For most adults, our credit scores affect important parts of our financial lives.
But what, exactly, is a credit score, and how is it calculated? Why does a credit score impact loan approvals and rates? How can you maximize your credit score?
What is a credit score?
A credit score is a numerical value that represents the creditworthiness of an individual, or in other words, how likely the individual is to pay back their debt.
There are multiple credit bureaus that compute credit scores with slightly different ranges, but the FICO score is the most popular. Credit scores typically range from 300 to 850, and the higher the better.
What makes up your credit score
- Payment history: How often you have a late payment matters to your credit score. And so does having an overall payment history. Payment history is the most important factor in determining your score — with it accounting for 35%.
- Credit utilization: How much of the available credit is being used also impacts your score.
One tip is to stick to using around 30% or less of the total credit limit available to you. This shows you are not desperate for cash, but you still accumulate a payment history. What shows up on your monthly statement is the amount your utilization is based on. To help decrease your credit utilization, you can either reduce your spending, pay off a portion of your credit card balance mid-month to lower what is shown on your month-end statement, or increase your credit limit.
Credit utilization makes up 30% of your score.
- Average age of credit accounts: The older your credit account, the better. Again, this just shows more payment history. The average age of your credit accounts represents 15% of your score.Tip: If you have an old line of credit that you don’t use, consider keeping it open to increase the credit history.
- Account types: Having a few different credit accounts — such as credit cards, car loans, student loans or home loans — can demonstrate your responsibility in managing debt.The types of accounts you have determines 10% of your score.
- Inquiries: Applying for multiple credits around the same time can lower your score because it makes you look desperate for credit. This accounts for 10% of your score.
The look back period for credit applications is three months, so to avoid lowering your credit, space out your applications.
How do you know your score?
Checking your score will not hurt your score!
To check, you can go to any of the three major credit bureaus to get one free annual credit report from each. The three bureaus are Equifax, Experian and Transunion.
Note that due to there being different score ranges, you may have slightly different scores from the different bureaus, but they should not be significantly different. If they are, look for discrepancies on one credit report compared to another; this could just be a mistake, or it could be an indication of identity theft. That is also why it’s good to check out your credit report at least annually because it shows your credit score, credit lines and any late payments.
Why this all matters
The higher your score, the better terms you can get on credit cards and loans. The biggest factor for most people will be their mortgage rates. Here’s an example of how better terms lead to you paying less:
You’re applying for a 30-year, $250,000 mortgage for a new home you want to buy. If you had a few late payments last year, and your credit score gets you a 5% interest rate, your total paid over the life of the loan is $483,139. But if you have a clean payment history and get a 4% interest rate, your total payments would be $429,674. That is over $50,000 less!
To build up your credit score, you should 1) focus on the five core factors above, 2) only apply for credit that you can afford (and need) and 3) be patient! Over time, good habits will outweigh the little mistakes.
Getting started on building credit: Credit cards
Opening up 2-3 credit cards — with applications spaced out at least three months apart from one another — can help you slowly build up credit.
Credit cards allow you to buy goods and services up to a certain monetary amount during a month, with the bank or credit card company paying for it at the time of purchase, and then pay back the bank/credit card company at the end of the month with no interest charged.
If that sounds almost too good to be true, you’re right. If you do not pay back everything that you borrowed by the payment deadline, you will see interest rates upwards of 30% depending on your credit card. Credit users need to be careful to manage their credit cards so that the interest doesn’t get out of control.
Choosing a credit card
Even though credit cards can be scary, you can get good benefits from them, too. When choosing a credit card, compare it to other options. You can get different interest rates, cash-back options, annual fees and more. Sometimes you can get little or no interest on the first six months of owning a card, which is a great opportunity for beginners in case they forget a payment.
Credit cards will also sometimes have an annual fee. Do your research to see if there is a card that makes more sense for you. Most big companies have their own credit card as well. If you shop a lot from a certain company, check out their credit card options to see if you can get cash back from your purchases.
Other helpful tips for credit card users
- Set a monthly reminder to pay your credit card bill.
- Set a reminder every four months to check your free credit report for discrepancies. (Reminder: You get one free report per year from each the three major credit bureaus, which allows you to cycle through checking them every four months.)
- Add your spouse or child as an authorized user. This will reflect a portion of your good credit habits onto their credit reports.
- Make it a priority to pay off your credit card each month.
- Just because you have a credit limit, does not mean that you should spend that much.