When it comes to the world of finances and borrowing, there is perhaps a no bigger name or deciding factor than your credit score. When you want to borrow money for buying a car, a home or open a credit card account, you are asking someone to trust your ability to pay them back on time. The lenders, banks or even landlords simply make their lending decision based on one number, your credit score. Simply put, if your entire life’s financial situation was made up of one number, it would be your credit score. Consequently, you must keep this number high by responsibly managing your money, bills, and debt. Below is everything you need to know about this significant three-digit number.
What is a Credit Score?
A credit score is a three-digit number that is designed to represent the likelihood of you paying back or paying off a loan. These scores are potential creditors and lenders such as banks, and car dealerships as a factor to determine whether or not to offer you a loan or a credit card. This number, typically between 300 and 850, is vital when it comes to applying for a car loan, credit cards, home mortgages and more. Generally, credit scores that range from:
300-579 are poor
580-669 are fair
670-739 are good
740-799 are very good
800-850 are excellent
Credit Score vs Credit Report:
Although your credit score is certainly tied and related to your credit report, it is technically separate. Your credit report is a detailed record of your entire credit history. This includes your number of credit accounts, how often you apply for credit and loans and any public records and debt collections such as liens, bankruptcies, and judgments. Your credit score, on the other hand, is a numerical summary of everything on your credit report. For example, if you have a history of strong on-time payments, your credit score will rise over time. However, if you have late payment history or delinquent accounts on your credit report, your credit score will go decrease. When you go and apply for a loan, the lenders will only consider and look at your score. Consequently, it is very important that you routinely check your credit report, and make sure all of the information is accurate. You can check your credit report and score on any of the three credit bureaus which are Equifax, Experian, and TransUnion.
How Credit Scores are Calculated:
Your credit score is a numerical value that is influenced by five different factors that all play a significant role in calculating your score.
Payment history: Accounting for 35% of your credit score, this is perhaps the most significant factor. This refers to how many late payments if any, you have. When you build a strong, on-time credit payment history, it allows the lenders to know that you are capable of paying your bills on time. This also increases your credit score when you don’t miss loan or credit card payments. However, missing credit card or loan payments certainly hurts your credit score and indicates to other lenders that you are a high-risk borrower who is incapable of making on-time payments.
Credit inquiries: Accounting for only 10% of your credit score, this is the least significant factor when it comes to credit score calculation. When you apply for any type of credit, the lenders generally perform what is referred to as a “hard pull” on your credit report. Since these only occur when you apply for credit, lenders will often get nervous if they see that you have a lot of inquiries on your credit report. This indicates to lenders that you regularly apply for lines of credit, which could indicate financial hardships. Not only can hard inquiries decrease your credit score but they can also cause you to pay much higher interest rates on loans and credit cards. Since your score is typically the only factor that lenders consider, a few points can make a huge difference when it comes to calculating loan interest amounts.
Account types: Although this only accounts for 10% of your credit score, individuals with the strongest credit scores tend to have a mixture of credit account types. According to statistical analysis, the type of accounts you have on your credit report is prophetic of your future credit risk. As the credit scoring model asses your creditworthiness, they look to see if you can responsibly handle several different types of financing. There are three types of credit accounts which are revolving, installment and open.
Revolving credit is the most common credit account type. These are loans that you can utilize freely up to a certain limit and require you to make monthly payments as well as interest charges if you carry a balance, such as credit cards.
Installment credit refers to loans that are for a specific amount of money with a fixed, routinely occurring monthly payment such as auto loans, personal loans, student loans, and mortgages.
Although it is rare, open credit allows you to borrow a specific amount that must be paid in full each month, which is what a charge card is.
Age of credit accounts: This factor accounts for 15% of your credit. Simply put, the older your borrowing history is, the better. If you have a credit history of 10 years or more, it is considered excellent. When you have a long history of credit, it shows creditors and lenders that you can responsibly manage your credit for a long time. Consequently, you must keep your very first, or oldest credit card or credit account open. Doing so will increase the overall age of your credit.
Credit Utilization: This factor is the second most important factor when it comes to calculating your credit score, and is usually expressed as a percentage. Credit utilization or your balance-to-limit-ratio is the total sum of your credit card balances divided by your credit card limit totals. When this percentage is high, it indicates to lenders that you may have a habit of overspending, are incapable of managing your finances, and irresponsibly utilizing your credit. A good rule of thumb is to always keep your credit card balances below 30% of your total credit limit. For example, if your credit limit is $1,000, you should keep your balance below $300.
Why your Credit Score is Important: Credit plays an essential role in the lives of just about every individual around the world. It allows people to purchase things that they need such as cars and homes without paying for it all at once. When you responsibly borrow money that you don’t have, it can enable wealth-building by allowing you to pay for college and even start a business. Your credit score will follow you forever and will be a major contributing factor when it comes time to make major financial decisions in your lifetime. It is no surprise that having a low credit score significantly hinders your ability to secure a loan of any kind. However, credit scores also affect home-insurance rates and even some employment opportunities. Simply put, if anything is tied to finances, bill-payments, or borrowing money, it is likely that your credit score will have something to do with it.