What does a credit score mean to me?
While it'd be nice to live a "credit-free existence," it can be difficult to do so in today's world. Purchasing a house, a car or securing a loan all requires some level of credit.
Your credit score is important when it comes to how much of a downpayment you need to make on a home. It determines how long you wait to gain approval. It determines whether you get the house or another interested buyer gets the house. It determines the interest rate on your loans. It is the gateway to your access to extra capital. It is the barometer of how “creditworthy” (or risky) you are.
Video: Is Your Credit Score Good or Bad?
Sometimes you can be denied credit or charged an extremely high initial premium when you try to take out a loan. You may be applying for college, taking out a mortgage, getting an auto loan, shopping around for insurance or opening a new credit card. If this happens to you, the Fair Credit Reporting Act states that the lender must specify the specific item(s) on your credit report that resulted in your denial or high premium. Ask questions to find out what you can do to appear more creditworthy. Sometimes it’s as simple as paying down your credit card balances a little further. Other times, it may take a few years for old default accounts to fall off your blemished record.
What Is a Good or Bad Credit Score?
Over two-thirds of Americans don't even know what a credit score is, says a recent Consumer Federation of America survey. The most commonly used credit score is called FICO and ranges from 300 to 850. Ideally, you will want as high a credit score as possible so lenders look at your portfolio and see that you’re a low risk borrower who is likely to repay your loans. In today’s market, a score of 720 – 850 is considered ideal. As of March 2009, the national average for credit scores is around 693. Once you start dipping below average, you will need additional financial statements, personal references and documentation confirming your job. You may have to wait a little longer to gain loan approval or plead your case a little more adamantly. If you have a score below 500, you should forget about applying for credit at all until you can improve your situation.
Your credit score will fluctuate over time depending on your financial activities and the transfer of information, so it’s important that you check your credit report each year to ensure everything has been recorded accurately. The Fair and Accurate Credit Transactions Act of 2003 entitles consumers to one free credit report a year from each of the three credit bureaus: Equifax, Experian and TransUnion. However, be aware that if you want to see the actual FICO score, you will need to pay an additional $6-$16.
Video: 3 Steps To Improving Your Score
What makes up a credit score?
Credit scores may seem like rocket science at first, but your credit score is essentially based upon five categories: Repayment history/lateness, total debt amount, length of credit history, type of credit - secured (mortgage) or unsecured (credit cards) and frequency of borrowing. Let’s get down to brass tacks.
In the overall breakdown of that credit score number, 35% is based on your payment history. It’s all too easy to say, “Who cares if my payment is a few days or weeks late? They’re still getting their money.” Yet in the world of credit scores, the worst thing you can do is miss a credit card payment, miss paying a utility bill, default on a car loan or skip a mortgage payment. In some cases, a missed payment can drop your score by as much as 100 points and take 24 months to recoup. To ensure this percentage of your score is favorable, you need to bring all your accounts current and make sure that the minimum monthly payment is covered each month at the very least. If you’re disorganized, try to consolidate your payments into one easy monthly payment, set up cell phone reminders or pay automatically through your checking account.
The second biggest factor on your credit score is how much credit you’ve been offered but haven’t taken, which accounts for 30% of your number. By only using 30% or less of your credit limit, you are showing that you can exercise restraint. On your credit card statements, look at your balance and your “total available credit/credit limit.” If your credit limit is $3,000, your balance should be $900 or less. If your credit is $1,000, your balance should be $300 or less. Sometimes people are hurt by closing their credit card accounts because it decreases their total available credit and makes it appear as though they’re using up more credit.
The third biggest factor on your credit score is how long you’ve had credit history, which is 15% of your number. Again, if you close your older credit card accounts, it will appear as though you haven’t had credit for very long. College students often wonder how they can gain access to credit for the first time. There are a number of credit card offers available for responsible students to begin a credit history. Student loans or auto loans with a cosigner are also good ways to get started also.
Another 10% is based on the amount of debt you've accumulated over the last year. When someone (other than you) looks at your credit score, this is reported as an “inquiry.” These inquiries are listed on your credit report so you can see who has been looking at your history. Generally these inquiries are made only by prospective employers, creditors, collection agencies and companies you have contacted for quotes. One of the worst things you can do is open up a ton of new credit card accounts in a short period of time. This shows that you’re reaching your spending limit, abusing credit privileges or mismanaging your finances in some way. However, don’t worry about shopping around for auto insurance quotes or anything like that. The credit bureaus can tell the difference between shopping for quotes one week, or opening up six credit cards to pay off other balances in six months’ time.
The final 10% is based on what kind of credit you have. Not all credit is created equally. Experts say there are three types of good debt that will improve a credit score, if approached wisely. One is a fixed-rate mortgage with a 20% down payment, which shows you’re able to manage a big financial commitment. Another is a low-rate school loan, which also shows you can make monthly consecutive payments on time. Putting down 10% or more on a car loan also shows that you are able to save up money. It’s also good to have a mixed portfolio to show you can manage complex agreements, so throwing one or two credit cards into the mix is a good idea.
One last thing to consider is that the most recent activity factors more heavily on your credit score. For example, 40% of a credit score is based on the last year, 30% on the last 13-24 months, 20% on the last 25-36 months and 10% on the last 37-plus months. Another ray of sunlight is that the statute of limitation for most credit report items is 7-10 years from the time your accounts are first recorded, so over time, negative information gets automatically removed.
How Can a Score Be Improved?
If you have a low score, there are many ways to improve it. The first step is to order your annual FREE copy online. Then you can check it over for any inaccuracies. Remember, 1 out of 4 credit reports contain serious errors that cause Americans to pay higher rates, which will end up costing them thousands of dollars in interest rate charges. You can dispute these charges rather simply by writing, phoning or messaging any of the three credit bureaus. Keep in mind that paying your bills on-time is the best thing you can do to improve your credit score, so try to tackle something that may be keeping you from accomplishing this essential goal. Try to cut expenses or bring in more income if that seems to be your problem. Once you’re aware of what comprises your score, you’ll have a better idea of how to transform your credit portfolio into a creditworthy record.