Credit provides you the capacity to borrow money and pay it back at a later date. It allows you to make purchases today (anything from groceries to a house) and pay it back in the future and, if necessary, over the course of months or years. When you use credit, most of the time, you will be paying interest on the amount you spend.
Credit used to be hard to obtain. You’d need to save the entire purchase price in advance or save up a large proportion of the purchase price and, then, borrow the rest from friends or family. Now credit is widely available, from credit cards and bank loans, to newer forms of lending over the Internet.
Why a Credit Score?
If you borrow money from friends or family they know you well. Your friends and family know if you are the kind of person who could and would repay a loan. To make credit more widely available, there need to be systems in place that essentially recreate that knowledge of your ability to repay a loan and the judgment about whether you’re the kind of person who repays their debts.
Your credit score informs lenders, who don’t know you personally, whether you’re likely to repay the credit they provide you. Your credit history is the basis for your credit score. Your credit history is an extensive list of those who currently or previously provided you credit. Credit includes revolving loans like credit cards and installment credit like auto and student loans. It also details your repayment history. Like a grade in school sums up your performance on a number of tests and homework assignments, your credit score turns a lengthy credit history into a single number.
Credit scores make credit decisions quicker and more fair. Lenders can see a single number and determine that you’re a good credit risk and credit scores don’t care about your race, gender, or marital status.
Credit scores also allow for more accurate credit rating and lower credit costs. If a bank knows you’re a good risk, they are more likely to offer you a lower interest rate than someone who is basically unknown to them.
Who gives me a Credit Score (and why do I have more than one)?
Three large credit bureaus in the United States (Experian, TransUnion, and Equifax) compile your credit history. The credit bureaus only assemble your credit history, they don’t create credit scores. Another set of companies use your credit history to generate your credit score.
The most widely used credit score is the FICO score. You can have a FICO score from each of the three credit bureaus. Each FICO score is based on the information each credit bureau keeps in its file. Another credit score commonly used is the VantageScore. Ultimately, you will have several credit scores, but they should be relatively similar.
How is My Credit Score Calculated?
FICO shares their approach to calculating their credit score. FICO uses five key segments and each is given a certain weight in the total calculation, so you can understand your credit score. Some parts of your credit history have a bigger impact than others. Keep in mind that lenders look at more than just your credit score – they will look at your employment history, income, and the kind of credit you’re requesting. FICO compiles their score like this:
- Payment History (35% of the FICO score calculation): “Are you likely to repay?” This section checks to see if you have paid off credit accounts and loans on time. Missed or late payments hurt your score, especially if you owed a lot and if the late payments occurred recently.
- Credit Utilization (30%): “Do you have the capacity to repay?” It’s okay to have other credit accounts and owe money. The key question is, do you have room to make payments on another account? If it looks like you’re already using most of the credit you have, that might be an indication that you are overextended. That makes you less likely to repay on new credit. To get a rough idea of your credit utilization, add up your total credit balances. Then compare that amount to the total of your credit limits. You will often hear that you want to keep your credit utilization under 30%. That means if you have $10,000 worth of credit available, you don’t want to have balances exceeding $3,000.
- Length of Credit History (15%): “Do you have a long history of handling credit well?” If you have a long credit history, it’s easier to judge how you manage credit. If you’re younger or haven’t had much credit there is less to work with, that means greater uncertainty for lenders.
- Mix of Accounts (10%): “Do you have experience with both revolving credit (credit cards) and installment type loans (car loan or mortgage)?” It isn’t necessary to have one of each type of account, but it provides another way for lenders to understand your credit history. The number of your accounts is, also, evaluated in this section. Think of Goldilocks, you want to have, “not too few and not too many” accounts.
- New Credit Inquiries (10%): “Are you opening a number of new accounts right now?” You may be considered a potential risk if you open several new credit accounts in a short period. New accounts will, also, lower the average age of your accounts. If you don’t have many accounts, then, a number of new accounts can hurt your score.
Does checking your own credit score impact your score? No, as long as you do it through one of the credit reporting agencies or an organization authorized to provide credit reports to consumers like myFICO.
What do Credit Scores Look Like?
As we noted, there are multiple scoring systems. Typically, they tend to look pretty similar with the scoring ranging from 300 to 850. Like a school grade of “A” ranging from 90 to 100, for example, there are “credit bands.” Again, there is no single system, but the ranges below are a starting point to better understand your credit score:
Excellent – from about 720 to 850;
Good – from about 690 to 719;
Fair – from about 640 to 689;
Poor – from about 600-639;
Bad – below 600
Average scores tend to range from about 675 to 695.
What Impact do Credit Scores have?
First, a low credit score may prevent you from getting a credit card or a loan. Many credit cards are available only if you have a certain level of credit. Second, you will pay more in interest on credit the lower your credit score. Have excellent credit? You may get an auto loan for 0%; have poor credit and you may pay 18% for that loan. If you take out a $20,000 loan for 5 years, the difference in the amount of interest you would pay is over $10,000! Your monthly payment goes from around $333 to over $500!
Credit scores may also impact your ability to get an apartment and a job. The bottom line is a good credit score is critical to making your financial life better. So, make sure you understand your credit score and why it is where it is. You may not be where you want to be today, but you can start putting together a plan to get there. You’ll be glad you did.
Where do I Get My Credit Score?
Per the Consumer Finance Protection Bureau, to obtain your credit score:
- Check with your current credit card or look at a current loan statement to see if its available.
- Talk to a non-profit credit counselor.
- Use a credit score service. Many services and websites advertise a “free credit score.” Some sites may be funded through advertising and not charge a fee. Other sites may require that you sign up for a credit monitoring service with a monthly subscription fee in order to get your “free” score.
- Buy a score. You can buy a score directly from the credit reporting companies.
Where do I get my Credit Report?
Credit Reports are available from each of the major credit bureaus. You can get one free credit report annually from each of the bureaus (Experian, TransUnion, and Equifax). Go to AnnualCreditReport.com to find out more. A credit report will show you your personal information, your credit accounts (credit cards, mortgages, lines of credit, auto loans) and your payment history, You may also see information on bankruptcies, foreclosures, wage attachments, liens and judgment.
The bottom line is understand your credit score and use it to your benefit!