Confused about your credit score…and WHY it matters? Check out the simple guide to understanding your credit score below!
Today I’m going to share with you the basics of credit scores. Yes, credit scores explained…SIMPLY!
Why am I doing this? Honestly, when I graduated college I was very confused about how credit scores worked. I didn’t understand the difference between a credit report and a credit score. I didn’t know how credit scores were calculated, or why I had several different scores. And I certainly didn’t understand why credit scores mattered at all.
Hopefully, in the next few minutes, everything will be crystal clear for you. Let’s get started.
What is a credit score?
A credit score is a number that lenders use to determine how likely you are to repay a loan.
The higher your credit score, the better – it means that lenders are more likely to let you borrow money since you are more likely to repay the loan.
What’s the range of credit scores?
Historically, credit scores range from 300 to 850. However, there are new types of credit scores that go up to 950.
Wait, there are different types of credit scores?
Yup, there are many different types of credit scores.
You are probably most familiar with the FICO score, which is developed by the Fair Isaac COrportation.
Another common credit score is the VantageScore which is calculated using a model created by the US’s three major credit bureaus (Experian, Equifax, and Transunion). Credit bureaus are companies that collect and organize individual’s credit information and sell it to lenders. You can get free credit reports on their websites.
The FICO Next Generation score is the credit score that goes up to 950.
The different credit scores are calculated differently.
What’s the difference between a credit score and credit report?
Simply put: A credit score is calculated using the information in your credit report.
A credit report is developed by credit bureaus and it is a report summarizing your credit history. It includes information about your credit accounts (credit cards, student loans, mortgage), credit limits, repayment history (do you pay your bills on time, or are you late?), and how much credit you are using (compared to how much you have available).
A credit score is calculated by using the information in your credit report. Even though different credit scores use the same credit report, the algorithms used to calculate the credit score is different. That’s why you may have several different credit scores.
How is a credit score calculated?
The exact algorithm for credit scores are not public knowledge. It is impossible to calculate your own credit score. However, the typical weight (importance) of various factors in your credit history are shared by the companies that calculate credit scores.
For example, the FICO score considers your payment history to be the most important. This is how the FICO score weighs each category on credit reports:
- 35% payment history (do you make on-time payments?)
- 30% amount owed (what is your total debt?)
- 15% length of credit history (how long have you been taking on credit?)
- 10% new credit (are you opening many new accounts?)
- 10% types of credit used (do you have a mix of credit like credit cards, mortgage, student loans?)
As discussed earlier, different credit scores are calculated differently. VantageScore has some different categories and weights. For example, VantageScore takes into account your credit utilization (how much credit you are using compared to how much you have available).
While the weights provide general guidelines on how credit scores are calculated, they may actually vary from person to person. Someone who just started using credit may have their credit score calculated differently.
What does my credit score mean? Why do credit scores matter?
Your credit score will fall under five categories ranging from ‘very poor’ credit to ‘excellent/exceptional’ credit. Check out the chart below to see where your credit falls (note the ranges are different for FICO and VantageScore).
But what does ‘excellent’ or ‘very poor’ credit mean – why should you care?
The better your credit (the higher your score), the more likely you are to get approved for credit. That means, you’re more likely to get approved for credit cards, a mortgage, a car loan, etc. If you can’t pay cash for a house (most people can’t) – you’ll need to get a loan. That means, you need good credit!
You may be a financial rockstar – you pay your bills on time, you have a high salary, you’ve never had any debt. But if you don’t have a credit history (which means you won’t have a credit score), you won’t be able to get a house loan. That’s why credit scores are important!
In addition to increasing the chance of getting approved for loans, you will also get a better interest rate. The better (lower) your interest rate, the less money you have to pay to interest (that’s a good thing!).
What credit score do I need?
As a general rule, a credit score above 700 is good.
Typically, a credit score of 760 or above will get you the best interest rate. A credit score below 620 makes it harder to get mortgages and approved for credit cards.
How can I improve my credit score?
There are many ways to improve your credit:
- Always pay your bills on time. Never miss payments on any of your loans (that includes credit cards). If you missed a payment or are late on bills, your credit score will go down.
- Keep your credit utilization low, ideally below 30%. For example, if you have a total amount of credit of $7,000, don’t put more than $2,100 each month on credit (don’t max out your credit cards!). Paying down your debt balance will also lower your credit utilization. So will increasing your credit limit (just call your credit card company and ask if they will raise your credit limit).
- Don’t take out a lot of lines of credit within a short period of time.
- If you don’t have any credit, get some now (you can do this by opening up a credit card). The longer your credit history, the higher your credit score.
- Make sure your credit reports are accurate. If there is something wrong on your credit report, it could be hurting your credit score. Fix it! Make sure that you check your credit reports from all three credit bureaus (Experian, Equifax, and Transunion).
High credit scores will help you build wealth
Having a good credit score helps you leverage the money that you already have. High credit scores allow you to borrow money at low interest rates. It helps you grow your wealth.
Do you know your credit score? When was the last time you ordered a credit report?