What Is a Credit Score and Why Is It So Important?
You have heard your credit score is important when it comes to qualifying for a mortgage, auto loan, low-interest credit cards, and more, but have you ever truly understood what your credit score is and how you can improve it? It’s never too late to start. Let’s take a look at what your credit score means from the lens of those making the financial decisions.
What Is a Credit Score
A credit score is a number determined by your credit history that represents your creditworthiness. The numbers begin at 330 and climb to 850, the higher the score, the lower your risk of defaulting on credit, per the big three bureaus that collect and determine your credit score: Experian, TransUnion and Equifax.
The three bureaus keep track of the amount of credit you have, your balances, late payments, charge offs, and more, as reported by your creditors.
The ranges for credit are:
- 300-579 = Poor
- 580-669 = Fair
- 670-739 = Good
- 740-799 = Very good
- 800-850 = Excellent
Where you fall on this scale, along with your annual income, is what determines if a lender will approve you for credit and loans.
Why Is a Credit Score Important?
When lenders consider you for a loan or credit , they are looking at how much debt you are carrying, otherwise known as your debt-to-income ratio. This is all of your monthly debt divided by your gross monthly income. This shows if you are overextended and your ability to take on new monthly payments.
Reviewing your credit report, lenders can see how much debt you carry, as well as your credit limits on open accounts. Even if you have $0 balance, the available credit paints a picture of what your maximum debt could be. Lenders can also see how many late payments you have made, from 30 to 120 days. One or two late payments are understandable but a series of late payments indicates you are struggling and could be a risk. Rightfully, lenders want to know you have the ability to pay back your debt. If you are deemed a risk, you can be denied or charged higher fees.
Even if you have excellent credit, if you have opened a number of new lines of credit in a short period of time, you’re score will drop as it may appear you are in need of funds and falling behind.
When calculating your credit score, there are 5 main factors that are reviewed:
- Payment history – accounts for 35% of your credit score
- Amount owed – accounts for 30% of your credit score
- Length of credit history – accounts for 15% of your credit score
- Types of credit – accounts for 10% of your credit score
- New credit – accounts for 10% of your credit score
Ways to Improve Your Credit Score
With your payment history and amount owed accounting for more than half of your credit score, these are the main areas in which you can improve your score. This means paying your bills on time and lowering the amount you owe so you are not maxed out on your credit. Increases in your credit limits can also help, if you are financially able to carry higher limits. Contacting your creditor and requesting a limit increase can improve your credit overview.
How long you have credit with various companies is important under the length of credit history. While you may think closing an account you do not use looks better to lenders, it’s actually better to keep a $0 balance and keep the account open; it will reflect positively for payment history, amount owed and length of credit.
The types of credit you have shows any mortgages, loans and credit cards. Mortgages and loans are viewed more favorably over having too many credit cards. While the bonus of applying for store credit card at checkout sounds like a way to save, too many credit cards — and new cards — will drop your score so ignore those 10% off your purchase price deals.
But not all that appears on your credit report may be true. Sometimes lenders and the bureaus have errors and when you spot an inaccuracy, you can contact the bureau to have it removed, which can also improve your score.
It’s important to review your credit reports with all three bureaus each year, as each one may have slightly different information. It’s free to receive an annual credit report from each bureau, as well. You’ll find an easy application on FreeCreditReport.com.
What are the Different Credit Scores?
Your credit score and a FICO score are similar yet different calculations. FICO is a creation of the Fair Isaac Corporation and is used by 90% of lenders and provides your credit score as listed above. FICO gives you a free estimator of your score on MyFico.Com.
Another credit score is a VantageScore, which claims to be more accurate than a FICO score and is the newer model. It uses the same credit range but VantageScore looks into your credit utilization. With this, it watches how you use your credit and make payments: Do you pay the minimum due each month or do you pay your balance in full, for example?
The bottom line
It may seem being judged by a number isn’t “fair,” but your financial habits provide insight on how well you manage your money. Taking control and improving your credit score shows your dedication and credit worthiness to potential lenders. It also is something to be proud of: If you have a high credit score, you are proving you are financially independent and thriving, no matter how much income you bring in. Make it a priority to improve your score not for a lender but for yourself.
