Credit scores are one of the most important concepts in personal finance. If you want to purchase a car, a house, or make any other large purchase, you’re going to need a good credit score!
Simply put, credit scores tell lenders how worthy you are of a loan. The higher your credit score, the more likely it is that you will get a good loan. Also, lenders generally give borrowers lower interest rates on loans if they have higher credit scores. The reason for this is that a higher credit score means that you are more likely to pay the loan back completely and on time.
Credit bureaus are organizations that use your financial data to create a credit score and report it to banks and lenders. The three major credit bureaus are Equifax, Experian, and TransUnion. You can use any of these bureaus to see your credit score!
The graphic above breaks down credit score ranges and the percentage of Americans with them. Excellent credit scores range from 781-850 while very poor credit scores range from 300-499. Ask yourself the following questions: in what range does my credit score fall in and am I satisfied with where I am? It is important to keep in mind that the credit score ranges may vary slightly based on the bureau.
Now that you know what a credit score is, let’s take a look at what goes into them and how you can raise your credit score.
There are five main factors that influence your credit score: payment history, credit utilization, credit history, mix of credit, and credit inquires.
Payment history is the most important part of your credit score, as it accounts for 35% of your FICO score. Payment history measures how often you pay your credit bills on time. For lenders, this tells how risky it would be to provide you with a loan or line of credit.
Credit utilization refers to the amount of credit you use relative to your maximum credit. For example, if you use $300 of a $1000 credit line, your utilization ratio would be 30% — calculated by dividing credit used by total credit. Lenders prefer for borrowers to have a utilization ratio no higher than 30%. Additionally, utilization accounts for 30% of your FICO score.
Credit history refers to the duration of your credit use. Longer credit histories are important when applying for loans because they can give the lender a better sense of your credit habits. Credit history uses the age of your oldest account, the age of your newest account, and the average of all of your credit accounts. Credit history accounts for 15% of your FICO score.
Mix of credit refers to the variety in your debt obligations. For example, you may have a mortgage, multiple credit cards, or personal loans. Lenders want to have a good idea of how diversified your credit is. Mix of credit accounts for 10% of your FICO score.
The last factor influencing your credit score is credit inquires, which measure how many new credit accounts you opened or are planning to open. Every time you apply for a new loan or credit card, it reports that inquiry to the credit bureaus. The more inquiries you have, the more risker you are seen by lenders because you are potentially taking on new lines of credit. Credit inquires account for 10% of your FICO score.
So, how do you go about raising your credit score? Here are a few tips:
- Keep credit utilization under 30%
- Pay your credit cards off in full and minimize overall debt
- Open a secured credit card to establish credit for the first time
- Refrain from applying for new lines of credit within short periods of time
Credit cards are useful tools in personal finance, but if used incorrectly, they can plunge you into deep financial trouble. Now that you know how your credit score works, you can make better financial decisions!