Whenever you apply to borrow money, whether through a credit card or a mortgage, the potential lender will run a credit check on you. This credit check looks at your credit report and your credit score. Lenders want to make sure you’re trustworthy enough to lend to. But what is a credit score exactly and how is it calculated? Let’s take a look at this crucial piece of your financial outlook.
What Is a Credit Score?
A credit score is a three-digit number that represents your trustworthiness as a borrower. This number is determined by using the information on your credit report. More specifically, it takes into account your payment history, length of credit history, debts, number of credit lines and new credit. While there are a few different formulas to create a credit score, these are the main factors that create a score.
All this information comes from credit bureaus, like the three major bureaus Experian, Equifax and TransUnion. Each bureau will have their own version of your credit report and credit score. Generally, though, credit scores will fall somewhere in the 300 – 850 range. The higher the score, the less risk you pose as a potential borrower.
How Is a Credit Score Calculated?
Credit scores are calculated with the information in a credit report. Again, the exact formula will depend which credit bureau you get your information from since they each pull slightly different data. Your score also changes constantly based on the new information that comes in each month. But if you consistently pay on time and spend within your credit limit, your score should stay about the same.
The most popular calculation comes from FICO, which is the score most lenders use when you apply for a loan or credit card. FICO calculates your credit score according to the following factors:
- Payment history: Have you paid on time? Do you have any charge-offs on your report? (35% of your score)
- Amounts owed: How much do you owe compared to your available credit? (30% of your score)
- Credit history: How old are your accounts, on average? Are they still active? (15% of your score)
- Types of credit: How many credit cards do you have? How many loans do you have? (10% of your score)
- New credit: Have you opened a new account or gotten a new loan recently? (10% of your score)
FICO assesses your history based on these parameters and comes up with a number between 300 and 850. VantageScore, an alternative to FICO, uses a slightly different formula than FICO, with more of an emphasis on your payment history. Even lenders can personalize the formulas. So when you look at a credit score, make sure you know exactly what information was used to create the score.
What Is a Good Credit Score?
Credit scores are measured on a scale from 300 to 850. Here are the basic credit score ranges. Again, the higher the score, the more “worthy” a lender sees you as a borrower.
|300 – 579||Bad Credit|
|580 – 669||Fair Credit|
|670 – 739||Good Credit|
|740 – 850||Excellent Credit|
How to Build and Maintain a Good Credit Score
In an interview with SmartAsset, credit card journalist Jason Steele said that as long as you “pay bills on time and carry very little debt, there’s almost nothing you can do to screw up your credit.” And he’s right! The real key to building and maintaining good credit is to spend what you can afford and pay that all back on time. This is what it means to be a responsible borrower.
When you spend what you can actually afford, it will be much easier to pay those amounts back. That way, your balances won’t accrue interest and grow to astronomical levels that you cannot pay back. This will also keep you at a good debt-to-credit ratio, keeping your credit score balanced. These habits will help you avoid falling into debt. Even further, you can avoid forcing your lenders to send your debts to collection agencies. This would drag your credit score down badly.
But just as you don’t want your usage to climb too high, you don’t want it to be 0%, either. Lenders want to know you can handle carrying and paying off debt. If you’re nervous about spending on credit but want to build credit it can help to use a credit card for recurring costs. You can set up your credit card to automatically pay your monthly electric or internet bill using your credit card. That way, you can build credit by paying a stable and manageable amount.
Remember that every time you apply for a new loan or line of credit, the lender runs a hard inquiry on your credit report. Hard inquiries cause a slight dip in your credit score, so it’s best to avoid applying to too many new loans all at once. Plus, new accounts lower your average account age. If you can, try waiting at least six months between opening new accounts.
Your credit score is a huge part of your financial picture. It determines almost everything from credit card approval to your mortgage interest rate. This makes it important to understand your credit score and where it comes from! Then you can focus on making responsible credit decisions like repaying debts on time and in full when you can.
Tips on Getting Good Credit
- When you’re spending on credit, like with a credit card, it’s important not to spend more than you can actually afford. That way, you can more easily pay back the amounts you used your credit card for.
- If you’re trying to rebuild your credit, you may want to look into a secured credit card. These cards require a security deposit to not only act as collateral if you default on your payments, but also to set a lower credit limit. This helps you stay in line when it comes to spending on credit. Then, when you’ve built good credit and good credit habits, you can move up to an unsecured credit card, perhaps even a rewards credit card.
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