Do you understand your credit score? We talk a lot about various personal finance concepts here and credit scores are another important part of personal finance. They are essentially a numerical representation of your creditworthiness, and they are used by lenders to determine your ability to pay back loans, credit cards, and other debts. A credit score can have a significant impact on your financial life because it comes up in so many ways, from renting an apartment to obtaining a mortgage, your credit score will creep up and follow you to show these people how responsible you are with your finances. So, let’s dive in a little bit to see what’s up.
What is a Credit Score?
A credit score is a number between 300 and 850 that represents your creditworthiness. It is calculated using your credit history, which includes payment history, amounts owed, length of credit history, types of credit used, any new credit. Lenders and other financial institutions will use your credit score to determine how risky you are to lend money to, which means your credit score will determine whether they approve your application for credit and the interest rate you will receive on that credit. The higher your credit score, the better our creditworthiness, the more likely you will be approved for a loan – or at least not denied because of creditworthiness.
Credit Score Categories
Credit scores are calculated based on information in your credit report. This most common scoring model is the FICO score, which is used by many financial institutions. FICO scores range from 300 to 850 and are calculated based on the following five categories:
- Payment history – this is 35% of your credit score. This includes payment patterns on credit accounts, such as mortgages, car loans, credit cards, etc. Late or missed payments can significantly lower your score.
- Amounts owed – this is 30% of your credit score. This refers to your credit usage, which is the ratio of your amount owed over the credit limit. Running up a high usage will negatively impact your credit score.
- Length of credit history – this is 15% of your credit score. This considers how long you have had credit accounts open, including the age of your oldest and newest accounts.
- New credit – this is 10% of your credit score. This includes how many new accounts that you have opened recently and the number of inquiries on your credit report.
- Types of credit used – this is 10% of your credit score. This considers the mix of credit accounts that you have, including credit cards, loans, and mortgages.
Those are the five categories that make up the FICO score. The math used to calculate FICO is proprietary and not shared with the public, so we are unfortunately unable to provide a mathematical example. But it is worth knowing the breakout above too so that you know where to focus your efforts.
Why do Credit Scores Matter?
Credit scores will have an impact on your overall odds of being approved for a loan. It is one of the primary factors that lenders consider when deciding whether to approve you for a loan or not. If your credit score is high, you are more likely to be approved for a loan and receive more favorable terms, such as a lower interest rate. Please note that a credit score is not the only factor used to determine loan approval. Income is another very significant factor that determines whether you can be approved for a loan or not. Credit scores are just a useful way to view an applicant’s current outstanding credit against their current income while also comparing how well that applicant has paid their bills. You are most likely to have credit score affect the interest rate that a lender approves for your loan though. Oftentimes the lower the credit score, the higher the interest rate will be because this is a way for the bank to hedge their investment risk.
Some insurance companies will use credit scores to determine the premium that you will pay for car or homeowner’s insurance. If you have a low credit score, you might be charged higher premiums. Additionally, employers might check credit scores as part of the hiring process, you might especially see this for jobs that require financial responsibility as part of the job description. Finally, landlords will often run a credit check for tenants when they apply to rent a unit or room from the landlord. You might see a landlord have strict requirements for credit scores. Landlords are not necessarily bound to credit scores, but they can set their own policies that a certain FICO must be met to be considered further. It is important to read the descriptions that landlords set in their rental advertisements or applications.
How to Improve your Credit Score
Improving your credit score takes time and effort, but it is possible. Here are some tips that can help you improve your credit score:
- Pay your bills on time. Since payment history is the largest factor in determining your credit score, make sure that you take this one seriously. Late or missed payments can significantly lower your score. One way to avoid late payments is to set up automatic payments or reminders to ensure you do not miss any payments.
- Keep your credit utilization low. This is the amount of credit that you use compared to your limit (e.g., you are approved for a $10,000 credit limit on a credit card and currently have a $2,000 balance owed on the card. In this example, the credit card utilization is 20%). The higher the percentage can lower your credit score. A rule I have often heard is to try to keep your credit utilization below 30%. For example, if your credit card limit is $10,000, try to keep your credit balance below $3,000.
- Monitor your credit report. You are entitled to a credit report per year from each of the major credit reporting agencies (TransUnion, Equifax, and Experian). Review your credit report for errors and dispute any inaccuracies. Additionally, Credit Karma exists and can provide you with updated scores quite frequently. It is important to note that Credit Karma is not a credit bureau and the credit scores that it provides you might not be the same that lenders use to make credit decisions. However, it can be a good way to get alerted when accounts are opened in your name.
- Limit new credit applications. Opening too many new credit accounts can lower your score. Only apply for credit when necessary and avoid applying for multiple accounts at once. Note: there is one caveat that I want to mention here – do not let this stop you from shopping around mortgage lenders. The impact on your credit score from credit pulls is not as significant as late payments, so it might be a wise idea to shop around lenders when you are looking for a mortgage and most of the time when you do this, the lenders do what are known as “soft pulls” on your credit that do not actually ding you. Ask your lender about this when you apply for a new credit account in the future.
- Keep old accounts open. Since the length of your credit history is a factor in determining your credit score, keep your accounts open. Closing accounts can shorten your credit history and lower your score. Keep them open and use them responsibly.
Final Thoughts, For Now
Your credit score is a crucial factor in your financial life. It affects your ability to secure loans, credit, and maybe even employment. Understanding how your credit score is calculated and taking steps to improve it can help you achieve your financial goals and build a solid financial foundation.
Remember that improving your credit score takes time and effort. Be patient, stay on top of your bills, and use credit responsibly. With time and dedication, you can improve your credit score and enjoy the benefits of good credit.
Disclaimer: I am not a financial advisor. The content on knowxchange.com or “this site” are for educational purposes only and merely cite my own personal opinions and experiences. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know and understand that all investments involve some form of risk. There is no guarantee that you will be successful in making, saving, or investing money. Additionally, there is no guarantee that you won’t experience any loss when investing. Please seek the advice of a financial professional and do your own research.