Spending Smart: Understanding Your Credit Score
In the world of personal finance, few numbers carry more weight than your credit score. A credit score is a three-digit number used to assess a borrower’s likelihood of repaying loans on time. Credit scores range from 300 to 850. An excellent credit score will give one access to top-tier rates and financial products, while a poor one can indicate serious credit issues and make it difficult to obtain credit or a loan.
Credit scores are used by lenders, landlords, insurers and service providers to assess a person’s reliability in meeting financial obligations on time. For example, when someone applies for a mortgage, lenders review their credit score to assess their history of making payments on time and in full. A low credit score indicates a weaker repayment history, making lenders less willing to approve a loan. Conversely, a higher credit score improves the likelihood of approval and access to better terms. Credit scores also influence interest rates, loan approvals, rental applications and insurance premiums.
The three main credit bureaus — Equifax, Experian and TransUnion — collect information from lenders, credit card companies, banks and public records to create credit reports. These reports are then used to generate credit scores. You can check your score through most bank apps or third-party services such as Credit Karma. Checking your own score is considered a soft inquiry and does not affect your credit, but when a lender checks it after you apply for credit, that’s a hard inquiry, which can cause a slight, temporary dip in your score.
A credit score is calculated from five main factors: payment history (35 percent), amounts owed (30 percent), length of credit history (15 percent), new credit (10 percent) and credit mix (10 percent). Payment history is the most important of these factors. It reflects how long a credit account has been open and whether payments have been made on time. Late payments are categorized as 30, 60 or 90 days past due. Once a payment is 30 days or more late, it appears on a credit report and can remain there for up to seven years. At 90 days, the consequences become more serious, and the debt may be sent to collections. The longer a payment remains unpaid, the more damage it does to one’s credit score.
Amounts owed refer to credit utilization, or how much of one’s available credit is in use. Using less than 30 percent of available credit is ideal, because higher usage can indicate financial stress and make lenders less likely to lend. Length of credit history measures how long accounts have been open; an average of seven years or more shows stability and reliability. Credit mix refers to having different types of credit accounts, such as credit cards, car loans and mortgages, which shows an ability to manage multiple financial responsibilities responsibly. New credit accounts can cause a temporary dip in one’s score because they shorten the average account age and indicate new borrowing. Each time a lender checks a credit report, it creates a hard inquiry, which may slightly lower the score and typically remains on the report for about a year.
Credit scores fall into five categories. Scores between 300 and 579 are considered poor and may indicate serious issues, such as missed payments, collections or bankruptcy. Scores from 580 to 669 are fair and may qualify for loans, but with higher interest rates. Scores from 670 to 739 are good, 740 to 799 very good, and 800 to 850 excellent — these borrowers enjoy the best rates and approval odds.
While credit scores can be an invaluable tool to secure loans, what about those who do not have one at all? When someone has no open lines of credit for a period of time, or has never opened a line of credit, their credit score is inactive. In this situation, lenders who choose to lend to borrowers without a credit score (and not all do) need to use other information to gauge a borrower’s ability and likelihood to repay, a process called manual underwriting. Lenders use income and asset information, employment and rent and utility payment data to justify the loan. While this is not available for all loan types, such as credit cards and personal loans, mortgages usually allow it.
For young adults who are just getting started building their credit, being added as an authorized user on their parents’ credit cards can be a shortcut that allows them to inherit their good credit history. Many banks report account history on both the authorized user and the primary account holder’s credit file. It’s important to note that one is not inheriting their parents’ entire credit history, only the specific account they were added as an authorized user on. While this strategy may provide a credit boost, creditors still want to see that the authorized user has their own positive credit behavior.
With much information about credit scores at your fingertips, it’s important to note a few tricks to keep up your credit score. Set up automatic payments and check your accounts monthly to ensure everything has been paid, and budget accordingly so you can pay everything on time and in full. Use as little of your total available credit as possible, preferably less than 30 percent, so that it does not signal financial stress to lenders. Even if you aren’t using your credit accounts, keep them open. Closing an old account can shorten your average age of credit. Opening too many new credit lines in a short period of time can signal to creditors that you are desperate for credit and can temporarily add hard inquiries, harming your score. Done strategically, however, opening new cards can help lower your credit utilization rate, increase the number of credit accounts and build credit history, all factors that can improve your score.
With so much financial advice out there, it can be challenging to know what to do. Some encourage having no credit cards at all and avoiding building a credit score, while others will advise opening as many cards and lines of credit as you can to maximize borrowing potential and perks. While there are sound reasons for both, it’s essential to understand the fundamentals of your decision and the repercussions, both positive and negative. When managed wisely, a credit score is a powerful financial tool. When ignored or misused, it can become one of your biggest liabilities.
The information provided in this article is for educational and informational purposes only and should not be construed as financial advice. Readers should consult with a qualified financial advisor or other professional before making decisions regarding their personal finances.
Photo Caption: Credit cards in a wallet
Photo Credit: Unsplash
