The Basics of Credit Scores and Why It Matters

What is your Credit Score?

Your credit score is one of the most important parts of your financial life. But what is it? A credit score is a simple three digit number measuring the implied creditworthiness of an individual. A credit score, in simple terms, is a rating of how an individual has handled credit in the past (i.e. loans, credit cards, etc.), so financial institutions can gauge whether they want to lend to you and at what terms. For example when you buy a house or a car, the financial institution that gives you a loan would like to gauge how likely you are to pay back said loan. This is where your credit score comes into play.

How can you find your credit score? There are a variety of tools – some of which are free – that will tell you your credit score and what it means. Having an average credit score is acceptable, but the more you build your credit score, the better the chances are of getting approved at favorable borrowing terms when you wish to make a bigger purchase.

What is your Credit Score?

Credit scores range from 300 to 850. Companies have certain criteria they assess when they look at your credit score. For example, a car dealer will assess your credit score differently from a mortgage lender, or even a credit card company. FICO and VantageScore are the top scoring models and allow individuals to get an idea of which bracket their credit score falls under.

Ratings Ranges
Exceptional 800-850
Very Good 740-799
Good 670-739
Fair 580-669
Poor 300-579

It is important to note that a credit score is based on information from an individual’s credit report, which lists their entire credit history. This includes all the credit cards they have opened, car loans, student loans, mortgages, to name a few. The top three credit reporting agencies are Equifax, TransUnion, and Experian. Generally speaking, a high credit score is interpreted to mean there is a high probability the lender will be paid back. Furthermore, the higher your credit score, the more likely it is your loan application will be approved, and the more likely you will have favorable terms such as a low interest rate. Lower scores, on the other hand – which can result from a history of late payments or from claiming bankruptcy, are a signal to potential lenders that you may be less likely to pay off the loan. So, having a lower score may cause your application to be flat-out rejected (at worst), or the loan is extended to you at unfavorable terms, such as a higher-than-average interest rate. However, it is not the end of the road for you if you have a low credit score.

Ways to Improve your Credit Score

Improving your credit score is not that something that can happen overnight. Patience is needed. Also, being consistently efficient and proactive will allow you to build your credit score. Here are a few ways to improve your credit score:

  1. Paying your bills each month: This is one of the key factors in establishing and maintaining a good credit score. Forgetting to pay bills can drop your score quickly.
  2. Lowering your credit utilization: Credit utilization is how much of your total credit limit you have tapped in to. For example, if your credit card has a $10,000 maximum, but your balance is only $2,000, your credit utilization is at 20%. Your total credit limit is aggregated across all sources, such as multiple credit cards and home equity. Lower credit utilization is seen as a positive, while high utilization is seen as a negative (i.e. because you have less available credit to tap in to, if needed). One way to easily lower your credit utilization is to call your bank and ask for a credit limit increase (you might even be able to do it online). Increasing your credit limit will increase your total available credit. Using the same example above, if your bank increased your credit limit to $15,000, then your $2,000 balance would put you at a 13% credit utilization rate which is more favorable than 20% and should boost your credit score.
  3. Periodically reviewing your credit scores: This is a way for you to discover if there are any mistakes that have been made that are negatively affecting your score. If so, you will need to proactively take steps to correct it. You are able to access your credit score free of charge once per year from each bureau. Credit monitoring services are also available for a modest monthly price if you’d prefer to outsource monitoring.
  4. Getting a secured credit card: A secured credit card is specifically tailored to helping you build credit. A cash deposit is paid to guarantee your credit line. The cash deposit serves as collateral in case you cannot make payments. Lenders will not have to worry as much because the security deposit will allow banks to cover missed payments if that were to happen. For this reason, secured credit cards may be useful for those with bad credit who cannot get approved for a regular credit card.
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If you have a low credit score that does not mean you are automatically disqualified from consideration. Low credit scores are not necessarily an indication of fiscal irresponsibility on your part. A low credit score could be the result of inactivity on your account, or if you are starting to establish credit and do not have any credit history. It seems counterintuitive, but in cases like this, creditors have no track record of whether or not you will pay them back. That is the risk they are taking.

Benefits of Maintaining a Good Credit Score

A good credit score can save you money, which over time can accumulate and make a substantial difference. Here are some advantages of having a good credit score:

  1. You are more likely to qualify for a new loan or credit card
  2. You have a better chance of receiving lower interest rates and better terms from lenders
  3. You will most likely save money on home and auto insurance
  4. You might be allowed to make a smaller down payment on certain major purchases,

If you are able to demonstrate that you can borrow and repay lenders without any liability, you will have a better chance of getting better terms that will help you in the long run.

So what?

Credit scores are used as a reference for both the lender and borrower when making bigger payments. Your credit score can greatly influence whether or not you get approved for better interest rates and terms. Credit scores indicate to lenders the riskiness of a borrower defaulting on a loan. Just because your credit score shows you are in a specific bracket, does not mean you are automatically approved or not approved. Many lenders have their own standards and opinions on what those scores mean. You might think the different credit score thresholds and credit scoring models make it difficult to get an accurate idea of your credit score; however, the information that is used by lenders is the same information found on your credit report. At the end of the day, making sure your credit report is correct is vital since credit scores are based on information from it.

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