The deeper you go into the financial world, the more you hear about the credit score. Everybody wants you to want to know what your number is. The way people talk about it, your entire financial future is dependent on your score. Even John Oliver did a (surprisingly informative) episode on it. Maybe they’ve gotten to you and you now obsess about those three numbers, or maybe you just don’t care. But what does your score even mean? And what’s it actually used for?
What Is Your Credit Score
As borrowing became more common and more established over the last century, the financial industry began to look for a quick way to rate borrowers creditworthiness. In the late 80s, the industry finally settled on the credit score (and the accompanying credit report) as we now know it. In short, the credit score is an attempt to put a number on the likelihood that you will repay your debts, and repay on time.
Who Determines Your Credit Score
Your credit score isn’t actually determined by a single organization, and it’s definitely not determined by the government. In fact, you don’t even have one single credit score. Three different companies, or credit bureaus, Experian, Equifax, and Transunion collect data about your payment history from lenders, collection agencies and other businesses and regularly compile the data in a credit report. This data is then used to calculate your credit score.
For the most part, the financial industry has settled on a single standard scoring method, known as the FICO score. Despite being standard, however, your FICO score can still vary depending on who is providing the data. Furthermore, there are still several other credit scores that are trying to compete with the FICO score. These claim to have better or more accurate scoring methods and use different formulas. There are even alternative FICO scores, such as the FICO mortgage score or FICO bankcard score. Some institutions choose to go with these alternative scores, instead of or in addition to the FICO score.
What’s a Good Credit Score
Because the credit score is anything but simple, the range of possible credit scores are seemingly arbitrary. Instead of being on a range of 1-10, 1-100, 1-1000, or something like that, the FICO credit score falls in a range of 300-850. Most of the competing scores fall in a similar range, although some go as low as 280 or as high as 990. Some have a narrower or wider range than FICO, and some are identical to FICO. Almost universally, a higher score is a better score. Instead of getting bogged down in the details and differences between all the scores, just focus on being a good borrower and customer. The scores will take care of themselves.
What Determines Your Credit Score
The single most important factor in your FICO score is your payment history. Lenders want to know that you have a history of paying bills on time. On time payments make your score go up, late payments make your score go down. Even worse than late payments, are payments that you never made. This can include bankruptcy, debts in collection, foreclosures, etc. Unfortunately, positive data is generally only reported by lenders, while negative data can be reported by anyone you owe money to. So you can pay your cell phone bill on time for 5 years straight, but it would never help your credit score. If you miss a single payment, however, it will go on your report and ding your score.
The second most important factor in your score is your debt utilization ratio. This looks at the amount of debt you have compared to the amount of credit you have available to you. If you consistently maxed out your debt limits, you look like a risky borrower. If, however, you are well below your credit limit, you are more likely to be able to continue making prompt payments. One easy way to keep your debt utilization ratio looking good is by maintaining credit cards with high limits and low balances. Just don’t let those high limits tempt you to spend more.
The next three factors are the length of your accounts, variety of credit type, and new credit application. These three are much more minor than the first two. A long history of positive credit tells lenders that you are experienced with handling credit and debt. A variety of credit tells lenders that you can handle both revolving credit, such as credit cards, and amortized credit with fixed payments. Lots of new credit applications can be a red flag to lenders that you might have run into difficult times and are trying to get some quick cash without having thought about repayment.
The last three factors together only account for 30% of your score, so don’t focus too much on these. If you’re not jumping around opening lots of credit cards and taking out lots of new loans, you’ll be fine these last factors. Consistently pay your bills on time, and only take on debt that you can budget for, and you’ll have an excellent score.
You Don’t Need to Borrow to Keep a Good Score
One common myth is that you have to maintain debt to keep a good score. This myth is perpetuated in part by lenders to keep business coming in. An entire industry built on lending people money makes billions in interest payments. Don’t buy this myth. There’s no reason you have to shackle yourself to debt and interest payments for the rest of your life just to maintain a good credit score. Even if this was the only way to keep a good score, it wouldn’t be worth it.
Fortunately, you don’t need debt to maintain a good score. However, it is helpful to have some lines of credit open. The easiest way to do this is to keep one or two credit cards. Use these credit cards regularly, but pay them off in full each month. Don’t just pay the minimum payment- pay the entire balance on your bill. As long as you completely pay down the balance, you’ll never owe a dime in interest. Sign up for autopay so you don’t forget to make your payments. Only use cards that are fee free and earn rewards and they’ll actually be earning you money. If you’re confident that you can use credit cards on regular purchases, and can still stay within your budget, great! Otherwise, just use your credit card on one or two regular monthly bills and don’t take the card shopping.
Regularly charging a few things to your credit card, and then paying them off at the end of the month will give you a good payment history. As you continue to be a reliable customer (even though the card company isn’t making money off you, they still get to collect fees from wherever you use your card), your credit card company will occasionally raise your limit. This will improve your debt utilization ratio. The longer you hold your card, the better your average account age will be. As long as you aren’t bouncing from card to card, you won’t have any new credit applications. The only negative is that you won’t have a wide variety of account types, but this factor only affects 10% of your FICO score, so you’ll be fine without satisfying this category. If you do come across a 0% auto loan, you might choose to take it to shore up this category, but it wouldn’t be necessary. If you have a home mortgage this would also help your account variety.
Why Does Your Credit Score Matter
The main purpose of your credit score is to evaluate your creditworthiness. Banks and other lenders use your score to determine whether they will lend to you, how much they’ll lend, and at what interest rate. A lower score means a higher interest rate and less borrowing power. This is especially important if you’re going to be taking out a large long term loan such as a home mortgage. More borrowing power means you’ll be able to buy a large house, although with larger payments. A lower interest rate means the overall cost of the mortgage is lower and you’ll be left with lower monthly payments. In short, a high credit score can save you tens of thousands over the life of a mortgage.
Your score is also important if you want to finance or lease your vehicles, carry a balance on credit cards or take out any other kind of loan. Again, a lower credit score will mean more expensive borrowing and smaller borrowing power.
Your Credit Score Even Matters if You’re Debt Free
In general, debt is just a burden that makes your finances more vulnerable to life changes, costs you thousands in interest and risks spiraling out of control. So perhaps you’ve decided to live debt free. You may have dug yourself out of debt and paid of your home. Perhaps you’re even taking the bold step of saving up to buy your first home in cash. You’re probably wondering why you should even care about your credit score. Since you have no intention of taking out debt, you don’t care what lenders think about you.
Although your FICO score is primarily used for lending, other industries have begun using it as well. Consumer Reports details how insurance companies use credit scores, or at least variations of traditional scores to help them determine your premium. Apparently the reasoning behind this is twofold- your score predicts the likelihood of you paying your premium and high scores correlate with safe driving. Fair or not, this seems to be the reality, and is a pretty good incentive to maintain your credit score.
Landlords often use your credit score to determine what kind of renter you are. A good credit score predicts a renter that will pay promptly and in full, helping the landlord avoid one of the biggest headaches of renting. Landlords will either entirely avoid renters with low credit scores or will require a higher security deposit. If you don’t own your own home, this is another incentive to maintain your credit score.
If you enroll in contract or post pay cell phone plans, cell phone companies will often run a credit check. They may offer a smaller selection of plans or require you to prepay if your credit score is too low. While not as big of a deal as high insurance rates or limited rent options, this may be an inconvenience as well.
As companies look for quick and easy ways to evaluate customers, its hard to predict what other industries will explore using FICO and other credit scores. Perhaps your credit score is indeed irrelevant to your life. If so, and if strictly using cash and checks is what works best for you, great. However, for most people, your credit score matters at least a little.
How Can I Monitor My Credit
Your credit score and report used to be top secret information. Well, not really, but it used to be a lot harder to access. At the very least, you had to pay to see it. Things have changed recently. In 2003, Congress passed FACTA- Fair and Accurate Credit Transactions Act. While this law doesn’t make accessing your score free, it does require the three credit bureaus to share your credit report with you. They are each required to share your report once a year. You can access this report through AnnualCreditReport.com. Be aware that there are lots of copycat sites. AnnualCreditReport.com is the only site you should use to get your free report. Getting your credit report involves sharing your social security number and other sensitive info. Copycat sites are either trying to con you into buying a product, or are trying to steal your identity. Bookmark or write down AnnualCreditReport.com, so you don’t forget it (I’m obnoxiously referencing it so it sticks with you)!
Remember that when you use AnnualCreditReport.com, you are entitled to a credit report from each of the three credit bureaus. They should look pretty identical, so you can either get all three at once to compare and check for errors, or you can spread them out over a year to monitor for identity theft or other activity. Either way, set a reminder on your calendar to help you remember to take full advantage of the service.
Regularly reviewing your credit reports serves two purposes. Firstly it allows you to monitor for errors and identity theft. Your credit report will list all your open accounts and new account applications. If you don’t recognize something or if there is incorrect data, you can contact the credit bureau and file a dispute. If you suspect identity theft, you can take further steps such as freezing your credit and other accounts before too much damage is done
Reviewing your credit reports also shows you where you can improve your credit profile. If you have excellent credit, great! But if you’re among the 80% of Americans that have dings on their credit, your credit reports may motivate you to do better. Don’t beat yourself up over the past, but you may not have realized just how many late payments you had on your accounts. Or you may not even have been aware that you had a medical bill heading for collections.
But I Want My Score!
As long as you monitor your credit reports and keep them free from dings, your credit score will take care of itself. But most of us still want to see that three digit number. When you get your credit report, the credit bureau will likely offer to show you your score for an additional fee. You don’t have to pay. Several credit card companies, including Discover and American Express, share your score with you if you’re a card holder. NerdWallet has a more complete list here.
Fixing Bad Credit
If you do have bad credit because of late payments, bankruptcy, foreclosure, collections, or whatever else, don’t despair. You’re not stuck with your bad history for life. First, clear up any errors on your credit reports by filing disputes with the credit bureaus. Secondly, remember that your credit rating takes into account your whole history. The more you continue to pay on time, the less the dings in your history will affect your report. Furthermore, negative events on your report aren’t allowed to stay on there forever. If nothing else, let time heal your credit. Just continue paying your bills on time and wait for the dings on your credit to fall off over time.
If your credit is particularly bad, or you need it cleaned up for a big purchase such as a home purchase, you can always turn to credit advocates or credit repair services. These companies will do everything within the realm of law and possibility to take negative items off your credit report. These services will cost you money, but may be worth the cost depending on your circumstance. Consumer’s Advocate has a list of credit repair agencies here.
Your Credit Score in Perspective
You can probably go through life without knowing your credit sore. Its not as magical as people like to make it sound. But it is surprisingly relevant. It’s relevant enough to make an effort to maintain a good credit profile and monitor your credit reports. Don’t go nuts over it, but do take care of it.
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- While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.