A credit score is a three-digit number, but it has a huge impact on your life. In short, your credit score is the sum total of your financial life.
This is essentially a measure of how likely you are to repay borrowed money or fulfill your financial obligations.
In this guide, we’ll help you understand how credit scores work and their features, so you can improve your financial life.
How credit scores work
A credit score plays an essential role in a lender’s decision to offer credit and on what terms.
The three main United States credit bureaus (Equifax, Experian, and TransUnion) are responsible for compiling and maintaining individuals credit histories.
Your credit score provides a quick summary of your creditworthiness, helping lenders assess the risk of lending to you.
There are two distinct credit scoring models used to assess an individual’s creditworthiness: FICO and VantageScore.
In summary, both FICO and VantageScore are credit scoring models that assess credit risk. While they consider similar factors, the specific algorithms and score ranges may differ.
Lenders may use one or both models when making lending decisions, so it’s essential for consumers to be aware of both their FICO and VantageScore credit scores, as well as monitor their credit reports regularly for accuracy.
FICO Score
FICO, which stands for Fair Isaac Corporation, is a well-established and widely used credit scoring model. It was created by the Fair Isaac Corporation and has been in use for several decades.
The FICO score calculates a person’s creditworthiness based on data from their credit reports. It considers factors such as payment history, credit utilization, length of credit history, types of credit used, and recent credit inquiries.
These scores typically range from 300 to 850, with higher scores indicating better creditworthiness. The specific ranges may vary slightly depending on the version of the FICO model being used.
VantageScore
VantageScore is a credit scoring model developed by the three major credit bureaus in the U. S.: Equifax, Experian, and TransUnion. It was created as a competitor to FICO and has gained acceptance in the credit industry.
VantageScore uses similar credit factors as FICO, including payment history, credit utilization, length of credit history, types of credit, and recent credit inquiries. However, it may use different algorithms to calculate scores.
This measurement has a range from 300 to 850, similar to FICO. Many lenders, especially those focusing on credit cards and consumer loans, use VantageScore in their lending decisions. It has also gained acceptance in mortgage lending.
How your credit score is calculated
Credit scores are calculated using a complex algorithm that takes into account various aspects of your credit history and financial behavior.
Even though the exact calculations can vary between different credit scoring models, the FICO score is the most common.
Here’s a general overview of how your credit score is calculated according to the FICO scoring model:
- Payment History (35% of the score): The most significant factor in your credit score is your payment history. It looks at whether you’ve paid your credit accounts on time. Late payments, defaults, and collections can significantly lower your score.
- Credit Utilization (30% of the score): Credit utilization measures the amount of your available credit that you’re using. It’s calculated by dividing your credit card balances by your credit card limits. Lower credit utilization, generally below 30%, is seen as better for your credit score. High utilization can indicate financial stress.
- Length of Credit History (15% of the score): This factor considers how long you’ve had credit accounts. A longer credit history is generally seen as more stable and can positively influence your score. It takes into account the age of your oldest account, the average age of all your accounts, and the age of specific account types.
- Types of Credit (10% of the score): Having a mix of different types of credit accounts, such as credit cards, installment loans, and mortgages, can positively affect your score. A diverse credit profile suggests responsible credit management.
- New Credit (10% of the score): Opening several new credit accounts in a short period can be seen as risky behavior and might lower your score. Each time you apply for credit (a “hard inquiry”), it can have a minor negative impact on your score.
Factors that affect your credit score
Several factors can affect your credit score, either positively or negatively. Understanding these factors can help you manage your credit more effectively.
Here are the key factors that can influence your credit score:
- Payment History:
Timely payments on credit accounts, such as credit cards, loans, and mortgages, have a significant positive impact on your credit score.
On the other hand, late payments, missed payments, and accounts in collections can have a substantial negative impact.
- Credit Utilization:
High credit card balances relative to your credit limits (high utilization) can negatively impact your score. Aim to keep your credit utilization below 30% to maintain a good score.
- Length of Credit History:
A longer credit history can positively influence your credit score. This includes the age of your oldest account, the average age of your accounts, and the age of specific account types.
- Types of Credit:
Having a mix of different types of credit accounts, such as credit cards, installment loans, and mortgages, can be seen as a positive indicator of responsible credit management. But it depends on how you manage them.
- New Credit:
Opening several new credit accounts in a short period can be seen as risky behavior and might lower your score.
Each time you apply for credit (a “hard inquiry”), it can have a minor negative impact on your score.
- Credit Inquiries:
Too many hard inquiries in a short time frame (such as applying for multiple credit cards within a few months) can negatively affect your score.
Soft inquiries (like those from pre-approved offers) typically do not impact your score.
- Credit Account Management:
Keeping your credit accounts in good standing and avoiding defaults or charge-offs is crucial for maintaining a positive credit history.
Closing old accounts can sometimes have a negative impact on your credit history, especially if they were your oldest accounts.
- Public Records:
Legal actions like bankruptcies, tax liens, and judgments can severely impact your credit score.
- Financial Events:
Major financial events, such as taking out a mortgage or paying off a substantial loan, can have both positive and negative effects on your credit, depending on how you manage them.
Credit score ranges: What is a good credit score?
Credit scores typically fall within specific ranges, and what constitutes a “good” credit score can vary depending on the credit scoring model being used and the lender’s criteria.
The two most common credit scoring models, FICO and VantageScore, have different score ranges.
Here’s a breakdown of the credit score ranges and what is generally considered a good credit score:
- FICO Credit Score Range:
Exceptional: 800 and above
Very Good: 740 to 799
Good: 670 to 739
Fair: 580 to 669
Poor: 579 and below
In the FICO model, a score above 670 is generally considered good, and a score above 800 is exceptional. Lenders often offer their best interest rates and terms to borrowers with scores in the very good to exceptional range.
- VantageScore Credit Score Range:
Excellent: 750 and above
Good: 700 to 749
Fair: 650 to 699
Poor: 550 to 649
Very Poor: 549 and below
In the VantageScore model, a score above 700 is typically considered good, and a score above 750 is excellent.
It’s important to note that while these ranges provide a general guideline, what constitutes a “good” score can vary depending on the lender and the type of credit you’re seeking.
Some lenders may have stricter or more rigid criteria, and the definition of a good score may differ for auto loans, mortgages, credit cards, and other types of credit.
How to build your credit
Building credit is essential for establishing a solid financial foundation.
It may take several months or even years to establish a strong credit history, so remember that building credit is a gradual process. However, with persistence and responsible credit management, you can build a positive credit profile that opens up financial opportunities in the future.
If you don’t have credit but are looking to build it
Building credit when you have no credit history requires a deliberate and patient approach.
Start by applying for a secured credit card, where you provide a cash deposit that acts as your credit limit. Make small, regular purchases, and pay your bills on time and in full each month. This demonstrates responsible credit use and can gradually establish a positive credit history.
Additionally, consider becoming an authorized user on a family member’s or friend’s credit card account to piggyback on their good credit habits. Over time, as your credit history grows, you can apply for traditional credit cards or loans.
Building credit takes time, so be patient and diligent in managing your finances responsibly.
If you have credit but want to strengthen your score
If you already have credit but aim to boost your score, focus on strengthening your credit management habits.
Start by consistently making on-time payments for all your credit accounts, as payment history is a significant factor in your credit score.
Additionally, aim to reduce credit card balances and maintain a low credit utilization rate, ideally below 30% of your credit limit. Avoid opening too many new credit accounts in a short period, as this can temporarily lower your score.
Keeping older accounts open can also positively impact your credit, as it demonstrates a longer credit history. Regularly monitor your credit reports for any errors or inaccuracies and dispute them promptly if found.
Lastly, practice patience, as improving your credit score can take time, but these responsible habits will contribute to a stronger credit profile over the long term.
How Credit Impacts Your Life
Your credit score has a significant impact on various aspects of your life, influencing your financial opportunities and sometimes even non-financial aspects.
First, you need to know that a high credit score makes it easier to qualify for loans, credit cards, and lines of credit. Lenders are more likely to approve your applications and offer you better terms, such as lower interest rates and higher credit limits.
A good credit score can lead to lower interest rates on loans and credit cards. This translates to lower monthly payments and potentially saving thousands of dollars over the life of a loan.
Besides that, a good credit history can also have a direct effect on housing: landlords and property management companies often check credit reports when considering rental applications.
When you’re ready to buy a home or rent a property, your credit score plays a critical role in whether you’re approved and the terms of your mortgage or lease agreement. A low credit score may result in higher security deposits, higher rent rates, or even rejection of your rental application
Poor credit can lead to financial stress, as you may struggle to qualify for loans when you need them or face higher interest rates, making it more challenging to manage debt.
In summary, your credit score significantly influences your financial life, affecting your access to credit, the costs of borrowing, and your ability to secure housing and services.
Building and maintaining a good credit score is essential for enjoying favorable financial opportunities and reducing financial stress.