If you’re like most Americans, you have no idea. And yet a bad credit score could disqualify you from getting a credit card or mortgage, or have you paying much higher interest rates on the loans you can get.
In this post, we’ll demystify the credit score, telling you exactly how your score is calculated, why it matters so much, and how to improve it.
1) What Your Credit Score Is
Whenever you borrow money or apply for loans, the information gets recorded on your credit report. The three main credit bureaus (Experian, Equifax and TransUnion) compile comprehensive summaries on exactly how much you’ve borrowed, how much you’ve paid back and how much you still owe.
Your credit score is a number from 300 to 850 based on crunching the data in these reports to gauge how well you manage your debts. Generally a score of 720 or above is “good credit,” whereas if you’re at 620 or below, you might struggle to qualify for credit cards and other loans.
Lenders look at a lot of other information when weighing up your application, of course, like your salary and employment history, but the credit score is a big factor.
The most obvious effect of poor credit is that you’ll be unable to take out new loans or credit cards. Even if you can get approved, you may end up paying a higher rate, getting a lower credit limit, or having to accept other unfavorable terms.
Your credit score also affects other things, like your ability to get car insurance, home insurance, a mortgage, or even a cellphone contract. And employers often check your credit history when you apply for a job (although they’re not allowed to ask for your actual score).
2) How the Score is Calculated
So how is this all-important score calculated? Basically it’s a mixture of the following factors – the percentages show how much weight each factor is given in calculating the score.
Let’s take each one of those in turn.
Payment History: That “due date” on the credit-card statement is not a suggestion: it’s mandatory. Miss it even by a few days, and your score goes down; make payments on time, and your score goes up.
Amounts Owed: The amount of debt you have is what most people think of as the all-important factor, but actually…it’s only 30% of your score. And what’s important is not just the overall amount, but the “utilization rate” – how much of your credit limit you’ve used. If you’re close to maxing out your cards, that’s bad for your score; if you pay down your balances, that’ll help you.
Length of Credit History: You might think staying out of debt is a good thing. For your credit score, however, it’s not. Lack of credit history harms your score, whereas the longer you’ve had loans and credit card accounts open, the better it is for your score.
New Credit: Going on a debt spree and opening lots of new accounts in a short period of time is a red flag for lenders. In fact, even applying for debt, and the resultant check of your credit, can lower your score. But the good news is that checking your own credit counts as a “soft inquiry” and doesn’t hurt your score.
Types of Credit Used: Showing that you can handle lots of different types of debt responsibly will increase your credit score. But it’s not a major factor, so don’t open any accounts you don’t need.
3) How to Improve Your Credit Score
The first thing you need to do is make sure your credit report is accurate. A Federal Trade Commission study found that a quarter of all consumers had a mistake on at least one of their reports.
Order copies of your credit report every year, and check them carefully. You can get free reports from the three credit bureaus at AnnualCreditReport.com. Check them carefully, and notify the bureaus if you notice any errors.
Note that the credit reports don’t include your actual numerical score. For that, you can go to a site like Credit Karma or Credit Sesame, which offer free credit scores. You often have to provide a lot of personal information, so if you’re not comfortable doing that, another alternative is to use a free credit score estimator like this one.
After you have the information and have corrected any errors, it’s all about managing your debt responsibly. The key thing to remember about your credit score is that it changes constantly. If you’ve got “bad credit” right now, you’re not financially scarred for life. Pay off your balances on time every month, and your score will slowly start to improve.
Pro tip: Although it’s good to pay down your credit cards and other balances, it’s not a good idea to close these accounts, according to Bankrate.com. Doing so will shorten your credit history and hurt your score. Leaving them open and only using a small portion of your credit limit shows you can handle debt responsibly, which is exactly what the credit score is designed to measure.
If you want more information, we’ve got a whole course devoted to understanding your credit score and improving it. Click here to get started.