If you thought grades ended when your school career ended you might want to think again. A consumer’s credit score can be thought of as a grade that rates each of us on our creditworthiness and a little bit about our financial health. Maintaining a good credit score can put us in a position to make large purchases like homes and cars at the best interest rates and lowest costs. But having a poor credit score can cost us thousands in our lifetime which is why we need to learn to maintain a positive credit profile. In the article that follows we will layout the most important things to know about your credit as well as explain five things everyone should know about their credit score.
What is a Credit Score?
A consumer’s credit score can be thought of as a three-digit number generated by a mathematical algorithm using information from one’s credit report. The credit score is designed to predict risk, specifically the likelihood that a consumer will pay their creditors on time or become delinquent on their credit obligations. Equifax has this to say about credit scores, “credit scores are calculated using information in your credit reports, including your payment history, the amount of debt you have, and the length of your credit history. Higher scores mean you have demonstrated responsible credit behavior in the past, which may make potential lenders and creditors more confident when evaluating a request for credit”.
A consumer has three credit scores, one from each of the three major credit bureaus – Equifax, Experian, and TransUnion. Mortgage lenders when considering the credit history of a potential home buyer will use the middle score of the three provided on one’s credit report.
Why is Having a Credit Score Important?
Our credit score is a key part of almost anything we want to do financially. If you plan to apply for your first apartment or buy a car the first thing that will be done by the property manager or the car dealer is to run your credit to see if you are credit worthy and if they can trust you to pay your bills on time. If you need private student loans for school or if you need a personal loan you need to have good credit to access these financial products. And as you start to get established financially, you should have a goal of buying a home and that requires good credit as well if you hope to qualify, get a good interest rate and keep your loan costs low.
So, you can see that credit plays a large role in our lives and having good credit is important to us having access to financial products when we need them and having access at the most competitive costs and interest rates.
What Are the 5 Factors That Affect Your Credit Score?
Credit can be an overwhelming topic for some that are new to this financial arena. There are so many things to learn about how to establish credit by getting that first credit card, how to manage credit once you have it, how much credit should you have and how much should you actually use? That is a big financial weight to put on someone’s shoulders if they are new to the credit game, so it helps to have the education to get started and the knowledge to maintain good credit going forward.
Your Credit Score is Based on Five Scored Categories
There are five key criteria commonly evaluated to determine one’s credit score. According to the folks at myFICO.com these five categories will have a different level of importance from one consumer to another based on the differences in each of our credit histories. For example, people who have not been using credit long may be scored differently than those with a longer credit history. The team at myFICO.com go on to say “as the information in your credit report changes, so does the evaluation of these factors in determining your FICO scores”. Here is a bit more detail on what categories make up our credit scores:
* Payment history (35 percent): making on-time payments has the most positive impact on your score.
* Amounts owed (30 percent): lenders like to see a consumer’s credit utilization at 30% or less of total available credit. Having large card balances or being near your credit limit on multiple accounts can negatively impact your score.
* Length of Credit History (15 percent): lenders want to see you can responsibly manage credit accounts over time. Try to get one or two credit cards that you like and keep them for the “long-haul” so the age of your oldest account is long and you build up your length of credit history.
* Types of Credit Accounts (10 percent): the score will consider your mix of credit cards, installment accounts, retailer cards, and mortgage loans if any. A balanced mix of different types of credit (i.e. – auto loan, credit cards, student loans, or mortgage) can help improve your score.
* New Credit (10 percent): data shows that opening several new credit accounts in a short period of time represents a greater risk for lenders, especially for consumers who don’t have a long credit history.
You Can Get a Copy of Your Credit Report for Free
This is no shortage of credit monitoring companies that will provide you daily, weekly, or monthly monitoring of your credit depending on how much you would like to pay. And while this is certainly an option, consumers should also know that they can get a copy of their credit report for free under rules set by the Consumer Financial Protection Bureau. (CFPB)
The CFPB notes on their website consumers are entitled to a free credit report every 12 months from each of the three credit bureaus – Equifax, Experian, and Transunion. This can be requested from AnnualCreditReport.com Consumers can request all three reports at once, or even better you can request the reports once every four months and monitor your credit all year long.
Does Checking your Credit Score Lower it?
I hear from clients all of the time that have a fear of running their credit because they think that doing so might hurt their credit score. I am here to tell you that this is simply not the case when you manage your credit properly. You see, if you are auto or mortgage shopping, or working with different utility providers that may run your credit, the multiple inquiries can be counted as one inquiry if you manage your credit shopping in the right way.
If you are shopping for an auto loan, a mortgage, or turning on utilities, you are allowed to have your credit pulled by multiple auto lenders in the case of car shopping, or mortgage lenders in the case of house shopping. And if you do your shopping in a 14 to 45 day period these inquiries will be counted as one hard inquiry. You need to know that all of these inquiries will show on your credit report, but if done within this window they will be counted as one credit inquiry. This doesn’t apply to credit card inquiries, just the types of financial products we mentioned. We provide more guidance here on how often you should check your credit report.
There are Different Credit Scoring Models used for Consumer Lending compared to Mortgage Lending
There are two major credit scoring models used in the US and those two companies are Vantage Score and FICO credit scores. The Vantage credit score company is owned by the three credit reporting bureaus – Equifax, Experian, and Transunion while the Fair Isaac Corporation, also know as FICO has been around for many years and they are as strong as ever.
FICO is the more prevalent score provided in more lending decisions than the Vantage Score. And FICO has different scoring models for different lending types because not all lending types are created equal. Auto lenders evaluate their clients slightly different than mortgage lenders do for example so FICO weights these two credit scoring models differently.
So, if you plan to pay a credit monitoring company any money to watch your credit, make sure you understand which scoring model they use so you are sure you are getting the score that you want.
Having a Low Credit Score can lead to Higher Interest Costs over your Lifetime if your Score remains Low
Rates and costs when applying for credit can vary widely for those with either a higher or lower credit score. If you want to apply for a credit card and you have a low credit score, if you can even get approved for the card you are going to pay handsomely in the form of a higher interest rate for the privilege of that credit card company taking a chance on you that you will pay your bills on time in the future. Having a low credit score can lead to a range of challenges when navigating the credit market.
However, if you have good credit, you can expect to routinely receive credit card offers in the mail asking you if you would like to add one more shiny new card to your wallet. And your credit card interest rate will be much more competitive than the person with that low credit score.
The same is true for mortgage and auto loans. Consumers with lower credit scores will pay higher interest rates and costs to get the loan because auto and mortgage lenders deem these consumers to be a higher credit risk due to their past payment histories.
For this reason, it is so important to build a positive credit history so you have good credit which will lead to you getting quoted the best interest rates and fees. This will save you thousands in the long run and will open up many financial opportunities in your lifetime. We provide guidance here on how to build your credit before buying a home.
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