If you want to purchase a product or service but don’t have the cash on hand, using credit is an ideal option. Credit is an agreement between you and a lender. The lender gives you funds up front and you agree to pay it back over time, usually with added interest. Lenders offer credit in the form of a credit card, auto loan, mortgage, or other installment loan.
Lenders determine how much money to offer you and how much interest to charge based on your credit score. This three-digit number tells lenders and other companies a lot about your financial picture, including the amount of debt you have and how well you usually pay it back. Building your credit history and increasing your credit score is important if you are trying to qualify for credit to purchase a home or vehicle, open a credit card, or acquire a personal loan.
Read on to learn how your credit score works and the steps you can take to increase it.
How Are Credit Scores Used?
When you submit an application for credit to a lender, such as a bank, credit union, or other financial institution, they will review your application to determine whether you are a good candidate. This includes assessing your creditworthiness by looking at your credit report and credit score. Essentially, these companies are determining your likelihood to repay the loan on time based on your history.
If you have a low score, lenders will consider you to be a high-risk borrower and might offer you less money or require you to pay a higher interest rate. Some creditors even choose not to offer any credit to borrowers with very poor credit scores. Borrowers with higher scores, meanwhile, are typically offered higher loan amounts and lower interest rates.
Why Your Credit Score Is Important
If you are planning to make a major purchase, apply for a credit card, or even insure your home or vehicle, your credit score will be taken into consideration. Your credit score can help you get the following:
- A home: If you are purchasing a home, you will need a mortgage. Lenders will look at your credit score, along with other qualifying factors, to determine how much money to loan you and how high your interest rate will be. Good credit can also help you qualify for other types of home loans, such as a home equity loan or a construction loan.
- Other major purchases: A credit card or loan can help you purchase anything from groceries to an engagement ring or even a vehicle. Credit cards or small installment loans are also a good way to start building credit if you have no credit history, so you can then qualify for a larger loan like a mortgage.
- Insurance: When you apply for life, home, auto, or any other insurance, providers may do a credit check to assess your insurance history and determine your rate.
- Employment: Potential employers sometimes check your credit to verify your identity. If you are applying for a role that will entail money management, they may also be determining whether you are responsible with finances. When companies do this credit check, they can only see certain details of your credit report, which excludes your credit score.
- Utilities: From mobile phone and internet service to electricity and water for your home, utility companies and service providers may look at your credit report or credit score. They can use this information to ensure that you have a positive payment history and determine your rates.
What Factors into a Credit Score?
Your credit score is determined based on your credit report, which includes financial data about your debts and payments. Factors included in the report are:
- Accounts, including those that are currently open and accounts that have been closed, with current balances
- Payment history, which includes the number of on-time and late (delinquent) payments that have been reported to the bureau
- Accounts that have been sent to collections or foreclosed
- Applications for new credit
- Declarations of bankruptcy
Credit bureaus report these details, and credit scores are assigned based on a scoring model. For example, a FICO Score, which is used by 90% of financial institutions, uses the following formula:
- Payment history: This accounts for 35% of your total score, meaning late payments will lower your credit score significantly. Delinquent payments stay on your credit report for seven years.
- Credit utilization: The ratio of credit you are currently using, compared with total available credit, makes up 30% of your score. This means that reaching or exceeding your credit limit on a credit card, for example, will lower your score.
- Length of credit history: The “age” of your accounts matters, making up 15% of your score. This is calculated as an average, so if you have a 5-year-old credit card and a 15-year-old mortgage account, your credit age will be 10 years. If you pay off a credit card or line of credit, you may want to keep the account open even if you don’t plan to use it.
- New credit: When you apply for a new loan or other credit account, the credit inquiry will show up on your credit report and can affect your score for up to a year. It’s best not to apply for or open too many accounts in a short period of time, as this makes up 10% of your score.
- Credit mix: Your credit report shows the number and types of accounts you have, including revolving credit, such as credit cards, and installment loans, such as auto or home loans. Lenders like to see a variety of types of credit, rather than one single type. This contributes to 10% of your score.
Credit scores range from 300 to 850. The higher your score, the more willing lenders will be to offer credit and the better your interest rates are likely to be. Each creditor has its own guidelines for this, but a score below 580 is considered poor, while a score above 799 is excellent:
- Excellent: 800 – 850
- Very Good: 740 – 799
- Good: 670 – 739
- Fair: 580 – 669
- Poor: 300 – 579
What Are the Types of Credit Scores?
There are three credit bureaus that report your information in the form of a credit report: Equifax, Experian, and TransUnion. Using this information, your credit score is calculated using a model. The most common of these is the FICO Score, though some lenders also use a credit scoring model called VantageScore.
Both FICO Score and VantageScore factor in payment history, current balances, available credit, recent inquiries, and length of credit history. What makes the scores different is the formula each company uses to calculate them. For example, payment history accounts for 35% of a FICO Score and 40% of a VantageScore, while recent credit inquiries make up 10% of a FICO Score and only 5% of a VantageScore.
How Can You Improve Your Credit Score?
If you are considering applying for credit and you want to increase your credit score, there are several steps you can take. Start by accessing your credit report to get an idea of what you’re starting with. You can get a free credit report through AnnualCreditReport.com. You will see the details that factor into your personal credit score and get an idea of steps you can take to improve it. You can also look for unknown accounts, credit inquiries, and other activity that could be a sign of identity fraud.
If you are trying to increase your credit score, these steps can help:
- Always make payments on time. Because this accounts for such a large portion of your credit score, missing a payment can have negative repercussions for up to seven years. If any of your accounts are past due, catch them up right away.
- Build up your credit. If you don’t have a variety of account types or have never had credit in your name, consider opening a credit card or taking out a loan. Begin with a small loan amount, especially if you are starting from scratch.
- Pay down high balances. Lenders look at your utilization rate — the current unpaid balance compared with the total credit limit — when considering whether to give you a loan. Pay down revolving accounts, such as credit cards or lines of credit, and try to keep that number below 30%. That means that if you have a limit of $10,000 on a credit card, you should try not to carry a balance higher than $3,000.
- Limit your new credit applications. While opening a new account might be a good move if you have no credit history, it can also shorten your average length of credit history. If you have a good mix of credit accounts, apply for new credit only as needed so you don’t have too many hard inquiries on your report.
