As a society, we are increasingly dependent on using credit to purchase goods and services. In fact, you probably used a credit card today to buy something at a store or online.
But buying products on credit isn’t limited to using cards. We also use credit in the form of loans to invest in bigger-ticket items such as cars, college tuition, and homes.
What you might not realize when you use credit to purchase something is that, in most cases, you are paying more for that product than if you used cash. You are paying more because you borrow money from a lender, be it a credit card company, credit union, or bank, and they charge you interest on the transaction.
A variety of factors determine the amount you pay for a specific item, the biggest being the loan’s interest rate. And it’s your credit score that ultimately determines this rate.
But what exactly is a credit score? How is it defined? And what, if anything, can you do to improve this rating?
This article will answer these questions and provide additional information to help you manage your credit.
So, What is a Credit Score?
A credit score is a three-digit number ranging from 300 to 850 that uses a variety of financial factors to determine an individual’s creditworthiness. Lenders use this number to evaluate risk and decide how likely a person is to pay back a loan based on their credit history.
Why Does Your Credit Score Matter?
Because your credit score is an indicator of your overall financial stability, it is vitally important to maintain it as it directly affects:
- Whether you get approved for a financial product, such as a credit card or loan
- The amount of interest you will pay on that product if you are approved
As a rule of thumb, the higher your credit rating, also known as your FICO score, the more likely you will get approved for a credit card or loan. Plus, a high score usually means a lower interest rate. On the contrary, an individual with a low FICO score, in the poor to the fair range, will typically pay a higher interest rate or may even fail to qualify for a credit card or loan.
What is a Good Credit Score?
According to the FICO® Scoring system, which is used by 90% of the top lending institutions in the United States, a good credit score falls between 670 to 739. As previously mentioned, scores range between 300 to 850.
By design, the higher the number, the better your credit score. When evaluating credit, lenders may often refer to this number in terms of credit level or quality, such as poor, fair, good, or excellent.
What Factors Are Used to Determine Your Credit Score?
There are five primary factors used to determine a credit score. Each one of these factors is weighted differently and evaluated to help determine your credit score. These factors include:
- Payment History (35%): Your payment history is one of the most critical components of your credit score. Lenders want to ensure that the money they provide is paid back on time. What they want to see here is a consistent history of paying debts. Therefore, even one missed payment in the past can hurt your score.
- Amounts Owed (30%): Amounts owed, sometimes referred to as debt burden, is another crucial area of consideration among lenders. Generally, the less you owe, the better your credit will be. However, other factors, like your credit utilization ratio, will be examined.
Your credit utilization ratio is the number of credit limits you’ve used across all your credit cards and lines of credit. In short, the closer you are to maxing out your credit limits, the worse it will be for your credit score.
- Length of Credit History (15%): Regarding your credit score, maturity matters. How long you’ve held credit accounts makes up 15% of your FICO® Score. This includes the age of your oldest credit account, your newest credit account, and the average age of all your accounts—generally, the longer your credit history, the higher your credit scores.
- New Credit (10%): Every time you apply for a credit card or a loan, the lender will check your credit report with one or more of the major bureaus. The bureau notes this check as a “hard inquiry” on your credit report, which will negatively impact your credit score.
- Credit Mix (10%): Not all debt is created equal. And, when it comes to evaluating your credit mix, lenders want to understand your loan landscape. As a rule, the more diverse your loans are, the better your score will be because it demonstrates that you have experience and can handle different types of debt.
How Can You Improve Your Credit Score?
There are many benefits associated with having good credit. The good news is if you have less than optimal credit, there are some things you can do to improve your score. Below are five steps you can take.
- Pay Your Bills on Time. As noted earlier, your payment history is the most influential factor in determining your credit score. As mentioned, you should do everything possible to avoid late or missed payments. One solution is to set up calendar reminders or autopay to manage recurring bills.
- Keep Your Credit Utilization Number Low. To help you manage your credit utilization ratio and keep it low, you should continually monitor your balances for each account to ensure you are not coming close to maxing out your credit limits.
- Only Apply for Credit When it’s Necessary. A hard inquiry is posted on your report every time you apply for a line of credit. Most lenders view too many or too frequent hard inquiries as a risk. To avoid the negative implications of a hard inquiry, you should refrain from applying for credit cards or lines of credit that you don’t need.
If you need to apply for new credit, do yourself a favor and research and try to get pre-approval or pre-qualification from the lender. In many instances, pre-approval results in a soft rather than a hard inquiry. Soft inquiries don’t affect your credit score, so you will reduce the risk of negatively impacting your credit score.
- Leave Old Accounts Open. Keeping old accounts on your credit report, like a paid-off student loan or credit card, can help your credit score. Therefore you should avoid the urge to wipe them from your credit history. Remember, having an account with a long history and track record of consistent payments is what lenders are looking for.
- Monitor Your Credit. When you view your credit report, a soft inquiry is pulled, which doesn’t affect your credit like a hard inquiry. Monitoring your score’s fluctuations can help you understand how well you manage your credit and whether you should make any changes.
Did You Know?
You are entitled by law to a free credit report from each of the major credit bureaus once per year. You can request these reports at AnnualCreditReport.com. There are also several credit monitoring apps and services, some of which are free that you can use to track your credit throughout the year.