Takeaways
- A credit score is a number between 300-850 calculated based on a credit report.
- You have multiple credit scores because different credit scoring companies have unique credit grading criteria and weighting.
- You can improve your credit score dramatically by making on-time payments and controlling your credit utilization.
- You can check your credit score for free.
You are probably one of the millions of consumers using credit daily. But have you been keeping track of your credit score?
Lenders use credit scores to help them issue new credit - credit cards, mortgages, auto loans, or other consumer credit products - to new and existing customers. Credit scores can significantly impact your credit availability and the cost of credit.
Your credit score impacts the cost of utilizing debt. Depending on your credit score, your cost of borrowing capital may be higher or lower than your friends or family based on credit scores alone. A higher credit score means lenders offer lower interest rates and better loan terms. Maintaining a high credit score can add money back into your pocket.
It’s a smart money move to understand your credit score and how you can positively impact your credit score over time.
What is a Credit Score?
A credit score is a number between 300 and 850 assigned to consumers based on their predicted ability to repay a lender for a new loan. Lenders use credit scores to assess the likelihood of you repaying them on time and in full. Companies issuing new credit cards, mortgages, auto loans, and other consumer debt products rely on your credit score.
Credit scores are provided when a lender requests your credit report. The lender typically receives your credit score and credit report to determine which credit products you are deemed eligible for.
For example, if you go to a lender to open a credit card, the lender will ask permission to request your credit report and score. Your bank will inform you this is complete, and the credit card company will determine what type of credit card (benefits) and annual percentage rate you will be offered.
Your credit score is a momentary snapshot and can be improved or reduced based on consumer behavior.
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How is Your Credit Score Calculated?
It’s important to remember that all the information that goes into your credit score begins and ends with your consumer habits. The process starts with consumers making financial decisions, such as signing up for a new credit card and deciding when and how much to pay.
Lenders then report information on consumer behavior to credit reporting companies, also called Credit Bureaus. Credit reporting companies make a credit report. There are three major credit reporting companies in the United States:
- Experian
- TransUnion
- Equifax
It is important to note that not all lenders report information to all three credit reporting companies. Differences in reporting can cause variability between credit reports for one consumer and different credit scores.
Learn More -> Are Credit Card Cash Advances a Good Idea?
Once the credit reporting company has created a consumer credit report, credit scoring companies take the information from the credit report and use complicated propriety mathematical models to produce a consumer credit score. There are many credit scoring companies, but the two most popular are:
Credit scoring companies create many scoring models. Some models are for general use, while others are industry-specific. For example, FICO creates a score specifically for lenders offering auto loans. FICO offers over 40 different scoring models.
Smart Tip:
Over 90% of top lenders use FICO scores. Improving your FICO score could help you get better terms and interest rates on your debt. More on that below.
Credit Score Ranges
Lenders determine what scores they will accept to take out a new loan, but here is Smart Money’s guide to credit score ranges and their categorization:
- A credit score of 800-850 is considered excellent credit.
- A credit score of 750-800 is considered very good credit.
- A credit score of 700-750 is considered good credit.
- A credit score of 600-700 is considered mediocre credit.
- A credit score of 300-600 is considered poor credit.
Factors other than your credit score can also affect how lenders assess consumers. Many lenders consider a borrower’s income, length of employment, and debt-to-income ratio. Additionally, your credit history can also affect your borrowing terms. For example, first-time home buyers are often charged higher interest rates because they are considered “unproven” borrowers.
Get Smart -> Is an 800 Credit Score High Enough?
What Impacts Your Credit Score?
Your credit score is calculated using various credit data from your credit report. Each credit scoring company, like FICO and VantageScore, factors variables into their score and assigns different weights to elements to determine the final score. The importance of these credit categories can change by consumers too. For example, the credit score of a consumer with no credit history will be calculated differently than someone who has a long and diverse credit history.
Here are two pieces of credit data that matter the most in both your FICO and VantageScore credit score calculation:
- Payment History: Missing a payment on any of your credit accounts can negatively impact your credit score. A late payment, which, according to federal law, cannot be reported to credit report companies until it is 30 days or more past due, should be avoided. Payment history measures how well you have paid your past credit account on time. By paying your credit card, mortgage, or auto loan payment on time each month, lenders will assign a higher score to this category.
- Credit Utilization: FICO calls this “amount owned” but both companies refer to credit utilization. Credit utilization is the amount of credit you use relative to your available credit.
For example, if you have three credit cards, each with a $10,000 limit ($30,000 in total available credit) and a $10,000 outstanding balance across the three cards, you have a 33% credit utilization. A smart money move is to keep your credit utilization low or below 30%. There are several ways to lower your credit utilization.
Having a higher credit utilization is not necessarily bad. However, credit scoring agencies perceive that the higher your credit utilization, the more you might be overtaxed to make consistent payments. In the eyes of credit scoring companies, this increases your risk of non-payment.
The next three pieces of credit data don’t have as much weight in determining your credit score but are still a vital part of the calculation:
- Credit Age: As a rule, the longer you have had credit accounts, like a credit card, the better your credit score. Credit reporting companies factor in how long your accounts have been open, examining your oldest and newest accounts and determining an average age. Credit age considers how long it has been since you used different lines of credit.
- Credit Mix: Your score is determined by the diversity of your credit types, such as mortgages, credit cards, retail accounts, or personal loans. It can be helpful to credit scoring companies if you show a diversity of credit types.
- New Credit: Opening a bunch of credit accounts in a short amount of time can be costly. Consumer data trends show that when consumers do this, there is a greater risk of default for the lender. That is why many hard pulls on your credit when setting up a new account can negatively impact your credit score.
How to Increase Your Credit Score
Simply put, focus on your creditworthiness. Creditworthiness is a lender’s willingness to trust you to repay your debts. And the best way to improve your credit score is to increase your creditworthiness. By concentrating on what is in your credit report, you can accomplish this by doing the following:
- Make Payments on Time: The fastest way to improve your credit score is to make your debt payments on time. This means budgeting and planning to avoid missing credit card or auto loan payments. Being consistent will pay off. If you have missed payments and are trying to improve your credit score, plan on making at least several months of on-time payments before seeing a noticeable improvement in your score.
- Control Credit Utilization: Lenders don’t want you to incur too much debt because it increases your chance of default. You can improve your credit utilization in two ways. The first is to decrease outstanding debt by making consistent payments to pay off your debt. The second is to increase the total amount of available credit. You can increase your available credit by requesting your credit card company to increase your total available limit. You can do this for free.
- Keep Accounts Open: Even if you stop using a credit card, it is better for your credit score to simply not use the card instead of closing the account. If you close a credit card with a large credit limit that you have had for years, it could negatively impact your score.
- Control Credit Application Timing: If you are contemplating opening a credit card, choose the best credit card available. Instead of having multiple mediocre credit cards, it is better to request to open one great credit card so that you get reward points, cash back, and other great features. By comparing credit cards first, you will only have a hard inquiry on your credit report once, which will help preserve your credit score.
- Correct Errors: Mistakes happen. Credit reporting companies sometimes receive the wrong information from lenders. Your credit report might contain false information that should be disputed.
Smart Money -> 7 Steps to Improve Your Credit Score
Monitoring Your Credit Score
You should monitor your credit score periodically. Luckily, according to federal law, all consumers are eligible to receive a free credit report. Consumers can find your free credit report from Annual Credit Report.
Checking your credit score annually doesn’t hurt your score. Personal banking apps even offer free credit scores and regular updates. Because credit scores fluctuate, monitoring your credit scores is a healthy financial habit.
Smart Tip:
Hiring a credit monitoring service can be helpful to ensure that your credit score is tracked regularly.
Smart Summary
Your credit score has a significant impact on your ability to borrow and the cost of that capital. If you are thinking about opening a new credit card, securing an auto loan to buy a new car, or applying for a mortgage to purchase a home, understanding your credit score can help you navigate this process. Better yet, planning will allow you to improve your credit score ahead of any major purchase.
Credit scores fluctuate as credit scoring companies receive different information from your credit report. Consistently trying to improve your credit, and understanding how your credit score is calculated, is a smart money move.
