Most financial decisions you make can be summarized into a three-digit number.
That one number can cost, or save, you hundreds of thousands of dollars over your life.
Lenders not only decide whether to give you a loan based on this number, it also determines how good your interest rate is. Lower interest rates means you can pay off loans a lot faster.
When buying a home, this has a huge impact on how much you ultimately pay.
This critical number is called your credit score.
Improving it is one of the big wins of personal finance.
So what’s a good score anyway? And how do they work?
How Credit Scores Work
A credit score takes personal data and uses the information to determine a number ranging from 300 to 850. It’s a summary of how likely you are to pay your loans back. Credit reporting agencies use an algorithm to analyze all the information they have on you ad give you a credit score.
Credit scores are broken down into several levels:
- Very Poor = 300-580
- Fair = 580-670
- Good = 670-740
- Very Good = 740-800
- Exceptional = 800 and above
Every time you make a payment, miss a payment, take out a new loan, or even have your credit report checked, that information gets added to your credit report. From there, your score gets calculated.
Credit scores tend to increase slowly over time. You’ll need a long history of flawless payments on several different types of loans in order to get an amazing score. That doesn’t happen overnight.
But your score can drop pretty quickly. All it takes is one missed payment and you’ll get hit. And a default on a loan is even worse, that will immediately tank your score and won’t get dropped from your credit report for years.
In college, I had to see a bunch of doctors for a herniated disk of mine. I was also moving around a lot at the time and one of the bills never made it to me. It went to collections and I paid it as soon as the collections agency got a hold of me. But it had already been added to my credit report and took 7 years for it to get dropped. My score took a huge hit during that period. Luckily I wasn’t trying to get a mortgage at the time.
Who Decides Your Credit Score
Your credit score is the result of an algorithm created by the Fair Isaac Corporation (now called FICO). While FICO is not the only credit scoring tool, it is the most popular. The exact math formula used to determine an individual’s credit score is kept under extreme secrecy.
What many people don’t realize is that FICO has multiple versions of your credit score which is why you might get two different results when applying for a store card verses a mortgage loan. Additionally, some lenders prefer to get your credit score from Vantage, Community Empower, Experian, Equifax or TransUnion.
Depending on who your lender uses to pull your score, it might be slightly different. The differences between the scores are trivial, it’s not worth spending time learning how they each work. You’ll use the same methods to improve them all.
Factors That Impact a Credit Score
Your credit score focused primarily on:
- Payment history
- Amount owed
- Credit age
- New credit
- Type of credit used
Your payment history makes up 35% of your total credit score. That means late payments or non-payment will have the largest impact on your credit score. This factor looks at whether you make your payments on time if you have any bankruptcies or accounts with a collection agency. And how long it’s been since you’ve had credit issues.
This factor makes up roughly 30% of your total credit score. The amount of money you owe is primarily concerned with the amount of money you owe debtors relative to your income and the amount of credit you have available. For example, if someone has a credit card with a $5,000 limit and they have a balance of $2,500, they’re total utilization score is 50%. Lenders like to see a total utilization score of less than 30%. Your credit utilization score includes all of your debt including credit cards, student loans, auto loans, home loans, and personal loans.
Your credit age makes up 15% of your credit score. This number just refers to how long you’ve had credit accounts open. The longer your credit history, the higher your score. This is why you’ll see advice to keep your oldest credit card open. That lengthens your credit age and improves your credit score a bit.
This portion of your score looks at how many new lines of credit you’ve obtained in recent months as well as how many times you’ve applied for loans or lines of credit. This section makes up 10% of your credit score. The one time you want to worry about this is when you’re applying for a major loan like a mortgage. Don’t apply for any new credit cards or other loans in the months before you apply for the mortgage.
Type of Credit
Your mix of credit types comprises the last 10 percent of your credit score. A mix of credit types (revolving, installment, and open) looks better on your credit score than a focus on one type of loan. Revolving credit includes credit cards that have a balance limit. This just means that you have continuous access to the line of credit as you pay off your total owed. Installment debt refers to loans or lines of credit that have a single balance you pay off. Open debt refers to open lines of credit that you can access indefinitely.
FICO vs. VantageScore
The FICO credit score is the most popular choice for most lenders, but it’s not the only score that lenders can access.
Fair Isaac (now FICO) launched the FICO credit score in the 1980s. The design of this score was to help lenders identify potentially risky borrowers. FICO held the market on the credit scoring industry for more than 20 years. In March of 2006, Equifax, Experian, and TransUnion worked together to launch VantageScore.
Both VantageScore and FICO provide the same service to lenders, but there are some differences between the two companies.
The biggest difference that consumers will notice is the credit score range and percentage that each component of the credit score considers. The FICO score ranges from 300 to 850, as mentioned above. VantageScore 3.0 recently adopted the 300 to 850 credit score range, but earlier versions used a 500-990 range.
Another major difference that affects the ending credit score is the factors that the credit scoring company considers. As mentioned above, FICO looks at five major components: payment history, amount of debt, credit history age, type of credit and new credit.
VantageScore looks at six different categories: payment history, age and type of credit, percent of credit used, total debt, recent credit behavior, and available credit. It’s also important to note that VantageScore weighs payment history heavier (40%) than FICO. Recent credit behavior and inquiries only make up 5% of the total credit score for VantageScore compared to the 10% FICO factors.
Neither score is better and I wouldn’t stress these details. Getting a few types of loans and paying them off flawlessly over a long period of time is going to be the best way to improve both scores.
Why Credit Scores Matter
Credit scores are important for several reasons. While many people think the credit score only matters if you’re applying for a home loan or car loan, your score can actually affect other areas of your finances.
A few other common uses of your credit score:
- Getting a cell phone
- Renting an apartment
- Purchasing insurance
- Applying for a job
- Opening a utility account
- Getting an auto loan
- Getting a home loan
- Applying for public assistance
Not only does it determine if you get a loan in the first place, your credit score also affects how much you have to pay in interest.
If you have a higher credit score you can get better interest rates on loans and credit cards. You may also get better terms on your insurance and phone bill. Having a low credit score could result in a higher down payment for a rental property or utility account.
Credit scores impact you the most when you apply for a mortgage. If you don’t have a good score, you might not be able to get a mortgage at all. And a great credit score can get you a much lower interest rate. You’ll save tens of thousands of dollars easily.
When you start saving for a down payment for a home, also check your credit score and do anything you can to start improving it. It’s definitely worth the effort.
Improving Your Credit Score
Time is a major player when it comes to raising your credit score. It takes time for your current lenders to report payments to the credit bureaus, so your score may not change for weeks or even a few months after you’ve made significant changes.
A few things you can do to help improve your credit score include:
Get current on your payments
If you’re behind on credit card bills or loan payments, make it a priority to get your payments back on track. Make your payment on time, every month, for every bill. If all you can afford is the minimum payment, pay that every month. If you’re struggling with paying your bills, you can call your lenders and ask for a reduced payment plan or consider consolidating your debt into one payment.
On-time payments make the biggest impact on your credit score, so this should be a top priority if your goal is to increase your score.
Pay off debt
Reduce the amount of money you owe and your score will go up. If you have any bills in collections, pay them quickly and ask the collection agency to note that they were paid in full on your credit report.
Aim to keep the balances on your credit cards lower than 30% of the total available balance to reduce negative effects on your credit score. If you have an account with a good payment history you could ask your lender to increase your credit line. Since your amount of available credit will go up, your credit utilization could decrease, helping you add a few points to your score. To really optimize your score, call your credit card companies every 6 months and ask for a higher limit. Even if it’s small, it’ll add up over time giving you a really low credit utilization.
Don’t close old accounts
Keeping old accounts open (even those you don’t use) is more beneficial than closing them. When you close a credit card account you reduce your available credit (which raises your credit utilization score) and you reduce your average credit age.
Even if you want to close a few accounts to simplify your life, try to keep the oldest account open.
Limit credit applications
Don’t apply for new lines of credit unless you need them. When you apply for a lot of credit cards or loans, each lender checks your credit. Hard pulls (when a lender has your permission to pull your credit information) can ding your score by a few points.
Apply for new loans when you need them but definitely avoid applying for anything before a major loan like a mortgage or a car loan.
Apply for a credit boost
Some companies, like Experian, offer a credit boosting service. This service allows you to add a bank account so that you can report positive payment history on most bills (like utilities, rent, and phone bills) to your account. These on-time payments will help give your score a bump within days instead of weeks.