Credit Scores Made Simple: A Beginner's Guide
Do you have a friend to whom you would lend your hard-earned cash? Conversely, do you have a friend to whom you wouldn’t lend your money because they’ve burned you in the past?
If those statements resonate, you understand a credit score's fundamentals. According to Equifax, a credit score is a three-digit number that lenders will use to determine if they want to give you money (Equifax, n.d.). Therefore, being a reliable borrower and possessing a higher credit score can impact everything from loan approvals to the interest rate you receive on a loan.
Understanding how credit scores work is essential for anyone who wants to afford a home or a car and even take out a business loan. In this blog post, we'll discuss a credit score, how it works, how to check your score, and tips for improving it.
What is a Credit Score?
The Consumer Financial Protection Bureau (CFPB) defines a credit score as a number that tells lenders how good you are at paying back your borrowed money (Consumer Financial Protection Bureau, 2022). I like to think of a credit score as a grade for your financial responsibility. The higher the credit score, the more likely the borrowed money will be repaid.
While the intricate details of calculating credit scores can be confusing, a few factors make up most of the calculation. For starters, credit scores are calculated using information from your credit reports, which show how you've handled credit in the past. The CFB lists timely payments, a low credit utilization rate, a more extended credit history, and the types of credit you have as some of the most critical factors in this calculation (Consumer Financial Protection Bureau, 2022).
How Credit Scores Work:
Now that we’ve built up basic credit score knowledge let's dive deeper into the factors that impact your score. Investopedia states that the most used credit score is the FICO score. The FICO score ranges from 300 to 850 (The Investopedia Team, 2022). Here is an explanation from Equifax of some of those critical factors previously mentioned:
Payment History: This is the most critical factor in determining your credit score. Generally, any lender will want to see you have a track record of making on-time payments. If there are missed or late payments, the lender will likely ask questions to get background information on what happened.
Credit Utilization: This is the amount of credit you use monthly compared to the amount of credit available. For example, if you have a credit card with a $1,000 limit and you charge $500 on it in a month, your credit utilization is 50%. Most lenders like to see a utilization rate of less than 30%. Your credit score will likely be negatively impacted if your utilization exceeds this.
Length of Credit History: The longer you have had credit accounts, the better it is for your credit score. This is because lenders want to see that you have a history of good credit habits.
Types of Credit: Having different types of credit, for example, credit cards, mortgages, personal loans, etc., will have a positive impact on your score.
New Credit: You must be careful when applying for new credit and opening new credit lines. Opening too many accounts at once can help your credit score because it could suggest you need to take on more debt quickly.
After all these factors have been weighed, lenders use your score to assess your credit risk (Equifax, n.d.). Then, they factor the credit score in to determine whether to approve your loan or credit card application. Again, the higher the score, the lower the credit risk you present, which will help you get more favorable loan terms and lower interest rates.
How to Check Your Credit Score:
Checking your credit score regularly is a good idea – that way, you know where you stand. According to the CFPB, one of the easiest ways to check your score is by obtaining a free credit report from one of the three major credit bureaus, Equifax, Experian, and TransUnion (Consumer Financial Protection Bureau, 2022). These reports can be obtained once a year at AnnualCreditReport.com.
Once a year is probably not often enough to be considered “regularly.” To check your credit score more often, you can pay for your reports or sign up for a credit monitoring service—additionally, some banks and credit card companies off free credit scores as perks for customers.
Be sure to check for errors that could be impacting your scores. If you find anything that doesn’t look quite right, you can contact the credit bureau to dispute them.
What are Credit Scores Used For?
We’ve already talked about how lenders use credit scores to make credit decisions, but landlords and even some employers also use credit scores. Here are some of the more common uses of credit scores, according to Nerdwallet.com:
Loans: This is the most common use for credit scores. The higher the score, the more favorable terms you will receive, like longer amortizations and lower rates.
Credit Cards: Credit card companies will look at your score to determine whether they will approve your application. Again, a higher score will allow you to have higher credit limits and lower interest rates.
Renting: Put yourself in a landlord's shoes – wouldn't you want to know the payment history of your potential tenants before offering them a lease? Landlords want to be sure that tenants can pay rent and that they will get paid.
Employment: This category primarily applies to careers involving financial responsibility, but many employers view your credit score like a character test. It could indicate irresponsibility if you have a low score and don’t have a good explanation.
Insurance: Many insurance companies examine your credit score to determine your premium payments.
Generally, higher credit scores will open more opportunities and save you money in the long run. Because of this, building and maintaining a respectable credit score is essential for your financial future (Liz Weston, 2022).
How to Improve Your Credit Score:
If you’re reading this and are realizing that your credit score isn’t where you want it to be – don’t get discouraged! Investopedia.com has provided a few action items that you can do to improve your score:
Pay your bills on time: Since this is the most critical factor, this is where you should start when rebuilding your credit score. Always make sure you’re paying your bills on time.
Keep your utilization rate low: Aim for less than 30% utilization. Many experts recommend keeping this rate more towards 10% or even 5% if you want to boost your score.
Build a more extended credit history: If you don’t have a credit account and want to build a good score, get a secured credit card. You can also look at becoming an authorized user on someone else’s credit card –make sure you trust that person to be responsible with their credit!
Only apply for a little credit at a time: Applying for multiple cards or loans will help your score. Instead, be selective about what you apply for and wait 3-6 months in-between applications.
Monitor your credit report: Use the free annual report and consider a credit monitoring program. That way, if your score suddenly drops or seems lower than it should be, you can address the error early on.
As with many essential things, improving your credit score takes time (The Investopedia Team, 2022). So be patient with your efforts. Remember: consistency is key! Establish good credit habits and stick with them. Over time, your score will improve and improve your financial opportunities.
Consumer Financial Protection Bureau. (2022, October 17). Credit Reports and Scores. Retrieved from https://www.consumerfinance.gov/: https://www.consumerfinance.gov/ask-cfpb/what-is-a-credit-score-en-315/
Consumer Financial Protection Bureau. (2022, October 17). Do I have to pay for my credit score? Retrieved from https://www.consumerfinance.gov/: https://www.consumerfinance.gov/ask-cfpb/do-i-have-to-pay-for-my-credit-score-en-1265/
Equifax. (n.d.). What Is a Credit Score? Retrieved from https://www.equifax.com/: https://www.equifax.com/personal/education/credit/score/what-is-a-credit-score/
Investopedia. (n.d.). Credit Score Factors: How Your Score Is Calculated. Retrieved from https://www.investopedia.com/: https://www.investopedia.com/terms/c/credit_score.asp#toc-how-to-improve-your-credit-score
Liz Weston, C. (2022, September 22). Why Your Credit Score Is Important. Retrieved from https://www.nerdwallet.com/: https://www.nerdwallet.com/article/finance/great-credit-powerful-tool
The Investopedia Team. (2022, September 18). Credit Score: Definition, Factors, and Improving It. Retrieved from https://www.investopedia.com/: https://www.investopedia.com/terms/c/credit_score.asp