Understanding your credit score
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All day long, we’re bombarded with messages, ads, announcements and videos on the importance of our credit score. It’s a mystery that seems to be unravelling and becoming more manageable. If you’re like me, this was and is a long journey with many mistakes made along the way. Wherever you are score-wise, don’t get frustrated or complacent, as credit is fluid. Here I’ll explore with you all things credit and share with you some tips on how to improve your score. Remember though, your score is definitely tied in with spending, so no matter how good a score you achieve, if you don’t improve your spending and savings habits, it’ll be extremely difficult to maintain a high score.
Definition of credit score
So first off, I just want to make sure that we distinguish between credit and credit score. While the two seem to be interchangeable terms, they aren’t exactly the same. Credit, according to this article in investopedia.com is a contractual agreement between a lender and a borrower for a specific amount, and where the borrower generally will have to pay back at a later date, usually with interest added on. Credit score is a prediction based on past behavior, spending and repayment habits as defined in this post by Consumer Finance. It’s used by lenders to determine if and how much credit to extend to you. The higher the score, the less risk in their eyes.
Range of credit scores
Credit scores range from 300-850. You can monitor your score for free with a company such as Credit Karma and every time you get your report, it will label your score like the system below.
300-579 Poor-here you have no credit history or very poor history with unlikely chances of obtaining additional credit. Getting help educating yourself and improving your credit score is very important in this range.
580-669 Fair-these consumers are considered risky borrowers who may have trouble qualifying for new or additional lines of credit.
670-739 Good-here you are considered as an acceptable borrower. While you won’t get the lowest interest rates, chances are much better than the other two tiers at obtaining new credit.
740-799 Very Good-at this level you will have a much eaiser chance of obtaining more credit. You’ve demonstrated more positive credit behavior.
800-850 Excellent-top tier of borrowers. Here, you’ll have a much better chance of obtaining new credit and will usually secure the lowest interest rates for repayment.
Credit score can range from 300-850. Is it time to check on yours?
One way of helping our children out of that Poor credit range is to teach them credit and financial literacy from as young an age as possible. A small trick to helping establish credit history is to add them onto your own cards and accounts from the age of 13. This will go a long way in them having a better score and greater sense of responsibility when they’re ready to leave the nest.
Components of credit scores
There are 5 key factors that affect your FICO score. FICO stands for the Fair Isaac Corporation, a pioneer in the credit score industry. Today, they are still the go to company for calculating credit scores, from personal to business.
Payment History-35% of your score. Pretty simple and logical. The more on time payments you make, the more positively this affects your overall credit score. There’s actually an even better pay by date then the due date on your statement. Read to the end of this post to find out what that is.
Credit Usage-30% of your score. The credit usage or utilization is the amount of credit you have versus how much you’re using. So let’s say you have 5 cards with $1000 limit on each. This gives you a total of $5000 credit. If the total amount you owe among the five cards is $2500 then you calculate the credit usage ratio by total amount owed / total credit available X 100. In this case, it would be $2500/$5000=.5 .5 x 100=50%. The key number is to get your credit usage under 20%. So instead of owing $2500, the ideal outstanding amount should be $1000 or even less.
Length of credit history-15% of your score. Lenders tend to believe that the longer you’ve had credit the better you’ve been able to manage it. They’ll look at the dates of your oldest and newest accounts and take that data under consideration when determining length of credit history. If at all possible, avoid closing your oldest accounts. Now, this doesn’t mean you can’t close any accounts. Any account which is in good standing and completely paid off can be closed, as those stay on your credit report for 10 years.
Credit mix-10% of your score. Credit mix refers to the kinds of credit and debt that you own. Many of us are familiar with revolving credit such as credit cards and personal lines of credit and probably own too many of these. While it’s good to have a line of credit available, it’s not considered good debt as many of us are constantly carrying balances and/or only paying the minimum amount. It’s good to mix it with installment loans which are considered good debt, such as student loans and mortgage loans. Here you receive a one time amount that you pay back over time which includes the interest.
New credit-also 10% of your score. Lenders tend to be wary of someone who has too many hard inquiries, which refer to lenders pulling up your credit score to determine if they’ll extend credit or not. It’s a red flag to them that you’re seeking new debt when you already have debt. Soft inquiries however, such as shopping for better mortgage rates won’t count against you and are actually a positive. You’re aware that better interest rates exist and you’re actively seeking them.
Impact of credit scores
There’s no other way to say it: a better credit score will help you in so many ways in your daily life. Below are some examples of how a better credit score makes certain things easier, faster or cheaper.
Better likelihood of getting new or more credit-as I mentioned, lenders believe a higher credit score equals a better likelihood of repayment. So as a reward, you’ll be given higher credit limits or just credit period over someone with a lower score. This has a secondary benefit because it increases your overall credit limit thus lowering your credit usage. See how that worked?
Lower interest rates-definitely one of the most important benefits of a higher score is lower interest for repayment of loans and credit cards. The difference between a 14% APR (Annual Percentage Rate) and a 24% APR is huge over the life of the loan or credit card balance. Think of what you will do with the extra money!
Insurance discounts-the higher your credit score, the lower the amount of car, homeowners and other kinds of insurance. Yes, a clean driving records goes a long way in lowering your bill, but so will a high credit score.
Avoid security deposits-those with higher scores can have small or even no security deposits when borrowing money or applying for a new credit card. You may even have a smaller deposit for apartment rentals. Conversely, those with a lower score will be forced to pay large security deposits. Large money upfront (security deposit) and higher interest rates (back end). That’s a double hit that can and will happen with poor credit scores.
Employment-by now, many of us know that prospective employers will pull a credit report as a factor in whether to hire you or not. You may not agree that your score should affect your ability to get the job, but employers think a good credit score implies dependability and stability. Those are of course traits most employers are looking for in their staff.
Mortgage rates-one of the biggest purchases we’ll make in our lifetime is a home, and your high credit score that you worked so hard to achieve will earn you a lower interest rate. Imagine saving thousands of dollars over the lifetime of the mortgage. Even before earning a lower interest rate, you’ll have had a better chance of purchasing the home over a prospective buyer with a lower credit score in the first place. Win-win!
More cell phone choices, greater purchasing power over vehicles, choices in renting or buying and on and on.
So, what was that secret boost to bump up your credit score that I mentioned at the beginning of this post? Go now, and check for the closing date of your credit card and start using that as the repayment date instead of the due by date. Credit scores are fluid, so unfortunately no one inquiring into your credit score knows that you plan on paying the balance by the due date. All the data shows is that on the closing date you owed this large amount. Paying off or down the balance at this time will bring down your total credit utilization below that magic 20% usage rate. You’re welcome!
I hope this post helps you understand your credit score more and gave some insight on how to raise it. You CAN manage your score better and you CAN improve it with time and a plan.
