Your credit score is the single most important factor in determining your ability to utilize credit throughout your life. Your credit score can be your best friend or your worst enemy. It can be the difference between getting a new loan or not, and it WILL BE the difference between getting the best rates and paying thousands more in interest.
Here’s the thing. People assume that they are being treated the same way when it comes to credit.
Hint: you’re not.
All the rates you will ever be offered for credit are dependent on your credit score.
Despite your credit score being THE most important financial tool in your life, most people don’t know what it is or how it works. Most importantly, most people don’t realize how much a bad credit score can hurt you financially, and for years!
You would think this stuff would be taught in school.
Alas, that’s why you have us! Our goal at Money Saved is Money Earned is to teach you how financial systems work, and along the way, save you big money!
So, without further ado, let’s talk about what’s in a credit score and how you can save big money by improving it.
What is Your Credit Score?
Your credit score is a number that represents your creditworthiness. Basically, your score it a representation of your responsibility with credit (will you pay your bills?), and is used by lenders to assess the level of risk associated with extending you new credit.
However, credit scores are not just used by lenders. Insurance companies, landlords, and mobile phone companies may also take a look at your credit score when determining your rates and whether or not to do business with you. This is because your credit score is a good determination of your responsibility with financial matters, and shows whether you will pay your bills consistently and on time. Thus, aside from determining your interest rates and whether you’ll be extended new credit, your credit score may also determine whether you get that apartment you applied for!
Who Tracks Your Credit Score?
Credit bureaus are responsible for collecting information from creditors, compiling that information into a credit score, and then providing that information to various agencies that may request it.
There are three major credit bureaus in the United States. They are Experian, TransUnion, and Equifax.
Something you must keep in mind about these credit bureaus is that your scores may be slightly different for each. This is because each of the “big three” is a for-profit business operating independently from the others, and thus they collect different information. Furthermore, creditors are not required to report specifically to any of the credit bureaus. As a result, they often report to only one or two of the bureaus, not all three.
The above factors combine to mean your credit score may be different depending on which credit bureau is reporting. However, your credit score from all three should be fairly similar (unless a major oops is only reported to one of them).
What Do the Numbers Mean?
To make matters even more confusing, there are multiple methods for calculating credit scores. However, the most common are FICO, and to a lesser extent, VantageScore. Although these methods are slightly different, they have commonalities that you should know about. Mainly, they both use similar criteria for determining your score, and the lower the score the more risk you are to a lender.
Another way of looking at it is this: the lower your score, the less likely you are to repay debt.
Credit scores are condensed into a three-digit number ranging from 300 to 850. No matter the calculation method, lower scores are seen as riskier and carry consequences from not being approved for new credit at all to outrageous interest rates and poor loan terms.
Intuitively, you’d think there would be an even range of bad and good scores, but that isn’t the case. In fact, there is a far larger range of unfavorable scores than there are favorable ones.
The table below gives you a good idea of the ranges of credit scores and how they are judged.
As you can see, you will need a credit score of at least 700 to be considered good and a low risk to lenders, while anything from 300 to 699 will put up red flags.
What Determines Your Credit Score?
Fortunately, the factors that determine your credit score are no secret.
According to the FICO site, there are five main factors that determine your credit score: amounts owed, new credit, payment history, length of credit history, and credit mix.
Let’s take these one at a time.
- Amounts owed (30%) refers to the amount of debt you already have. Owing money on accounts does not necessarily mean you are a high-risk borrower. However, if you tend to carry large balances on credit cards, or have many high amount loans, this may become a factor in gaining new credit because your debt/income ratio is maxed.
- New credit (10%) is the number of new credit accounts opened recently. This is important because opening several new credit accounts in a short amount of time shows greater risk, especially if you have a short credit history.
- Payment history (35%) is whether or not you pay your bills on time, and is one of the most important factors in determining your credit score.
- Length of credit history (15%) refers to how long you have been using credit. Factors such as age of your oldest and newest accounts, as well as the average age of your accounts, are taken into consideration when calculating this aspect.
- Finally, credit mix (10%) is the type of credit you have established. Your credit score will be higher if you can show you can responsibly handle a mix of different types of credit, including credit cards, mortgages, retail accounts, and other types of personal loans or lines of credit. They also like to see a mixture of revolving and closed-end credit accounts.
While FICO makes their information public and available on their website, VantageScore keeps the information to themselves. Luckily, I (Tawnya) happen to have the inside track on the factors that make up a VantageScore 3.0 credit score from TransUnion because I utilize the Credit Journey tool offered by Chase (and if you’re a Chase credit card holder or member you can likely utilize this tool too here). For VantageScore, the five factors are: payment history, outstanding debt, utilization, credit type and history, and recent inquiries.
- Payment history is your track record for making payments on time on previous and current credit accounts.
- Outstanding debt refers to the amount of debt you currently have.
- Utilization is the amount of credit you’re currently using compared to the amount you have available to you. VantageScore recommends keeping your utilization at or below 30%. For example, if you have a credit card with a limit of $5,000, VantageScore would prefer you keep your balance to $1,500 or less (30% of $5,000).
- Credit type and history refers to the type of credit accounts you have as well as how long you’ve had them. Someone with a longer and more diversified credit history is seen as less risky.
- Finally, recent inquiries refer to the records made when lenders check your credit information. Every time you apply for a new credit card or loan, the lender makes an inquiry into your credit score and history, and that counts as an inquiry. A large number of recent inquiries can indicate that you are trying to spend beyond your means or having financial difficulties, and may be a red flag to lenders.
A quick note about inquiries. Inquiries fall into two categories: hard and soft. Hard inquiries are recorded when lenders check your credit information for the purposes of potentially extending new credit, while soft inquiries occur for other reasons (such as landlord checks) or when you check your score. However, only hard inquiries will impact your credit score (may cause a temporary drop).
Most hard inquiries remain on your credit report for up to two years, and all remain on your report for at least a year. Keep this in mind when applying for new credit, and try to spread your applications out to avoid drops in your credit score and potential rejection of applications.
How Your Credit Score Can Save You Money
We’ve already mentioned multiple times that having a good credit score can save you money when it comes to interest rates, but just HOW much money can be astounding.
Let’s take a mortgage for example.
The same FICO site that brought you the credit score factors above also provides a loan savings calculator that shows you just how much you can save in interest depending on your credit score.
You can do these calculations yourself with your mortgage balance, but we have provided calculations based on a $200,000 mortgage principal balance below.
Look at the difference!
Even a difference of a few points on your credit score could cost you thousands in interest on a mortgage, as much as $68,000!
And that’s just the difference between a fair and an excellent credit score, what if you had a poor or bad credit score?!
As you can see, not all credit scores are created equally, and not all consumers are treated equally. That’s why it is so critical to actively cultivate a good credit score from the beginning.
How Can You Improve Your Credit Score?
Here’s the heart of the matter.
It’s very important to begin building your credit score on a positive note and to continue to improve it as you build credit history. It is entirely possible to have a good/excellent credit score at a young age (at last check mine was 784 and I’m only 31!), but it takes a concerted effort and the discipline to make smart financial choices.
Even if you have bad or poor credit, you can begin to turn your credit life around by following these tips from VantageScore to improve your credit score. It’s not hard to improve your credit score, it just takes time and knowledge about the system.
- Pay your bills on time each month.
- Check your credit report on a regular basis and remove inaccuracies (you can contact the creditor for the account or a credit reporting agency to have it corrected). You are entitled to a free credit report every year from all three major credit bureaus. You can receive reports from all three agencies by going to annualcreditreport.com.
- Make a concerted effort to manage your debt by keeping your credit utilization below 30%, and pay down other loan balances as soon as possible.
- Avoid too many hard inquiries by applying for new credit in moderation (remember hard inquiries stay on your credit report for up to two years).
- Finally, and most importantly, give yourself time. Time is a significant factor in improving your credit score, as you must establish a long history of using credit responsibly. Also, it will take time for negative records on your credit report to be removed (as much as 7-10 years for late payments, collections, and bankruptcies).
Moral of the Story
Your credit score is the single most important financial tool you will have in your life. Your credit score determines your ability to gain new credit, and the interest rates you will pay on your loans.
If you’re new to credit, it’s very important to remember that establishing credit takes time and patience. Begin with a small loan or a credit card, or even student loans (but pay them off as soon as possible!). When you do open your first credit accounts (or pay utilities), make sure you pay all your bills on time and carry balances under 30% utilization.
Remember, it is vital that you begin your credit life on the right foot, as negative records remain on your account for 7 to 10 years, even if you pay them off. While it’s always best to pay your debt as soon as possible (this will reduce your total debt/interest paid and show a willingness to repay obligations), these negative records will still affect your credit score until they are removed.
To put it simply, a good credit score equals Money Saved, while a bad credit score equals Money Spent.
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