If you’re interested in personal finance, you’re likely to have already been told how your credit score is crucial. Your credit score is a three digit reflection of your current financial situation and how responsibly you handle your finances. While you may not see how important your credit score number is, you’ll learn that it can affect everything in your life and how you can make it work for you.
What’s Your Credit Score?
This is the first hurdle many people face, as we don’t simply have one credit score. So, when people talk about their credit score, they are speaking about one of their scores. There are actually three credit agencies, Experian, Equifax and TransUnion, and each one records your financial information a little differently. There are also a number of different credit agencies that also gather your financial data and use this information to calculate a credit score for your profile.
As we just mentioned, credit scores are a three digit number, but this can be 300 to 900+ depending on the credit score model. Typically, when you approach a lender to apply for a new financial product or service, they will rely on one credit score. The most frequently used is FICO or Fair Isaac Corporation, which is considered to be the industry standard. But, not all lenders use FICO and may use VantageScore or other scoring models to assess your application.
Understanding Credit Scores and Their Impact
| Credit Score Range | Rating | Impact on Your Finances |
|---|---|---|
| 800 – 850 | Excellent | Best interest rates, easy loan approvals, high credit limits |
| 740 – 799 | Very Good | Competitive rates, better credit card rewards |
| 670 – 739 | Good | Decent loan terms, may not get the lowest rates |
| 580 – 669 | Fair | Higher interest rates, potential difficulty getting approved |
| 300 – 579 | Poor | Hard to get approved for loans, may require deposits or co-signers |
How Credit Scores are Calculated
Financial institutions and creditors report their client’s financial data to one or more of the major credit bureaus. The bureaus then use this information to produce credit reports and calculate credit scores. Each time you make your auto loan payment or pay your credit card bill, the amount you’ve paid, whether the payment was on time and other information is recorded.
The credit scoring models each have their own methods to calculate scores, but there are a number of common factors.
Your Payment History
Your payment history is a vital element for calculating credit scores across all scoring models. In simple terms, this is a record of what payments you’ve made on your various credit accounts and whether the payments were made on time. This helps a potential lender to have confidence that you will pay back a debt if you’re approved for a new account.
Payment histories also provide an insight into how well you’ve managed your credit obligations in the past. It includes reporting for various credit accounts including credit cards, auto loans, mortgages, student loans and other forms of debt. It will show any late or missed payments, any collection data or if you’ve had any bankruptcies. Generally, credit scoring models take how much you owe, late payments, and if you’ve recently missed payments into account.
This is usually the factor that carries the most weight in credit score calculations, which is why younger people typically struggle to obtain credit approval. They can’t get approval to borrow money, as there is no history of repaying debt.
Credit Utilization
If you’re unfamiliar with personal credit, you may find this term confusing. Essentially, it refers to the amount of credit you’re using as a percentage of your available credit. This percentage is calculated across the entirety of your credit accounts, so it can seem complicated. If you have a credit card you’re no longer using, you may assume that you have a good credit utilization ratio, but you may not have considered your auto loan, personal loan and other credit cards.
As an example, if you have just one credit card with a $1,000 limit, $300 outstanding balance and no other debt, your credit utilization is 30%. On the other hand, if you have several credit cards, and a personal loan with total credit limits of $20,000 and outstanding balances of $6,000, you still have a 30% credit utilization.
Ideally, you should try to keep your credit utilization ratio as low as possible, but it should be under 30% if you want to have a good credit score. A low credit utilization shows potential lenders that you can responsibly use your credit, as you don’t have multiple accounts that are “maxed out.”
Credit History Length
Credit score models also consider how many new credit accounts you’ve recently opened, but they also check your credit history length. This is another reason why younger people can struggle getting credit.
Credit history lengths are typically calculated as an average. So, if you open a new credit account, you will immediately decrease the length of your credit history.
As an example, if you’ve had a credit card for 10 years and another for 6 years, the average length of your credit history is 8 years. But, if you then open a new credit card account, that 16 total length will now be spread across three accounts, which drops your average down to approximately 5.5 years.
It is still important that you have a long running account, but it is worth noting that opening up new accounts can have a negative impact on your credit score, until the new account is more well established.
Credit Variety
This may appear a little random, but whether you have managed different types of credit can help you to get a higher credit score. Credit score calculation models tend to reward consumers who have a variety of types of credit on their credit report. This shows you can responsibly handle both installment loans and revolving credit, so having a balance of credit cards, auto loans, personal loans and a mortgage can be beneficial.
Although it may seem that credit variety should not matter if you make on time payments, potential creditors do like it when consumers can handle different credit types. So, if you have a loan and a credit card, you’re likely to have a higher credit score compared to if you only had two credit cards.
Credit Inquiries
When you apply for a new credit account, the potential creditor will need to check your credit report before making an approval decision. Running your credit in this way is called an inquiry, but it could be a hard or soft inquiry.
A soft inquiry will not impact your credit score, as it is a more basic check that provides a simple overview of your financial situation. This type of inquiry is often used for pre-approval of products, but potential landlords and insurers may run a soft inquiry to check your financial responsibility.
A hard inquiry is a more detailed check, where the potential lender checks your full credit report. This type of inquiry is recorded on your credit file. In and of itself, a hard inquiry is no big deal, but it can cause a drop of several points in your score. Additionally, multiple hard inquiries over a relatively short period of time can be a red flag for a potential lender, as it could indicate a more desperate need to get more credit. So, if you’ve had numerous inquiries on your credit report, it may be reflected in a lower credit score.
The Impact of Your Credit Score
A credit score is usually considered excellent, good, fair or poor and there is a number range for each of these categories. So, once you know your three digit number, you can determine how good your score is. For example, FICO has multiple scoring models with a number range of 300 to 850. Scores of 670 or above are considered good or excellent. Likewise, VantageScore has a scoring range of 300 to 990 across its scoring models and you’ll need a score of 661 to 780 to consider yourself having good credit.
So, you may be wondering, why your credit score actually matters and if you have any control over it anyway. But, it is important to recognize that your credit score has the potential to affect almost everything in your everyday life. Even if you are not seeking a new credit card, personal loan or mortgage, a poor score can severely limit your options. There are many instances when your credit is checked even if you are not applying for credit. For example, if you want to open a new bank account, if you don’t have good credit, the banking institution may decline your application or only offer you an account with very basic features.
Your credit rating can also impact your insurance. There are insurance credit score models that help insurers to determine your risk profile. So, if your score indicates that you are not particularly financially responsible, the insurer may assume that you’re also a careless driver.
Fortunately, having a good credit score can also create a positive impact on everything around you. With a good score, it will be easier to secure a lease for a new home, you’ll have access to a wider variety of financial products and you can also access lower rates when you borrow money.
Potential lenders will use your credit score to determine the interest rate that will be applied to your new credit card or loan. The rates are calculated according to risk profiles and if the lender has confidence that you will responsibly handle the new debt and make payments with no issues, you’ll be approved for a lower rate. Bear in mind that the rates advertised for financial products are often reserved for those with good or excellent credit, so if you want to access that great deal, you’ll need decent credit. A poor or fair credit rating means that lenders have less confidence in your ability to repay, which is reflected in a higher rate.
While this may not seem like such a big deal, a rate difference of even just one or two percent can have a substantial financial impact on your long term financial health.
As an example, if you’re shopping for a new home and need a mortgage of $250,000 with a 30 year fixed rate. With a 670 FICO score, you could pay as much as $161 less per month compared to someone with a similar profile and a FICO score of 620 (example rates used, not reflective of actual savings).
This is not only a significant difference in your monthly costs, but over the full term of the home loan, it adds up to more than $57,000 in additional interest charges.
Checking Your Credit Score
Now you can appreciate how your credit score can affect almost everything around you, you need to know how to access your actual score. It is actually quite easy to find out your current score and there are a number of ways. The major credit bureaus will provide a copy of your credit report for free once every 12 months and this file includes your current credit score. There are also numerous service providers offering access to credit scores, including credit score websites, and apps. However, you may find credit score access is a feature offered with your bank account package. There are banks and budgeting apps that allow you to monitor your score and see how it changes when you make different financial choices. Some of these handy tools even include predictions, so you can play around and see what would happen to your score if you took out a new loan or missed a payment.
Remember that financial data is reported to the major credit bureaus every month, so your credit score has the potential to continually change. It can go up if you’re making positive changes to your spending and money habits, but it can also go down if you have financial difficulties. So, it is important that you’re familiar with your credit score.
How to Make Your Credit Score Work For You
We’ve already discussed the ways that having a good score can have a positive impact on your everyday life. The simplest way to make your credit score work for you is to continually look at improving your score. There are no quick fixes to improving your score, but with strategic planning and boosting your score before you apply for a new financial product or make a financial life decision, you can improve your approval odds and secure a better deal.
For example, if you’re planning on getting a new home, working on your credit score in the months before can help you get a better mortgage deal or improve the chances of beating out other potential tenants when the landlord runs every applicant’s credit.
Although the prospect of improving your credit may seem daunting, it is all about developing good financial habits. There are a few tips and things that you can work on to help you to get started.
Work on Creating a Positive Payment History
Whether you’re had some issues in the past or you simply have a limited credit history, working on creating a positive payment history can have a significant impact on boosting your credit score.
Those that currently have credit accounts should focus on making payments on time, each and every month. If you struggle to remember billing dates for your credit cards and other accounts, you could sign up for auto payment. This will ensure that the minimum amount due is paid automatically from your designated bank account. In this way, you can avoid late payments and the associated charges, making an additional manual payment if you have the money when you get paid.
Those with no credit accounts or finance products reported to the credit bureaus will need to be a little more creative. You could apply for your first credit card and focus on making a few purchases and clearing the bill each month. Of course, you will need to be realistic about the type of card you can get. You’re unlikely to qualify for a card with lots of perks and benefits, but you should have no issues getting a secured credit card.
You’ll need to pay a deposit to secure the card, but you can then use it and pay the bill each month. Some card issuers even have schemes where clients who manage a secured credit card well for a period of time will get an automatic upgrade to a standard credit card and their deposit is refunded.
Avoid Maxing Out Accounts
Your credit utilization ratio is another important factor in the credit scoring models, so you need to try to keep yours as low as possible. Although it is tempting to buy those things you’ve been dreaming of when you get a new card with a good limit, this will not only increase your credit utilization, but it could be detrimental to your long term financial health.
Don’t Apply on a Whim
There can be some great offers and deals advertised, and you may even receive direct mailers offering you a fantastic credit product, but don’t apply for any new credit on a whim. Applying frequently, even if you’re approved can damage your credit score. Each application will trigger an inquiry that could be logged on your credit report.
So, think about whether the new credit product would be beneficial to your long term financial health and if there are any financial decisions in the coming months that could be affected before you even consider applying.
Although the three numbers that make up your credit score may seem insignificant, they truly can affect almost everything in your everyday life. Fortunately, you can make your credit score work for you for good long term financial health.
