What is a Credit Score and Why is it Important?
When applying for credit, lenders will check your credit score to see how good it is. But what exactly is a credit score; how is it calculated; and why is this number so darned important?
A credit score is a number that strongly indicates to lenders and creditors how likely you are to pay back the debt you owe, based on your past borrowing behavior. The higher your score, the more likely you are, in their eyes, that you will pay back the money you borrow.
Your credit score is used to determine whether you can get credit for things like: a credit card, a loan to finance your college tuition, a loan to buy a house or car, or even to start up a new business. Not only that, it is used to determine what kind of loan you qualify for, how much credit you qualify for and what your interest rate will be.
What's a Good Credit Score?
The most widely known type of score is a FICO score. FICO is short for Fair Isaac Corporation and is considered by many to be the most accurate. The three major credit reporting agencies, Equifax, TransUnion and Experian also calculate credit scores based on their own statistical model.
But how do you know what a good score is and what a bad score is? Well, that's sort of a gray area since different scores are calculated in different ways; different creditors use different scores; and no one knows exactly how they are calculated since those formulas are proprietary to the companies using them. Scores may range from around 300 to 900 with the average credit score in America being at about 740. Here is an approximate range of how credit scores are judged:
Excellent credit = 720 and above
Good credit = 660 to 719
Fair credit = 620 to 659
Poor/bad credit = 619 and below
A Basic Breakdown
Although the exact formulas used to calculate credit scores is still a mystery, Fair Isaac has disclosed an approximate breakdown of what comprises a credit score and how much weight they carry:
Timeliness of payments = 35%
The amount of revolving debt in relation to the amount of your total revolving credit = 30%
Length of credit history = 15%
Type of credit used (installment, revolving, consumer finance) = 10%
Amount of credit recently obtained and recent searches for credit = 10%
Certain things can significantly impact your score, such as late payments. One or two is not bad, but the more payments you make that are late, the harder it hurts your score. Bankruptcies, foreclosures and judgments are also "blemishes" that can significantly impact your score. The more blemishes you have, the more lenders become concerned about your ability to manage your debt.
Having bad credit, however, is not the end of the world. It still may be possible for lenders to give you a loan, provided your credit score is not too low. But be aware that you may pay a higher interest rate and more fees since you are more likely to default--fail to pay the loan back.
There are ways you can improve your credit score, such as paying down your debts, paying your bills on time, and disputing possible errors on your credit report. But on the flip side, there are ways you can also hurt your score, so remember: DON'T close an account to remove it from your report (it doesn't work); DON'T open too many credit accounts in a short period of time; and DON'T take too long to shop around for interest rates. Lenders must pull your credit report every time you apply for credit. If you are shopping around with different lenders for a lower interest rate, there is generally a grace period of about 30 days before your score is affected.
Check Your Credit Report Regularly
Since the FACT Act (Fair and Accurate Credit Transactions Act) was passed, U.S. residents are entitled to viewing their credit report from each of the three credit bureaus for free once every 12 months. It's a good idea to check your credit report regularly so you can correct any errors that appear on your report or if you've been the victim of identity theft. To do this, you can go to www.annualcreditreport.com.
It's generally recommended to request a free copy of your credit report from one bureau every four months so that you can keep an eye on your credit more often than just once a year. Your scores are not included in those reports, but they can be purchased for a nominal fee. Also, when you request your credit report, you may be subject to several "pre-approved" credit card offers. You can reduce the amount of this kind of "junk mail" by calling 888-5-OPTOUT (888-567-8688).
Your credit score is a very important number that you should always be aware of. It's a measure of your financial responsibility--the higher your score, the more willing lenders and creditors will be to lend you money. One of the best things you can do before applying for a loan is to check your credit report and score.