to 30% of the available credit you’ve been given across all your accounts. Another term for the amount of credit you use is the credit utilization ratio, and it’s best to keep it under 30%.
3. Payoff Debts: If you have high balances on credit cards, pay on the cards that have the highest utilization rates or balances first, while making minimum payments on other cards.
4. Build Positive Credit History: Keep your accounts open and in good standing for longer periods. If you don’t have much credit history, consider opening a new credit card or becoming an authorized user on someone else’s account.

Key Takeaways

Maximizing your credit score can get you better loan terms and interest rates. There are many great free resources out there to check your score, but it’s important to note that it’s not worth obsessing over if you don’t have a major loan you’re looking to get approved for in next few years.