Your credit score is the fundamental piece of information that lenders will look at in determining whether you’re eligible for financing. They determine rates, and much more – therefore either costing or saving you money. Here’s everything you need to know about credit scores, and how to get a great one.
Credit scores are one of the most important pieces of your financial life. If you want to buy a house, you’ll need a good credit score. If you want to buy a car, you’ll need a decent credit score. If you want a credit card, you’ll have much better options with a good credit score. It affects the interest rates you’re offered, which can cost you or save you tens of thousands of dollars (or more) over the course of a single home loan.
So what is a credit score?
A credit score is a number intended to estimate the probability that you’ll pay back money you borrow. It’s calculated based on the information in your credit report. This information includes how you’ve handled past debt and whether or not you pay your bills on time. It’s used by lenders to decide what interest rate they’ll offer you, which can make it difficult for people with low scores to find good rates and terms.
Credit scores range from 300 to 850. Although the ranges vary depending on the credit reporting agency, generally credit scores from 580 to 670 are considered Fair; 671 to 740 are considered Good; 741 to 799 are considered Very Good; and 800 and up are considered Excellent.
When you’re shopping for a loan, you’ll start to see decent interest rates and fees when your credit score is 670+. This is an acceptable risk level for lenders. For those with lower credit scores, you’re considered a “sub-prime” borrower – or a borrower that presents a high risk of defaulting on the loan. You definitely don’t want to be in that category if there’s any way you can help it. Things get very difficult for sub-prime borrowers. If your credit score is below 580, you’re probably not going to be able to get a loan and you should focus on improving your credit score before trying.
Who determines credit scores?
Credit scores are calculated by each of the three major credit reporting agencies – Equifax, Experian, and TransUnion. You may see slight differences between your credit score at each of these agencies as they each do the calculation of credit scores a little differently. If you have an error on one credit agency, you’ll want to check the other two to make sure it’s not on their reports as well.
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How are Credit Scores calculated?
Your credit score is tied to your personal information – your name, address, and social security number. It is calculated from five factors:
- Your payment history – how you’ve handled past debt and whether or not you pay your bills on time. It’s used by lenders to decide what interest rate they’ll offer you, which can make it difficult for people with low scores to find good rates and terms.
- How much money you currently owe – this is called the “amounts owed” factor, and in short, it’s a measure of how much credit you have access to versus how much you’ve borrowed. This is why it’s important to not have your credit card balances be high. If you’re operating close to the margin of how much credit you have access to, you’re considered a higher risk borrower.
- The age of your other lines of credit – this is the account age factor. You want to show a long term relationship with credit, and a long term successful usage. It’s impossible for a young person to succeed in this factor, so don’t worry too much about it if you’re young. Just maintain good payment history and keep your credit card accounts open.
- Types of credit – this is the diversity factor, or credit mix factor. Lenders like to see a normal or health mix of revolving credit (like credit cards), and installment credit, which are things like car loans, mortgages, and student loans. It’s best to have history with both types of credit.
- New credit – this is the regularity with which you’re applying for new credit. Each time you do this, your credit get’s slightly diminished. This is because credit agencies don’t want you to run up lots of new lines of credit in close succession.
What are the key factors that impact your credit score?
The key to getting good credit is to live within your means and keep a conservative financial position. That is, make sure that you don’t take out too much debt relative to your income. Here are some of the key factors that impact your credit score:
- On Time Payments – that means every bill, every month. Just because you don’t have a line of credit with a company, doesn’t mean that they won’t report to the credit agencies if you don’t pay them on time. A great example is credit card companies, power companies, and in store credit cards (like Macy’s and Home Depot) – if you stop paying them, they will absolutely report it to the credit agencies and your score will take a big hit.
- Don’t run up a credit card balance. If you set an automatic payment in full each month on your credit card, you’ll be forced to live within your means, and your credit score will ge stronger and stronger over time.
- Apply for credit only when you can afford to pay for it. You don’t want a bunch of credit inquiries on your account, even if they are temporary, and you definitely don’t want to default on a line of credit.
- Regularly check your credit statements to ensure that there aren’t any errors to be found. If you see errors, that can take a lot of time to clear up, and you should start right away.
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Why do credit inquiries hurt your credit score?
Credit inquiries can do a lot of harm to your credit score. When you make a request for a loan, the inquiry will show up on your credit report and can cause your score to drop as much as 10 points or more – even if you don’t actually get approved for the loan. This is because credit reporting agencies are interested in how often you’re trying to get approved for new loans or lines of credit. If you’re racking up a lot of new accounts quickly, that can indicate trouble for your personal finances, and ultimately do damage to your credit score.
This is only true of “hard inquiries” such as those a mortgage lender, bank, or credit card company uses. On the other hand, you don’t need to worry about checking your credit harming your credit score because that’s called a “soft inquiry” – that is it’s not an inquiry about opening a new line of credit. When shopping around for a lender, you’ll want to do your homework first, then get the process started with your preferred lender. If you allow multiple lenders to start pulling your credit, your score will take a hit.
If I have a good Credit Score, will I get approved for a loan?
The answer is more nuanced than most people realize. The credit score plays a big role in an approval decision, but it’s not the whole story. Lenders will still factor in other indicators of your ability to repay, including your debt-to-income ratio, your income, your monthly expenses, and what the purpose of the loan is.
A good credit score may or may not make a difference in your loan decision. It really depends on the factors that are important to the lender, and it’s possible for someone with an excellent credit score to be denied if they have too much debt relative to their income.
How can you check your credit score?
You’re entitled to a free credit report every year from each of the three credit reporting agencies. You can request a free credit report at the central website that they have established for this purpose. Click the link below.