Your credit score is an important piece of your personal finance journey. It’s a grade of your financial health. Your score is determined based on a scorecard, called your credit report, which major financial institutions use to decide whether to loan you money. The higher your credit score, the better.
Here we’ll cover the basics of credit scores, what they are, why they are important, what is considered a good credit score, and some tips on how to maintain or improve your credit score.
What is a credit score?
Your credit score is a grade of your financial health at a point in time. Your credit score is determined based on a scorecard of your credit history, called your credit report. Think of your credit report as the report card of your financial health. It is the scorecard that major financial institutions use to decide if you’re likely to repay a loan that they might make to you.
What is the difference between a credit score and credit report?
Your credit report details the history of your interactions with lenders. For example, the history included can be as recent as the car loan you took out three years ago, or as far back as the credit card you opened 10 years ago. Similar to your report card from school which showed your scores in a variety of classes, your credit report shows how timely you’ve been on your various loan payments, what types of credit you have open, and how long you’ve had a credit history.
If your credit report is a detail of your credit history, your credit score is your grade at a point in time. Your credit score is a 3 digit number, generally between 300 and 850. Credit scores typically fall into the following ranges:
What factors impact your credit score?
Credit scores are impacted by a variety of factors in your credit report, and these factors can cause the score to go up or go down. The main factors impacting your score are the following:
Payment history is a record of the payments you have made to lenders over time. Consistent and timely payments on your credit cards, student loans, or any other outstanding debt contribute the greatest to your payment history and the health of your credit. The longer your timely payment history, the better for your credit score. No late payments!
Credit utilization is the measure of how much of your total available credit you are using. “Total credit” refers to the amount of revolving credit you have available at your disposal.
How is credit utilization calculated? For example, if you have 3 credit cards, and each have credit limits of $10,000, $15,000, and $20,000, respectively, your total available credit would be $45,000. Credit utilization is expressed as a percentage, and a general guideline is that your utilization should be no more than 30%. This would mean that in our example, you are using less than $13,500 of the $45,000 of credit you have at your disposal. The lower your utilization percentage, the better for your credit score.
Credit history is the record of all of the interactions you have had with lenders over time and how you paid back those borrowings. The longer your credit history, the better. While it may be tempting to close old credit card accounts or credit cards you no longer use, if it’s an old credit card account with no annual fee, it could be more advantageous to keep this account open. Older credit card accounts show that you have a longer credit history which is beneficial to your credit score.
Recent credit inquiries
Frequent hard inquiries can negatively impact your credit score by a few points. But, what’s a hard inquiry? A hard inquiry occurs when you apply for a new form of credit (such as a loan or credit card), and the person or company you are borrowing from formally requests (or “inquires”) about your credit history. Companies inquire about your credit history to better understand how well you’ve paid back previous loans and use this information to decide how much they are willing to loan to you and at what interest rate.
Having multiple hard inquiries in a short period of time can be an indicator of concern for a lender.
How does a hard inquiry differ from a soft inquiry? A soft inquiry generally will not impact your credit score and is typically the result of you looking up your own credit score or a company looking up your score to pre approve you for a particular offer. In these circumstances, your credit score is not being pulled in reference to a specific loan application, and therefore the purpose is strictly informational. Therefore, these informational pulls do not impact your credit score in the same way hard inquiries impact your score.
Mix of accounts
The different types of credit you have at your disposal is your credit mix. A healthy credit mix is one with a variety of different accounts that include both installment debt, such as your car loans, mortgage, or student loans, as well as revolving debt like your credit card.
Credit scoring institutions, such as TransUnion, Equifax, or Experian, use the information above to calculate your credit score. This is the information that appears in your credit report and it is updated regularly based on reporting from the banking and financial institution you transact with.
Why is a credit score important?
Your credit score determines your ability to enter into certain types of loan transactions and the interest rate on the loan.
A higher credit score allows for greater borrowing opportunities at lower interest rates. When taking out a loan, such as a student loan, automobile loan, or mortgage, sufficient credit history and a good credit score are necessary.
The difference between a good and fair credit score when applying for a loan could mean the difference of one or two percentage points of the interest rate. If one or two percentage points doesn’t sound like a lot, let’s look at an example.
As part of purchasing your dream home, you decide to take on a mortgage with the following information:
- Mortgage Price = $200,000
- Loan type = 30 years, fixed
- Interest rate = 3%
Over the life of the loan, with your good credit score and an interest rate of 3%, you will pay about $103,392 in interest. If in this same example, you had a fair credit score, which caused your interest rate to be 4%, you would pay $143,495 in interest over the life of the loan. That is a difference of $40,103 in interest over the life of the loan, all due to a change of one percent in the interest rate.
Long story short: your credit score matters!
How can you improve a struggling credit score?
If your credit score is struggling to maintain its A+ status, it’s time to take a look at the debt you have, and your current strategy to pay it off. Consider the following questions as part of your self-assessment:
- What debt do I have?
- Am I making monthly payments on all of my debt?
- What are the interest rates on my debt?
- Are there any debt balances with significant interest rates I can pay off now?
Once you’ve determined the status of your debt, consider automating your monthly payments. Consistent, timely payments can generally help improve your credit score. By setting up automated monthly payments on your car loan, credit card bills, and student loans, you’re helping to establish a better payment history, which is one of the largest contributing factors to your credit score.
If you notice a sudden drop in your credit score and you haven’t recently missed a monthly payment, or applied for a new loan, be sure to review your credit report. Your credit report could be mistakenly picking up personal information that isn’t yours. Monitoring your credit report at least once per year allows you to find any errors that could be negatively impacting your credit report.
Remember that deciding to make consistent and timely payments today on your outstanding loans likely won’t improve your credit score overnight. Consistency is key!
This blog is not intended to provide any tax, legal, financial planning, insurance, accounting, investment, or any other kind of professional advice or services. To make sure that any information or suggestions in this blog fit your particular circumstances, you should consult with an appropriate tax or legal professional before taking action based on any suggestions or information that we provide.