You always hear how important it is to know your credit score and maintain a good one. But with so much information out there, you’re probably wondering “how do credit scores work?” and don’t know where to start.
The following is everything you need to know about credit scores, why you should care about them, and how you can use them to reach your financial dreams. Let’s get to it.
What is a credit score?
Lenders developed credit scores to help them understand the level of risk certain borrowers might present.
They start by measuring a certain number of credit criteria (detailed below), and from that borrowers are given a three-digit score.
A lot of people try to strive for the “perfect” credit score. They assume that’s a goal that can unlock all of their financial wishes. But this is a pointless endeavor.
That’s because what many of those same people don’t know is that we all have more than one credit score. That’s why it’s more helpful to focus on the range that your credit score falls into rather than the credit score itself.
However, before we get to that, it’s important to understand that credit scores and credit reports are not the same.
A credit report is a listing of your financial accounts and the details thereof. According to MyFico, this includes:
- What types of credit you use.
- The length of time your accounts have been open.
- Whether you’ve paid your bills on time.
- Your address.
- Whether you’ve been sued or arrested, or have filed for bankruptcy.
A credit score, on the other hand, is simply a numerical illustration of your creditworthiness. While the score is based on information on your credit report, your credit score is not listed on your credit report.
Therefore, consider these to be two separate things, but working on one will improve the other.
How do credit scores work?
There are two major credit scores, FICO and VantageScore. And there are five factors that make up how these scores are calculated. However, what affects your credit score is not always valued equally.
Here’s the breakdown of the FICO score, as seen in MyFico:
1. Payment history
Payment history is the most influential factor of your credit score at 35 percent. It’s also the easiest to control. Simply make your payments on time for all of your bills and you’ll score highly in this area.
2. Amounts owed
Amounts owed clocks in at the second most important factor of your credit score at 30 percent.
This is also known as credit utilization or your credit-to-debt ratio. You can factor this ratio by adding up the amount due on all your revolving lines of credit. Then add up the amount of all of your credit limits and compare these two numbers.
For example, if you have two credit cards with a $500 limit each and no other revolving lines of credit, then you have a total limit of $1,000. If you owe $50 on each credit card, then you have a $100 balance in total. This equals out to a 10 percent credit utilization ratio.
To score highly in this category, keep your ratio at 30 percent or below.
Note: you might stumble on a “fact” stating that you need to carry a balance over from month to month to have a good credit score. This is simply not true.
Since a lower credit utilization ratio equals a higher score, a zero balance is the best thing you can have. Why? Because it will give you a zero percent credit utilization.
Lenders want to see you using your credit cards, but that doesn’t mean you have to carry a balance and pay interest on that to get a good score. So if you pay your balance off every month, you’ll stay out of credit card debt and improve your credit score at the same time.
3. Length of credit history
This next factor of your credit score is worth 15 percent and will improve as time goes on, as long as you don’t cancel your credit accounts.
That’s because this factor is length of credit history. Therefore, keeping your accounts open demonstrates you can maintain a good length of credit history.
Credit card issuers do sometimes close a credit card account due to lack of use. So you may need to periodically use old cards for small purchases and pay them off before the interest hits. That way, you can keep your accounts open and contribute to this portion of your credit score.
4. Credit mix
Credit mix refers to the types of credit you have, such as lines of credit and installment loans. This mix is worth ten percent of your score.
Ultimately, you’ll score better if you have more than one type of credit. But it’s not worth enough of your score to take a loan out that you don’t need.
On the flip side, if you’ve been struggling with student loans and have a credit card, then your student loans can do something good for you. They’ll contribute to your credit mix.
5. New credit
Finally, there’s new credit, also worth 10 percent of your credit score.
This factor, though not worth a ton, can cause quite a bit of confusion for consumers. That’s because many fear that having too many inquiries on their credit score will hurt this factor.
Here’s the easy way to remember the rules on this one. If you’re shopping around for new credit, do it quickly. And always apply for the same amount.
For example, if lenders see that you’ve applied for three home loans for $250,000 within two weeks, it will be clear to them that you’re rate shopping.
But if you apply for a home loan for $250,000, a credit card, and an installment loan of $10,000, then it could look like you’re overextended. And if you’re overextended, you might be a risk.
Therefore, just shop for what you need and don’t stretch out the new credit applying process days for more than 45 day. That way, you won’t take a hit on this portion of your credit score.
What types of credit scores are there?
There are multiple models of each, and lenders may use different models based on the product they’re financing (i.e. mortgages versus auto loans).
Because of this, everyone has many credit scores. But if you follow the range your score falls into, then you’re in good shape.
FICO credit score ranges
FICO has five credit score ranges as described by Experian:
- 300-579 “Very Poor”
- 580-669 “Fair”
- 670-739 “Good”
- 740-799 “Very Good”
- 800-850 “Exceptional”
VantageScore credit score ranges
VantageScore has five credit score ranges as described by Experian:
- 300-549 “Very Poor”
- 550-649 “Poor”
- 650-699 “Fair”
- 700-749 “Good”
- 750-850 “Excellent”
What the credit score ranges mean to you
These range descriptions are pretty self-explanatory. In short, the higher your score, the easier it will be to obtain new credit.
But, borrowing money isn’t the only thing your credit score can affect. It can also affect your future employment opportunities and approval for things like an apartment lease or insurance.
Whether or not you want to finance purchases, you need to be aware of your credit score. Work to get it as high as possible so that it never stands in your way.
How to improve your credit score
There are a few different things you can do to get your credit score as high as possible, but they’ll depend on your current range.
If you’re new to credit
Looking to establish credit for the first time? If you take the following steps, you should see an uptick in your score in about six months to a year:
Get a credit card.
It’s usually not difficult to get a credit card for the first time, though the credit limit will probably be low. However, if you’re new to the U.S. or have trouble getting a credit card, you can opt for a secured credit card instead.
Get a secured credit card if you can’t get a regular credit card.
A secured credit card is one in which you put down a down payment. This acts as a security deposit that you get back if you close the account or are upgraded to a traditional credit card – so long as your balance is paid off.
Many companies who offer secured credit cards regular review accounts to see if they might be eligible for an upgrade. That makes this is a great option to help you establish credit.
Make all of your payments on time.
Why do you need credit to build credit? Because it’s the best way to show lenders that you can handle credit responsibly.
And the best way to do that is to make your payments on time every month and pay your balances as soon as you can so you can also avoid going into debt.
Try alternative credit reporting.
You can also look into alternative credit-building tools like RentalKharma. They verify that you have made your rental payments on-time, then report it to TransUnion for inclusion on your credit report.
If you’re trying to improve bad credit
If you want to improve your credit score and avoid having it fall into one of the lower ranges, there are a few steps you can take.
- Pay off delinquent bills or accounts: accounts that have gone to collections stay on your credit for years. That’s why you’ll want to take care of them as soon as you’re able.
- Negotiate a payment plan with your creditors: if you’re unable to pay off delinquent accounts, reach out to your creditors and explain your situation.
- Get a secured credit card to rebuild your credit: as stated above, a secured credit card will help demonstrate you can responsibly handle credit.
- Make sure there are no errors on your credit report: if there are any errors, learn how to dispute credit report errors ASAP so you can get them off your report.
If you want to improve or maintain good credit
Let’s say your credit score isn’t in bad shape but you want to increase it. Here are some tips to help:
- Check your credit report annually: and dispute any errors that you come across quickly.
- Apply for a credit limit increase: doing so will decrease your credit utilization. Which, remember, makes up 30 percent of your score.
- Pay all your bills in full and on time: this will continue to demonstrate that you can handle credit responsible, and help you avoid acquiring debt in the process.
- Pay off your debts: by keeping a low-to-zero balance on your debts you maintain a great credit history for lenders to view.
Some may worry that increasing your credit limits is counterintuitive to paying off debt.
Just remember that if you increase your credit limit, you shouldn’t increase your balance. Otherwise, you’ve done nothing to improve your credit utilization or your credit score.
Don’t go into debt to improve credit score
There are a lot of myths on how to improve credit scores, some of which can be disastrous to your finances. All you have to remember is that whatever keeps you financially sound will help you improve your credit.
In other words, if you want to appear to be a responsible borrower, use credit. But, pay it off every month so you don’t go into debt.
And if that’s not possible (which it may not be for a mortgage, auto loan, or student loan), then pay it off as soon as you can.
Most importantly, always pay your bills on time. And don’t co-sign on accounts you can’t afford to pay off should the borrower default.
In the end, if any credit scoring advice coming your way promises a quick fix or seems too good to be true, it probably is.
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