Credit Scoring Explained
Credit bureaus gather information on you and use a formula to create your credit score, which can range from 300 to 850. Where you fit on that scale will have a significant effect on whether you can get the loan you want.
Lenders and other businesses use this credit score to assess you because it shows them how likely you are to repay the money you borrowed. Therefore, it’s essential for every consumer to work on improving their credit score as it affects your financial life in so many ways. So, let’s take a closer look at credit scores and how they affect you.
Benefits of High Credit Scores
If you have a low credit score, it might be difficult to get approved for the loan you want. And, even if you do get approved, you can expect to pay more in interest and other fees, as well.
What’s more, this doesn’t affect you only when you’re trying to get a loan. You may also have to pay a deposit to utility companies or pay more for your auto insurance in some states if you have a low credit score. Plus, you might not be able to live in that rental home or apartment you like if the landlord doesn’t want to rent it out to a tenant with a low credit score.
However, if you have a higher credit score — usually 720 or above — you won’t face these problems. In fact, you’ll have more borrowing options available to you with better interest rates, and you may even qualify for 0% interest rates on new credit cards and/or not have to pay interest when financing your new car.
Where You Fall in the Credit Score Range
The two main credit scoring systems, FICO 8 and VantageScore 3.0, both have credit score ranges from 300 to 850. And, the closer you are to 850, the better your chances will be when you need to apply for a loan.
While lenders may have different standards for what they’re looking for in a borrower’s score, there are some general rules. Specifically, a score:
- Less than 629 is considered poor
- Between 630 and 689 is fair
- In the 690 to 719 range is good
- Above 720 is considered excellent
- Of 850 is considered a perfect credit score (and, as you would expect, is extremely difficult to achieve)
Meanwhile, although the scoring ranges are the same between FICO and VantageScore, your score won’t necessarily be the same on both systems. For instance, they might move in the same direction due to events that occur in your life, but they place different emphasis on various credit factors, so their results will differ.
The most recent data shows that the average American’s credit score is 711 with FICO and 688 with VantageScore, or in the “good” range with FICO and at the top of the “fair” range with VantageScore. The data also shows that, on average, people’s credit scores improve as they age.
What Affects Credit Scores
While both of the scoring systems consider the same information to come up with your credit score, they do weigh them differently. Nevertheless, the two most important aspects are: 1) whether you pay your bills on time and 2) how much of your available credit you are using. In the credit world, they call this credit utilization.
If you always make sure your bills are paid when they need to be, your credit score will reflect that. But, just one mistake or one forgotten bill and there will be a negative mark on your credit report for years.
The amount of available credit you use is also an important part of what makes up your score — and is almost as important as paying your bills on time. Namely, it’s ideal to use no more than 30% of your available credit. However, don’t worry too much if you have to use a lot more than that as it won’t have a long-term effect on your score. That’s because the moment that lower utilization is reported, your score will bounce right back.
Of less importance — but still playing an important role in your credit score — is your accounts’ ages, as well as a mix of credit types and credit applications:
- Your score will benefit from older accounts. For this reason, and to improve your credit utilization, it’s a good idea to avoid closing old accounts, even if you no longer use them.
- Credit scoring systems are also looking for some diversity of credit accounts. For instance, if you only have credit cards, it won’t be as good as having a loan, as well.
- Hard inquiries on your credit report put a slight dent in your score temporarily. When you apply for credit, a hard inquiry is added to your report.
How the Credit Bureaus Get their Information
Three main credit bureaus handle the data used to create credit scores. TransUnion, Equifax and Experian gather the information and sell it to lenders and other businesses that need to evaluate their customers. These lenders may also report credit information back to the bureaus. That’s because companies like to share information as it adds to the knowledge they can use to assess a potential borrower’s risk. They do this voluntarily and the person being reported has no say as far as whether this information should be provided.
Your Credit Score Isn’t Everything
However, your credit score is just one part of what a lender looks at when they review your application. Your income and your debts factor into their decisions, as well. In particular, your debt-to-income ratio helps determine the monthly payments you can afford and the amount you can borrow. When buying a home, a lender uses all of these pieces of data to grant a mortgage preapproval.
Keeping a Check on Your Score
It’s a good idea to monitor your credit score — especially if you plan to get a home loan soon — in case there are errors in your credit report that are holding down your score, for example. There are also a few things you can do in order to benefit from a good credit score in the longer term, including: paying your bills on time; not relying too heavily on credit; not applying too frequently for credit; and keeping your old accounts open.
Even when following these guidelines, your credit score will rise and fall over time. But, by being a little careful in how you handle your credit, you can pay less in interest on your loans and improve your financial life.
From a financial perspective, your credit score is one of the most important data points about you, and it’s worthwhile to try to increase it. Plus, you can also save a substantial amount of money over the life of your loans with a higher credit score, which will deliver better terms and conditions from lenders.