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It’s just a three digit number, but you probably know that your credit score is a very important piece of your financial puzzle. And while other factors like income, savings, debt history, and debt to income ratio may be better financial indicators, there’s no denying the fact that your credit score matters.
Still, credit scores can be confusing, which leads many people with few answers and several questions:
- What is a good credit score?
- Does my credit score matter?
- Can I get a loan with bad credit?
- How is my credit score calculated?
Sure, intuition tells you if you have a good credit score, it can be easier to buy a house or car, get a small loan, or even get better insurance rates.
It’s also true that a bad credit score can hurt you in many ways. If your credit score isreally low, it can keep you from getting a loan, buying a car, or simply make it much more expensive to borrow money.
Whether you have good credit or bad credit, it’s important to understand the impact that your credit score can have on your overall financial well-being—and then make a plan to increase your score.
Before we go on, let’s take a moment to understand some of the basics about credit scores.
How is a Credit Score Calculated?
In the past, the exact formula for how calculating credit scores was a bit of a mystery. Some authorities argue that we still don’t knowexactlyhow this works, but MyFico has shared how they utilize the different pieces of a credit report to calculate their scores.
Here are a few important items to note from the chart above:
- Your Payment History (35%) and your Amounts Owed (30%) are two of the biggest factors that determine your credit score. They help lenders evaluate their risk and the likelihood that you’ll be able to repay your loan on time. If you have a habit of making late payments or have allowed your debt to swell to extremely high levels, that could explain recent decreases in your credit score.
- The third most important factor is your Length of Credit History (15%). This category includes a careful review of your oldest open account, the average age of your active accounts, and even the age of your most recently opened account. (This is partially why many experts recommend against closing accounts unless you have a really good reason.)
TL;DR – If you have pay your bills on time, avoid borrowing too much money, and maintain your accounts over time, it’s fairly easy to maintain a high credit score.
That said, it’s important to note that each of these categories may be weighted differently for each individual borrower, according to MyFICO. For example, an adjusted weighting system may be utilized for a borrower who has a limited credit history, i.e. is just starting out as a borrower.
It’s equally important to understand that a credit score is unique and constantly evolving. Slight changes over time can have varying impacts on your credit score, while bigger changes tend to have a larger impact on your credit score.
What is the Range of Credit Scores?
Today, both the FICO and VantageScores models calculate credit scores on a scale from 300-850 with 850 being considered the highest score. Different points along the sliding scale represent generally accepted ranges of “good,” “bad,” and in-between score ratings.
The credit score chart below illustrates generally accepted score ranges, though it is important to keep in mind that individual lenders often establish their own credit score quality ratings.
What is a Good Credit Score?
Again, it’s worth noting that most lenders determine their own internal rankings when evaluating a potential borrows credit worthiness. (This means it is possible that one company could find a potential borrow to have an “excellent” credit profile, while a different lender could evaluate the same borrower less favorably.)
That said, the above chart illustrates that a credit score above 700 is generally considered good. And as we’ve discussed, a good credit score can open doors for borrowers to secure the most competitive interest rates when applying for a mortgage, car loan, etc.
Naturally, lenders also look at variables such as employment history, income, and the type of credit/loan you are requesting when evaluating a loan and determining interest rates.
How Can I Monitor My Credit Score for Free?
If you don’t know your credit score or haven’t monitored it for recent changes, our favorite place to check scores for free is Credit Sesame. Setting up a new account only took me a few minutes, and the insight gained into my credit score was well worth the time.
When you create your free account, Credit Sesame will send you monthly updates on your credit score, constantly monitor your reports for suspicious activity, and even provide$50,000 in complimentary bonus identity theft insurance.
Each month, you can use the Credit Sesame app to track your loan payments, check your credit score, review your credit ratios, and see how you might be able to save money by refinancing existing debt.
Here’s the best part: Unlike other competitors, Credit Sesame doesn’t ask you to sign-up for a free trial and hand over your credit card information. It really is free to sign-up.
Another option worth checking: Your current credit card provider may offer you the chance to get a free credit score report, according to Credit Knocks.
How Can I Improve My Credit Score if it is Low?
Dealing with a low credit score can be challenging, but it certainly doesn’t have to be a long-term or permanent problem. In fact, if you’re willing to commit to a few simple strategies, improving your credit score doesn’t have to be too difficult.
1. First, commit to making sure that you never have a late payment again. Set reminders in your calendar app, set-up automatic payments to at least pay your minimum account balances, or put up a million post-it note reminders around your house. But don’t have any future late payments.Late payments can kill your credit score.
2. Second, do everything you can to keep your credit card balances as low as possible. When lenders see revolving credit usage linger at 30% or higher, especially on credit cards, they see this as a big red flag.
I recommend paying off your credit card balances in full each month, if you can. And if not, pay off as much as possible each month until they are paid off. Keeping a small balance on your credit cards from month to month is not going to improve your credit score in any meaningful way.
3. Third, continue to work on paying down other loan balances as much as you can. When you reduce your loan balances, you’re simultaneously increasing your available credit. Banks like to see this. (And your score should improve, so make sure you're checking it as your balances decrease.)
4. Fourth, be careful to minimize the number of new inquires on your credit. If you are rate shopping before completing a new purchase or loan refinance, try to keep your inquires contained within a 30 day period, as this should not damage your credit scores.
5. Finally, if your credit is extremely bad, applying for a secured credit card is worth your consideration.
The bottom line is simple: Bad credit can cost you hundreds of thousands of dollars over time due to money spent in interest. Why? Basic financial theory leads lenders to charge higher interest rates as a premium to cover the additional risk they take on when lending to borrowers with subprime credit.
So make sure you take active steps to improve a low credit score—and once you get it above 700, keep it there!
Related Reading:
7 Habits of the Rich
You Can Keep Your Credit Score in Check
Whether you’re the owner of an excellent credit score or looking to get back on track with your finances, we hope the tips in this article have helped you see the importance of a good credit score.
One word of caution: A good credit score does not mean you are given carte blanche freedom to spend yourself deep into debt. If you’re looking to build real wealth and one day retire without worrying about money, you should be very careful when borrowing money and only do so if it is a short-term, temporary solution.
