Credit scores help lenders assess the likelihood that a borrower will default on a loan.
If you apply for a new car or home mortgage, or even an apartment rental, the lender will check your credit score to determine whether to extend your credit and at what interest rate.
In this guide, we’ll explain what is a credit score, how credit scores are determined, how your credit score can affect the terms of your loan, and what you can do to improve or maintain a good credit score.
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What is a credit score?
A credit score is a numerical representation of an individual’s creditworthiness based on their credit history. It is calculated using various factors such as payment history, credit utilization, length of credit history, types of credit accounts, and recent credit inquiries. Credit scores typically range from 300 to 850, with higher scores indicating better creditworthiness.
Lenders and creditors use credit scores to determine an individual’s eligibility for credit, loans, and other financial products, as well as to set interest rates and terms. Maintaining a good credit score is important for financial health and can lead to better opportunities and lower interest rates.
Why does your credit score matter?
Your credit score is a measure of how likely you are to repay the money you borrow. It’s designed to predict whether or not you’ll default on an obligation, such as a loan or credit card.
Credit reporting agencies (CRAs) – Equifax, TransUnion, and Experian – issue credit scores when you apply for a credit product. Banks, credit card companies, and other lenders use these scores to help them decide whether or not you should be given credit.
The higher your score, the more likely it is that you’ll get approved for a loan or line of credit. Lenders may also look at your individual factors to determine if they are comfortable loaning you money, and at what rate.
How are credit scores calculated?
There are three major credit-reporting agencies (CRAs) in the United States: Equifax, Experian, and TransUnion. Each CRA collects information about you when you open a new line of credit (a credit card, car loan, mortgage, etc.) or make a significant change to an existing account (for example by adding yourself as an authorized user to someone else’s credit card). In addition to collecting information from lenders, the CRAs also collect information from public records such as bankruptcies, foreclosures, and lawsuits.
The CRA then sells your credit report to creditors, employers, or other users who use it to assess whether you will repay a new debt (such as a credit card) or existing debt (such as an auto loan).
Your FICO score is calculated by sorting through the information in your credit report and tallying up various types of information. Generally, the most heavily weighted factors are on-time bill payments and the amount of debt you owe. credit scores range from 300 to 850. A credit score above 760 is considered excellent; 720 to 760 is very good; 670 to 720 is good; 660 to 670 is fair, and below 660 is considered poor.
Credit reporting agencies (CRAs) don’t provide your credit scores for free. However, there are several ways to get your score, including AnnualCreditReport.com, Credit Karma, MyFico.com, or through various financial products such as credit cards and free online personal finance tools.
What affects credit scores?
Generally, the information that appears on your credit report will have a greater impact on your credit score than any factor that is not reported. In addition, anything that helps you manage your existing debt will improve your credit score. Here are some of the most significant factors in calculating a credit score:
Payment history.
Your payment history makes up 35% of your credit score. Long credit history is generally better than a short one, so you’ll want to make payments on time, every time. This includes not only paying your bills on time but also making sure that any accounts with collections or public records are paid off in full and reported as such.
Debt and credit utilization.
You’ll want to keep your outstanding debt low, and ideally no more than 30% of your available credit limits on any individual account or overall.
Don’t forget to take into consideration other forms of debt you might have when determining how much you can afford to spend each month. It’s also a good idea to keep an eye on your credit utilization rate even after you’ve paid down your debt since it can vary from month to month based on how much available credit you have.
Length of credit history.
Having a long credit history is usually beneficial, but not always. While a “shorter” credit history will hurt your credit score, a long history with no late payments and low debt will help your score.
How recently have you applied for credit?
New accounts or even just inquiries into your credit can negatively impact your credit score in the short term, but this is less of an issue than it used to be. In most cases, new credit accounts and/or inquiries will only have a small impact on your credit score and it will diminish over time.
Types of credit in use.
Creditors like to see that you can handle different types of credit, so using a mix of revolving and installment accounts such as store cards and student loans can be beneficial. On the other hand, if you only use one credit type, such as only using installment loans, it might be viewed negatively by creditors.
How long accounts have been open?
Your credit score benefits from having both short-term and long-term established credit accounts. However, older isn’t always better — closing old accounts can actually harm your score.
Account inquiries.
Intense periods of credit activity can temporarily hurt your credit score, but this impact diminishes over time. In most cases, a single inquiry will not have significant long-term effects on your score.
Credit report inquiries are also flagged so that they do not affect your score when you check it for a specific purpose, such as a credit card or auto loan application.
Account status and type.
Credit accounts that are open, have been used recently, and have a low balance relative to their limits will generally have a positive effect on your credit score.
The opposite is true for closed accounts or those with high utilization rates. In most cases, closing an account will not hurt your credit score, but creditors may take longer to update the status of closed accounts than open ones.
What is a good credit score?
There’s no single answer that fits every lender or situation. A good credit score can vary depending on whether you’re trying to get a loan for a house, car, credit card, or even a job.
There are three main credit-reporting agencies — Equifax, Experian, and TransUnion — that collect individual credit information from creditors. Each of these credit bureaus then has its own scale for measuring consumer creditworthiness based on the information collected.
Credit scores are widely used by lenders because they’re relatively simple to obtain and use, allowing scores to be quickly accessed by many potential creditors.
One of the best ways to determine what score you need is simply to check your score for free with a trial subscription from one of the major credit scoring agencies. No personal information is required, and you can see how different actions affect your score — which can help you get a better idea of how creditors view your creditworthiness.
The bottom line
A credit score is a crucial aspect of one’s financial health. It is a numerical representation of an individual’s creditworthiness, which lenders and creditors use to determine their eligibility for credit, loans, and other financial products.
A good credit score can open up various opportunities and provide better terms and interest rates, while a poor credit score can lead to higher interest rates and even loan denials. Therefore, it is important to maintain a good credit score by paying bills on time, managing credit utilization, and monitoring credit reports regularly. By doing so, individuals can increase their chances of obtaining credit and achieving their financial goals.
