Credit Scores in a Nutshell

Via LearnVest By Bethy Hardeman of Credit Karma ~

If your homework is graded on a scale of 0 to 100 by your teachers, your financial habits are graded from 300 to 850 by your credit score.

A good credit score can save you some serious cash—think $5,000 on a 60-month $20,000 auto loan, according to one study—and even more when you purchase a home, but a poor credit score can get your loan application for either denied altogether.

Your credit score is a three-digit number that predicts the likelihood that you’ll pay back a loan or credit card balance by evaluating your past financial behavior related to loans and credit cards. In other words, it evaluates your “creditworthiness,” or whether or not a lender should approve you for a loan or credit card. Your credit score will rate your creditworthiness on a scale from 300 to 850 as poor, fair, good or excellent.

Credit Scores in a Nutshell

When credit scores were first developed, they were not standardized. Lenders and creditors would create their own “score card” to assess the risk of lending to a consumer based on that person’s credit report. In the 1980’s, the Fair Isaacs Company, an analytics service, created the first standardized credit scoring system in the hopes of eliminating inconsistencies. The resulting FICO score remains the most well-known credit score today.

Each of the three credit bureaus—Equifax, Experian and TransUnion—sell their own FICO scores to consumers by using Fair Isaacs software to generate the scores. For that reason, you don’t have just one FICO score. Each of the three credit bureaus produces several versions, but they are similar: If you’re rated “excellent” by one credit scoring model, you should be “excellent” in all the others.

Credit Score: This is the three digit number, ranging from 300 to 850, that lenders use in tandem with your credit report in order to decide whether or not to approve you for a loan or credit. They’ll also use your credit score to help set terms such as your interest rate and your credit limit.

FICO: This stands for “Fair Isaacs Company,” which created the first standardized credit scoring system in the 1970’s. The FICO credit score remains the most well-known, but it is not the only credit score used by lenders.

Credit Card Utilization: This percentage represents how much of your available credit card limits you’re using at a given time. It can be calculated by taking your total credit card balances and dividing that number by your total limits.

Derogatory Mark: This is an item on your credit report that can have a severely negative impact on your credit score. Derogatory marks include bankruptcies, foreclosures, accounts in collection, tax liens and judgments.

Creditworthiness: This is a term that lenders use to judge how big of a risk it would be to lend to you or approve you for a credit card. The better your credit score, the more creditworthy you’re judged to be.

Credit score models generally include some typical factors, listed here from most influential to least (don’t worry if you don’t know what all of these are; we define them below):

  • Percent of on-time payments
  • Open credit card utilization
  • Derogatory marks, such as accounts in collections and bankruptcies
  • Average age of open credit accounts
  • Total number of accounts
  • Total hard credit inquiries
Also, read >  How To Improve Your Credit Score : Tips From 15 Finance & Credit Experts

These are all taken from your credit report and are the factors most useful for predicting the chance that you’ll default on a loan. For most credit score models, you’ll receive a score between 300 and 850. Many creditors won’t tell you exactly what score you need to have to be considered a “good” or “excellent” borrower in their eyes, but there are some general guidelines.

  • 300 to low 500s – Poor
  • Mid-500s to mid-600s – Fair
  • High 600s to low 700s – Good
  • 720 and above – Excellent

If you’ve checked your credit score recently, these general ranges will give you a good idea of where you stand. If you haven’t, you can get your free TransUnion credit score daily at Credit Karma, which will also explain which factors of your credit you should focus on. To see your Experian credit score, check out Credit Sesame, which shows you your updated credit score monthly. (Both of these sites also give you more details, like your total debt.)

Why Your Credit Score Matters

As we stated earlier, your credit score, along with your credit report, is used by lenders to determine your creditworthiness, or the likelihood that you’ll pay back your debts on time, and whether to approve you for the credit card or home mortgage you want.

But that’s not all. Your credit score can also save you money over time, or cost you a lot.

Let’s look at an example. If you have a credit score between 620 and 639, you’ll have a hard time getting approved for a mortgage. But let’s say you do, and you receive a $300,000, 30-year mortgage with a 20% down payment. Your average annual percentage rate of 4.9% will have you paying $3,312 more per year than an excellent credit score consumer who received the same terms at 3.3% interest, according to SmartMoney. Over the full life of the loan, that’s an extra $99,360.

Granted, that’s an extreme case. But it still proves a point: a good credit score is important to get you the best rates on loans and other lines of credit because—ultimately—it saves you money.

What Makes Up Your Credit Score

So how do you get a good credit score? By paying special attention to the factors that make up your credit score

  • Percent of on-time payments. This percentage shows lenders how often you make your credit and loan payments on time. Making on-time payments is the best way to maintain a good credit score over time. Usually, paying late one time won’t ruin your credit. If you know you’re going to be late, contact your creditor to ask about a grace period; companies will be lenient if you are usually on time. Credit card companies also typically don’t report a late payment to the credit bureaus until you’re more than 30 days late.
  • Open credit card utilization. This is a heavily weighted factor of your credit score. You can calculate it by taking your total credit card balances and dividing that number by your total credit card limits. The resulting percentage is your utilization rate. Ideally, you should keep your balances under 30% on average for good credit health. It will show lenders that you use credit responsibly and that you don’t rely too heavily on borrowed money. You don’t need to carry over a credit card balance from month to month in order to keep your cards active. Just making a few small purchases and paying them off each month will build your credit.
  • Derogatory marks. If you have a derogatory mark on your credit—like an account in collections, bankruptcy, foreclosure or tax lien—it will greatly reduce your credit score. Most derogatory marks can take seven to ten years to clear from your credit history. It’s best to avoid derogatory marks altogether, but if you have one on your credit report, know that your credit score will take a hit and a lender may be wary to lend to you.
  • Average age of open credit accounts. This average includes credit cards and loans and shows lenders how long you’ve been using credit. It’s not a heavily weighted factor in your credit score, but the longer your credit history, the more accurately a lender can assess your creditworthiness. They’ll have more past history to go on.
  • Total number of accounts. Consumers with more credit accounts generally have better credit scores because it indicates that more lenders are willing to grant them credit. Also, having various types of credit shows an ability to manage multiple kinds of credit. However, this factor of your credit isn’t weighted as heavily as your credit card utilization or percentage of on-time payments.
  • Total hard credit inquiries. A hard credit inquiry typically occurs when you’re applying for credit and a lender checks your score to decide whether or not to approve you. (This is opposed to a soft inquiry, which occurs when you check your own credit score or report or when your credit history is checked for other non-lending purposes—like if an employer does a credit check.) Hard inquiries negatively affect your credit, but their impact on your credit score lessens after a couple of months. Also, in the case of shopping around for the best mortgage or auto loan rates, each hard inquiry will count as just one on your credit if they’re done during a relatively short period of time, like a few weeks. However, applying for several credit cards will result in several hard inquiries—they won’t combine into one.

Credit scores can seem confusing, so here’s a general outline of what happens when you apply for, say, a credit card.

First, you’ll fill out an application for the credit card, entering some personal information and your Social Security Number. When you submit your application, you’re essentially giving the company permission to initiate a hard inquiry on your credit. They’ll use your Social Security Number to obtain your credit information from a credit bureau—you probably won’t be told which one in advance—and will review your credit score, credit report and self-reported income. You’ll then be notified of one of the following:

  1. You have been approved, and you will be notified of your credit limit and interest rate.
  2. You have been denied. Due to 2011 financial regulations, when you’re denied for credit you’ll get to see what credit score was used to make the decision. You’ll also be told which adverse credit factors influenced the creditor’s decision. This is great because you’ll know what you need to work on before applying for credit again.

What You Should Do Now

  1. Don’t make another late bill payment.
    Just like your credit report, your credit score will best benefit from on-time payments. Making all of your bill payments on time should be your top priority when it comes to your credit.
  2. Maintain your credit card balances at less than 30% of your credit limits.
    Your credit card utilization is one factor of your credit score that you can easily influence from month to month. Know what 30% of your limits is, and stay under that amount.
  3. Check your credit score regularly.
    Use Credit Karma and Credit Sesame to keep an eye on two of your credit scores for free. Checking your own score will not negatively affect your credit, since it initiates a soft inquiry.
  4. Know your focus.
    When it comes to building credit, the best thing is to maintain healthy financial habits. However, depending on what your financial situation looks like, you might want to focus on specific aspects of your credit. For instance, if you have substantial credit card debt, you’ll want to work on bringing it down to a lower utilization rate, as mentioned in #2. If you have a derogatory mark on your credit, you’ll want to work on either getting it removed or knowing when it will naturally fall off your credit history, depending on what it is.
Also, read >  I Want to Monitor and Improve My Credit Score

Remember …

A good credit score is important if you ever plan to apply for a credit card, student loan or even a mortgage. Start by checking your credit score so you know where you stand. From there, use the tips we’ve outlined here to build your credit. That way, when it comes time to apply, you’ll already be in good shape.

LearnVest is the leading lifestyle and personal finance website for women.