A Beginner's Guide to Credit Scores
Having good credit can mean better financial opportunities. It might make you eligible for loans or credit cards that aren’t available to folks with lower credit, setting you up to make big, important purchases. It can also lead to other perks, like lower interest rates and higher credit limits.
But how do you know if your credit is good, bad or somewhere in between? And, what steps can you take to improve it?
The very first step is to gain a basic understanding of what a credit score is and what it's used for.
Credit score basics
Before a company decides whether they’ll loan you money or give you a line of credit, they'll evaluate your application and determine how likely it is that they’ll be getting their money back from you within a predetermined period of time. Part of that means evaluating your credit score.
Let’s say you apply for a car loan. Your goals are to get the car you want, to pay the loan off as quickly as you can and to pay the least amount of interest on it as possible.
The loan company’s goal is to make as much money as they can off of your loan while also ensuring their money will be returned to them when they want it. They’re hoping you will only make the minimum payments on your loan—after all, early loan payoffs mean that you are paying less money in interest for that loan.
The company wants their money back, so they need a way to determine how likely it is that you can deliver. That's where your credit score comes in.
Looking at your score is the way companies can make an educated guess about your creditworthiness, or how likely you are to make your minimum payments on time. (Though the way companies weight the disparate aspects of your finances can vary depending on the situation.)
What makes a credit score
Mathematical models are used to determine credit scores, according to Deborah McNaughton, a credit and mortgage expert and author of personal finance books, including “Money Trouble: Surviving Your Financial Crisis.”
These scores are based on a variety of factors, including whether you’ve made past payments on time and the types of credit (such as car loans, credit cards and student loans) you already have.
There are many types of credit scores, but “most lenders,” or about 90 percent, “use the FICO (Fair-Isaac Corporation) score” when evaluating your creditworthiness, said Beverly Harzog, a consumer credit expert and advocate and author of five books, including “The Debt Escape Plan: How to Free Yourself From Credit Card Balances, Boost Your Credit Score, and Live Debt-Free.”
Since it's the most commonly used credit score, let’s take a look at the basics of FICO.
From “excellent” to “bad”: Categorizing FICO scores
FICO scores range from 300 to 850, and the higher your score is, the better, Harzog said.
FICO scores fit into one of five basic categories. The exact score range for each category varies a little with the economy, but here are the general guidelines, as explained by Harzog:
- Excellent: 750 to 800 (“You get the best deals with that.”)
- Good: 700 to 749
- Fair: 650 to 699
- Poor: 600 to 649
- Bad: 300 to 599
And there are five basic factors that are used to calculate these scores:
- payment history
- the percentage of your available credit you're already using
- taking on new credit
- the length of your credit history
- and the mix of the different types of credit you already have
You could go from bad credit to pretty good credit if you focus on those factors,” Harzog said.
Let's get into each of these five FICO ingredients.
Winning is as easy as paying your bills on time
When companies are trying to decide if they should lend you money, one of the big factors they look at is whether you’re paying your current bills on time. In fact, your payment history makes up the largest portion of your FICO credit score. It accounts for 35 percent–or more than one-third–of your credit score.
“Pay your bills on time,” Harzog said. "All of your bills."
The secret’s in the ratio
Lenders also want to know how much of your credit you're already using. For example, if you owe $200 on a credit card and your credit limit for that card is $1000, you are using 20 percent of the credit that is available to you for that particular card.
Thirty percent of your FICO score is based on how much of your available credit you're using, Harzog said. Your overall credit utilization is calculated, as well as that for each of your lines of credit (each individual credit card and loan), she added.
Make it a goal to keep each of these values under 10 percent in order to really boost your credit score, Harzog said. If you can’t meet that goal, at least keep the values under 30 percent, McNaughton advised.
Let’s say, for example, you have two credit cards. The first has a credit limit of $5,000 and the second has a credit limit of $500.
If you owe $250 on the first card and $250 on the second card, you are using just 9.1 percent of your overall available credit. You are also using just 5 percent of your available credit on the first card.
However, you are using 50 percent of the credit that’s available to you on the second card. Your credit score could take a hit because you're using so much of your available credit for this second card.
“Always pay your bills in full and on time,” Harzog advised. She called carrying a balance from month to month “wasted money” because of the interest you pay on it.
The new credit conundrum
Ten percent of your credit score is influenced by new credit. Obtaining a new line of credit eventually has a positive impact on your credit, as it increases the amount of available credit you have, Harzog explained.
However, every credit inquiry from a credit card company reduces your score by two to five points, so you should be careful about how many credit cards you apply for, especially if it’s likely that your application will be denied.
If you apply for a bunch of home mortgage loans around the same time, this will only count as one credit inquiry, Harzog said, because it is common for people to shop around when they’re looking for a new home mortgage loan.
Your credit history: Here’s hoping it’s long
The length of your credit history is something that you have limited control over, especially when you’re young. After all, you can’t have 30 years of credit history if you are only 25 years old. Still, 15 percent of your credit score is determined by the length of your credit history.
Using credit cards will beef up your history—if used responsibly. If a credit card “doesn’t have an annual fee and you aren’t abusing it,” keep it open even if you aren't using it much, Harzog advised. Use it occasionally, paying it off every month. Depending on the credit card's terms, if you don’t use it for a couple of months the company could close your account due to inactivity, Harzog said.
Know your credit mix
Do you have credit cards, loans or both? Your credit mix is used to determine 10 percent of your credit score, according to Harzog.
“Having credit cards and installment loans with a good credit history will raise your FICO Scores," according to myFICO, the consumer division of FICO. "People with no credit cards tend to be viewed as a higher risk than people who have managed credit cards responsibly.”
Stay in the know on your credit scores
There are three major credit bureaus: Equifax, TransUnion and Experian. You can get a free copy of your credit report from each bureau once every 12 months using AnnualCreditReport.com, McNaughton and Harzog said.
Check your credit report for any errors. If you find them, dispute them. Checking your credit report is also a good way to make certain you aren’t a victim of credit card fraud, McNaughton said.
“A lot of credit card fraud happens and you may not know it unless you get a credit report," she said. "It’s a good safeguard for you.”
Don't like the looks of your credit reports? Improve as many of the five factors that influence your FICO credit score as you can to bring the number up, the experts advised.