There's a lot of talk about credit scores, but it seems like not a lot of people truly understand what they are, how they are derived and why they are so important. Here's a quick tutorial so you can understand why yours might be higher or lower than you thought and what you can do to improve it.
In very basic terms, your credit score is a three-digit number that evaluates your creditworthiness based on your credit history. It is a cumulative number that measures your success over time compared with other people. It is especially important if you are applying for credit or any type of loan because it represents the risk a lender will take when you borrow money.
The average U.S. consumer's credit score is between 600 and 750 (although the full range of scores is from 300 to 850). The higher the number, the lower the risk for the lender and potentially the greater benefits for you, the borrower. Anything over 700 is typically considered good while scores greater than 800 are excellent.
It is not uncommon for someone to have more than one credit score because there are three main credit bureaus that create credit reports. Those credit reports are then used to calculate a credit score using different scoring models. One of the most common scoring models is created by the Fair Isaac Corporation, otherwise known as your FICO score. FICO considers a number of criteria contained in your credit report with a primary focus on payment history (35%), followed by total amount of money owed (30%), length of credit history (15%), amount of new credit (10%) and types of credit used (10%).
- Payment history is the most straight-forward of the criteria, simply reviewing whether or not you have paid your bills on time.
- Some of the others become more of a risk analysis. For example, the second criterion evaluates how much you’re using of the total credit you have available, since it is assumed that people who are close to maxing out their credit are headed for financial trouble and more likely to miss payments.
- The length of history criterion doesn’t just consider the average age of your accounts, but also the last time you’ve accessed them.
- As part of the final two (and smaller) considerations, it’s important to note that opening multiple new loan/credit card accounts at one time will hurt your score, while handling a variety of different accounts, i.e. car loan, student loan and credit card, will make you look more responsible and less risky.
If you've never stopped to ask about your credit score, now might be a good time because credit scores are used by a wide array of industries to evaluate you, including banks, insurance companies, landlords and employers. Having the right credit score can mean the difference between being approved or denied for a loan. Most importantly from a financial perspective, your credit score affects the interest rate you’ll pay, as well as your credit limit (how much you can borrow). Even a difference of 20-30 points could translate into thousands or tens of thousands of dollars in interest payments over the life of the loan, depending on the term and amount.
So, what if you don't have an ideal credit score? Can you do anything to make it better?
Yes, but it will take time and effort. It's important to address and correct any errors in your credit report. The more difficult fixes can only be made over time and by adopting good financial habits, including:
- Pay bills on time! Set up alerts on your phone or use automatic bill pay to ensure you don't miss a payment.
- Don't max out your credit cards - even if you pay them off each month.
- Don't open too many different credit cards at one time.
- Diversify your type of debt. Don't just open a bunch of credit cards; rather apply for a car loan or student loan to balance out your debt portfolio.
Most important is to remain vigilant. Through various apps and portals such as Credit Karma, you can regularly check your credit report for errors without a charge or impact on your credit rating. Did you know you are entitled to one free copy of your credit report every 12 months? Learn more here.
Your credit score is one of your most valuable assets, guard it accordingly!