Back to Basics: Credit Scores

The importance of a credit score extends far beyond day-to-day purchases on a credit card – it encompasses all debt, including car loans, student debt, and mortgages.

If you’re not quite sure of your score, you’re not alone. U.S. consumers tend to be hands on when it comes to using credit, but hands off when it comes to understanding what their credit score is and how it is calculated.

So, let’s pull back the curtain on this mysterious three digit number so you can be best prepared for your path to financial success.

 

What is a credit score?

Simply put, a credit score is a calculation that tells lenders the story of a borrower's history, and how likely they are to pay money back.

A majority of lenders will look at a person’s credit score when making a determination to lend money. The numerical value ranges from 300-850. Generally, this conveys the risk a creditor takes in lending money to a borrower through the following scale:

• Poor: 300 to 629
• Fair: 630 to 689
• Good: 690 to 719
• Excellent: 720 to 850

The higher the number, the more likely you are to pay the loan back on time and in full. As a result, consumers with high credit scores are likely to qualify for a loan with a better interest rate.

On the other hand, a low credit score might mean higher interest rates or that a lender is unable to loan money out because these borrowers are less likely to pay it back in a timely manner. This is common, as well. In fact, 42% of Americans say their credit scores prevented them from obtaining a financial product in 2022.

The good news is you’re not alone! Credit reports change frequently, and there are steps you can take to improve your credit score.

 

No Shame in This Money Game Episode 5: Credit Scores

 

How is credit score calculated?

Calculating a credit score isn’t just adding and subtracting. In fact, you can’t calculate your credit score on your own. To get an accurate depiction, you need to go through a third party financial institution, like Equifax, TransUnion, or Experian.

Worth noting: Each financial institution performs the calculations in slightly different ways, so your reported credit scores may vary by a digit or two depending on the service you use.

Third parties also track credit reports, which are used to calculate a credit score. The most important aspect is payment history, which takes up approximately 35% of the calculation. Other factors taken into account include:

• Amount owed (30%)
• Length of credit history (15%)
• Credit mix (10%)
• Lines of new credit (10%)

Pro tip: Not all credit inquiries are created equally.

• A hard credit inquiry is used when you apply for new credit, like a mortgage, auto loan, or personal loan. The number and frequency of hard inquiries can impact your score. Examples

• A soft credit inquiry, on the other hand, does not impact your credit score and is more of an “in the know” tool. This is often used for pre-approved credit or loan offers. Checking your own credit is another example of a soft credit inquiry.

 

How can I improve my credit score?

Even if you don’t have an upcoming need for a mortgage or other type of loan, healthy credit comes in handy if you’re faced with an unforeseen life event or a large payment you can’t cover out of pocket. The good news is there are ways to raise that three digit number!

Three ways you can improve your credit score include:

• Make payments on time. This is the most important aspect of credit. Prioritize submitting payments on time, and pay your debts back in full whenever possible. Remember: Paying a portion of what you owe is always better than paying nothing at all. If you stop making payments all together, not only will you be charged late fees and higher penalty interest rates, but your credit score could drop significantly.

• Avoid maxing out your cards. Did you know the average consumer spends 12 to 18% more when using credit cards versus cash? Yet, experts advise to use no more than 30% of your allotted credit. If your credit max on your card is $5,000, for example, try to keep your balance under $1,500. Using all of your available credit on one card, also known as maxing out your credit card, could cause your score to decrease by multiple digits.

• Only open lines of credit when you need them. Avoiding using large amounts of credit is a good goal, but this isn’t always an option. Life happens, and sometimes you need more money than you have on hand. Opening lines of credit only when you need it will help you manage payments as well. Worth noting is opening new lines of credit might temporarily decrease your score by a few points.

 

Stay in the know

Keeping close tabs on your credit score is a great way to have a better understanding of your financial situation, but this can be stressful. Check out these ways you can adjust your budget accordingly and manage financial stress.