What is a credit score? Everybody has one, you see commercials all the time advertising free credit scores. When are they important & what is the difference between a good and bad credit score? Those are all questions we will answer today!
What Is A Credit Score?
A credit score is a number that estimates your individual ability to pay off debt. For example, you want to buy a new car but can only do so by getting a loan from a bank? When you apply for the loan, the bank is going to look at your credit history and credit score are key factors to see what interest rate you qualify for.
A higher credit score means a lower interest rate. Vice verse, a low credit score equals a higher interest rate.
Your credit score is essentially like the odds of various horses at the Kentucky Derby. The favorite horse has a lower payout. They are most likely to win, so the reward is smaller. Instead you bet on the horse with the lowest odds of winning, and if they win, you win a lot of money. Banks assign higher interest rates to people they feel are more likely to default or miss a payment on their loans.
There are a couple different companies that offer credit scores, but the “Granddaddy Of ‘Em All” is the FICO score. It is used by 90% of lenders when processing loan applications.
The FICO score ranges from 350 to 850. These numbers are broken down into different categories:
- Excellent Credit: 750+
- Good Credit: 700-749
- Fair Credit: 650-699
- Poor Credit: 600-649
- Bad Credit: 599 or below
There are sub-variations of the FICO score and its competitors (Experian, Equifax, and TransUnion) depending on the industry of the loan applications, so score criteria might vary a little. However the above numbers are a good basis.
Still using FICO, its NG2 score is primarily used for home mortgages & the NG8 is primarily for auto loans.
The above image is the FICO NG2 score provided by my credit union. As you can tell, the possible score ranges from 150 to 950. It is a wider range than the traditional 300-850 FICO range.
Why Is A Credit Score Important?
A credit score is only important if you plan to borrow money to buy something.
- *Disclaimer! There are three caveats to the above statement
- Caveat #1: Car insurance providers are increasingly using your credit score to help determine the cost of your monthly premium.
- Caveat #2: Employers will check job applicants credit scores for certain industries & positions. If you are applying for a job that handles money, don't be surprised if they ask permission to run a report of your personal credit history & credit score.
- Caveat #3: Landlords are very likely to check the credit score & credit history of prospective renters. They want to make sure you are likely to pay your rent on-time and/or not trash the place & escape in the middle of the night after you cannot pay rent.
Another common question is if inquiries will penalize your credit score. The only time your score is temporarily lowered is when you apply for credit to borrow money. Your score is not affected when it is acquired for any of the above caveats or if you subscribe to a legitimate credit monitoring service.
Real World Example
Returning to the primary reason a credit score becomes important when you need to borrow money from the bank because you don't have enough of your own to buy it.
Let's see how your credit score will affect your monthly payment on the $20,000 car you want to purchase!
If you have an excellent score, you will qualify for a low-interest rate like 1.49% for 36 months. With a lower credit score, your interest rate might range from 3.35% to 6.99% for 36 months.
Let's see how much that the monthly payment increases depending on the interest rate for a $20,000 36-month new auto loan:
- Monthly Payment at 1.99% APR= $572.76 (Excellent Credit Rating)
- 3.35%= $584.71 (Good Credit Rating)
- 4.59%= $595.74 (Fair Credit Rating)
- 6.99%= $609.25 (Poor or Credit Needs Improving)
How much more in interest will you have to pay on a $20,000 car loan with a higher interest rate? Let's see:
- Total Interest Paid With Excellent Credit Rating= $619.36
- Good Credit Rating= $1,049.56
- Fair Credit Rating= $1,446.64
- Poor Credit Rating= $1,993
Is that $1,300 difference like a kick in the teeth?
The same also applies for any loan whether it's a home mortgage or line of credit, except the interest rates will probably be higher so there will be an even wider difference.
Lower Credit Score=Higher Interest Rates=Less Money In Your Pocket
How Is A Credit Score Calculated?
There are several variables that are used to calculate your credit score:
- 35% based on previous debt & payment history (how much & did you pay on time?)
- 30% based on current amounts owed
- 15% length of time you've been in debt
- 10% based on new credit accounts
- 10% based on types of credit accounts (Do you have credit cards, home mortgage, car loan, student loan, etc.)
Your score will be lower if you have recently opened a new credit card or opened new debt, carry high credit card balances or miss payments.
Revolving debt, like credit cards, are also factored into calculating your credit score. The more you use them, and keep your balance below 20% the card limit, the higher your score! On the other hand, if you have a $5,000 credit limit and your monthly balance is always near that limit, you will be penalized with a lower score.
So there are other “Catch-22s” that can affect your credit score rating. If you have recently applied for credit or borrowed money, your score will be lower, but will gradually increase as you pay off the balance.
You can also be “penalized” if you have no history of debt. You will probably have a lower score if you do not have credit cards or have borrowed any money in the past 8 years, regardless of your debt-to-income ratio or how much money is in your savings account.
To a certain extent, you are rewarded with a higher credit score for routinely borrowing money and paying off the debt on time. It might seem counter-intuitive if you are financially responsible, but banks remain in business and reward savers with interest paid by the people who draw loans from the bank.
There is good news for those with little or no credit history but need to apply for a credit card or loan, some financial institutions do manual underwriting. This is where they take your job history, income, and assets into consideration. This practice is most common when applying for a home mortgage.
How Do Credit Reports Impact Your Credit Score?
The various financial institutions base your credit score provided from the information on your credit report. There are three different credit bureaus that each generate their own credit history report for you. These agencies are Experian, Equifax, and TransUnion. Different banks and companies will report information to different bureaus.
If you make payments on different loans, all three will most likely get your payment information on a monthly basis. But different banks and employers will only report the number of attempts to access your credit to certain bureaus. If you apply for a car loan, they might pull your report only from Experian, which means the other two agencies might have no record that you tried applying for a car loan.
American law states that you can view you credit history report for FREE once per year from all three bureaus. I encourage you to look at your report annually to make sure there are no errors. For example, a clerical error at your bank may show you missed a payment on your loan or credit card when you actually paid on time. There are ways to dispute the error & your score will be corrected accordingly.
There are two excellent sources to access your credit report. You can visit CreditKarma.com .
Credit Karma gives you a free credit report and score. It's not a FICO score but it is very similar. Clicking on the banner below will allow you to start the process!
Also, your bank might offer free or low-cost access to your credit report and credit score. If you pay for a credit monitoring service, you can view your credit report and/or credit score on-demand at no penalty to your score.
How Your Credit Score Gets Penalized
I recently read an article that 68% of Americans under 30 have made a “financial mistake” that negatively impacted their credit score.
Exceeding credit card limits, missing a payment on a credit card or loan, defaulting on a loan (includes mortgage foreclosures) or having an account sent into collections. The MSNBC article also stated that 72% of the survey takers had not received any financial education before entering college.
How else can your score be penalized?
- Apply for new credit or credit limit increase
- Your credit score will be temporarily reduced each time you apply for a new credit card or loan.
- Score will also decrease if you apply for an increased credit limit on your credit card.
- Close An Existing Credit Card
- Sounds silly but the various agencies view it as one less access point you have for available credit.
- Monthly Credit Card Balance Exceeds 20% Of Credit Limit
- If you use a credit card, aim to keep your monthly balance below 20%. For example, if your credit limit is $10,000, try to keep your monthly balance below $2,000. You can make a payment mid-month to keep your balance low.
- Errors On Your Credit Reports
- You can review your credit reports for free once per year. Use this advantage to make sure there are no clerical errors on your credit history report. You can correct any errors on your report.
Each situation will affect your credit score differently. A great, FREE resource tool to calculate hypothetical scenarios is through Credit Karma. You can also use their service to access your credit score & credit report.
How To Improve Your Credit Score
This section is more targeted for those that need to repair their credit. I'm not going to encourage anybody to routinely intentionally acquire debt, like financing a new car every few years, just to keep your score high. I would rather have a lower score with extra money in the bank.
Here Are A Couple Ways To Improve Your Score:
- Open A Secured Credit Card
I am a “credit card libertarian” which means use your credit cards responsibly, if you have one. If you don't want some plastic in your wallet, that is okay too. Credit cards can become dangerous, really quick.
So if you can responsibly maintain a credit card, banks offer two types of credit cards designed to build and improve credit scores. If you have poor credit you can qualify for a secured credit card. This is basically a prepaid credit card. It means you have to front your own money upfront before you can begin using the card. So if you front $500, you can only spend up to $500. But this will allow you to slowly improve your credit score & you can get the option for a credit limit increase in as little as 12 months of regular payments.
If your credit limit is high enough, you might also qualify for a non-secured credit card. This is a credit card that doesn't require a down payment, but might require an annual fee. It will also have a low credit limit & high interest rates near 20%, and you won't be able to do balance transfers. If you make on-time payments for at least a year, your limit will eventually increase.
- Credit Builder Loan
Your local bank or credit union might have this option. Its concept is similar to a Certificate of Deposit (CD) where you might invest $1,000 in a one year CD. If you withdraw the money before it's been in the CD for less than one year, you will be penalized proportionally. If you withdraw three months after opening the CD, you might only be able to withdraw $800 and the bank keeps the remaining $1,000. At the year mark, you can withdraw the entire $1,000 plus interest earned with no penalty.
For credit builder loans, you cannot access the money until you make the required amount of payments. If you want a $700 loan, you will need to pay the bank the $700 before you can actually access the $700 and your score can get improved. If you miss a payment, your score can be penalized.
- Make Your Loan Payments On Time
This is a no-brainer, but I'll mention it again. Pay your bills & loans on-time. Not only will you avoid a late fee, but installment loans linked to your credit score can only go up if you keep paying them on-time.
One example I have is after I paid off my student loans and automobile loan, the banks automatically raised my credit limits without my request two separate times.
How Do You Feel About Your Score?
Now the last remaining question is how do you feel about your score. Most people might not have any reason to even know what their score is and don't find out what it is until they apply for a loan. Usually, when you apply for a loan, the bank or dealership will provide your score at the time of your application.
The big piece of closing advice is that you shouldn't care too much about your credit score as the folks on tv and the radio make it out to be. Yes, it is important because you will probably need to borrow money to purchase a house or maybe for a reliable vehicle.
The most important thing is to make sure you pay your bills on time & save as much money as possible. Money in the bank can serve as collateral or a down payment, in the event of a lower score. You don't want to rely on solely on your credit score when applying for credit or a loan.
So if you are curious what your score or credit history report is, check that out for starters. Maybe this is the first time you have ever check your score. You don't want to be surprised when you might need it.
What's your opinion on credit scores? What advice or experience do you have with credit scores?
Josh founded Money Buffalo in 2015 to help people get out of debt and make smart financial decisions. He is currently a full-time personal finance writer with work featured in Forbes Advisor, Fox Business, and Credible.