What is a credit score?
Inevitably, in your journey towards homeownership, lenders will run an extensive credit check on you. It’s a commonplace activity with an important objective: to gain access to your personalized credit score in an effort to better evaluate your ability to pay back debts in a timely, reliable manner.
Suffice it to say, your credit score is a highly significant factor in determining your mortgage rate and the type of loan you qualify for. And to earn a good credit score, you need to demonstrate an ability to borrow money and to pay it back on time. Sounds simple enough, right?
Here’s the thing: Your credit score is really an expression of your entire credit history. From your first credit card transaction to your most recent cell phone bill, a score has been slowly emerging and then consistently tracking you, evolving as your borrowing and payment habits have changed throughout the years. Depending on your track record, this can either be helpful or detrimental to your credit score, and thus your future lending needs.
Financial reputation is of paramount importance, and yet many people lack a sophisticated understanding of what factors go into defining their credit score. This article addresses the agencies responsible for formulating your credit score, the factors that affect it and some best practices for maintaining good credit.
A general introduction to defining your credit score
Once you decide to borrow money from a bank or an approved lender, you will have to agree to an extensive credit check that will produce, among other things, a credit score from one of the three main credit reporting agencies.
A credit score is a three-digit number that succinctly articulates your credit history and financial reputation to future lenders. Essentially, it’s a reflection of your ability to pay your debts in a consistent and timely manner.
This is critical information to lenders, who will be using it to guide decisions such as how much money they are willing to lend you, over what time period you will be allowed to repay the borrowed sum and what your specific interest rate will be.
Remember, payment activity goes a long way in dictating credit score, and your credit score has an outsized bearing on your ability to both borrow money and borrow it at consumer-friendly rates. To put a finer point on it, a good credit score will save you valuable money when it comes to obtaining a mortgage.
First the credit report, then the credit score
Whether it’s paying monthly bills on time, repaying that old college loan or ensuring you make the minimum monthly payment to your credit card account, your credit history is often always in a state of flux, changing month by month, payment by payment.
A credit report gathers together this wide sweep of data both past and present, including all borrowing activity, payments, outstanding bills, loan balances, open and closed accounts, current available credit and more. This information is compiled by the following three principal credit bureaus:
These bureaus, or agencies, collect information from all your known creditors. Essentially, this means companies and entities that you have both borrowed from and made payments to over the years. Examples include mortgage companies, banks, independent lenders, credit card companies, landlords, utilities, healthcare providers, etc.
Once the credit agencies have received your credit information, they generate a credit report. This report contains your credit score and summaries of your borrowing and payment history.
More on credit bureaus and understanding your credit score
There are a number of places online where you can research your credit score for free. You can also order a more comprehensive credit report from one of the three credit bureaus once a year at no cost.
The three agencies use similar but distinct methods to formulate your credit report, which in turn helps create your score. As a matter of process, Experian, TransUnion and Equifax generally receive slightly different information from available creditors, often in varying degrees of detail. This results in credit reports that produce different credit scores.
Historically, credit bureaus then take this information, and in collaboration with the Fair Isaac Corporation, produce a credit score, known as your FICO score. While the algorithms behind the score tabulations are not widely known, all you have to know as a consumer is that this score is the numerical expression of your creditworthiness. Scores exist on a range between 300-850. They generally break down as follows:
<580 = Poor
A significantly below-average score. If you score less than 580 you are almost certainly a credit risk to lenders.
580-669 = Fair
While this score demonstrates some creditworthiness, it’s fair to average at best. However, there are lenders who will approve loans to applicants in this range with some provisions.
670-739 = Good
Now your score is getting better. For many U.S. lenders, a score in this range is considered slightly above average.
740-799 = Very good
An above average score. Clearly, you’ve taken care over the years to create a responsible credit history. A score in this range demonstrates that you are a low-risk borrower.
800-850 = Exceptional
If your score is above 800, then you are indisputably in possession of a superior credit score. As a result, you will likely be offered very favorable lending terms.
Other credit scores
It’s worth noting that while the three main agencies have collaborated and continue to collaborate with Fair Isaac to create FICO scores—the credit score that is used by over 90% of current lenders to make decisions—this is not the only credit score out there. In recent years, the credit bureaus have come up with their own credit score; it’s called the VantageScore and it’s also widely used by creditors.
Factors affecting your credit score
Some people are shocked when they finally look up their credit score. Others are cool as a cucumber because they’ve maintained expert financial hygiene over the years; building credit, staying within budget and demonstrating an ability to make timely payments.
To gain a deeper understanding of what goes into determining your credit score, it’s imperative to examine some of the key factors:
- Your payment history: This is without question the most important factor when determining your credit score—and the least forgiving. Even a single missed payment can negatively impact your score and take considerable time to remedy. From a lender’s perspective, this is perfectly logical: They need to see evidence of you paying money back on time in order to view you as a prime candidate for future loans at good rates. In a typical FICO score, payments are weighted at 35-40%.
- Amount you owe: Credit bureaus look at the total amount of credit you have allocated and then examine how much credit you are currently using. This is called credit utilization and it’s usually expressed as a ratio. Typically, a higher credit utilization will lead to a lower credit score and vice versa. Creditors associate higher risk with individuals who are regularly approaching or exceeding their credit limits.
- Types of credit: It’s not uncommon for those with exceptional credit scores to possess a wide portfolio of credit accounts that demonstrate creditworthiness. Not just credit cards but student loans, auto loans and, of course, mortgages. The three credit agencies like to see that you can balance a variety of credit and still make payments on time.
- New credit: While a well-managed credit mix can lift your credit score, too many recently opened credit accounts can have a negative effect. Anyone who’s ever applied for a mortgage or a credit card will be familiar with “hard inquiries.” These can negatively impact your overall credit score, demonstrating credit risk in the eyes of credit bureaus. The good news: If your overall credit health is sound, the impact will be minimal.
- Length of credit history: To achieve an optimal credit score, it’s important to demonstrate length of credit history, ideally up to 10 years or more. Bureaus will take note of your oldest opened account as well as more recent ones and also the average age of all your accounts. While not the most salient factor, account age still matters. There’s a proven relationship between a long credit history and a high credit score.
Credit score best practices
Many people find out too late that their credit score is severely underperforming.
It can create a feeling of powerlessness to realize that actions taken (or in many cases, not taken) years ago have such a resounding and lingering effect on your ability to borrow money and qualify for loans and mortgage products.
However, the damage is not necessarily permanent. According to lending experts, there are several things you can do to repair and improve bad credit over time. Let’s take a look:*
- Pay bills on time: Even if you’ve struggled with this in the past, there’s nothing like turning over a new leaf and starting right now to make sure every bill is paid on time going forward. You can positively influence future credit reports (and scores) by ensuring every payment is made in a timely manner.
While missed payments will take a while to completely disappear (up to 7 years), the further back they are, the less they count towards your credit score. Creating a new track record can demonstrate the necessary financial maturity that can lift credit scores over time.
- Keep balances low on credit cards and pay off current debt ASAP: Attack the root of the problem by lowering your credit utilization ratio and reducing your total amount of currently used credit by paying off prior debts. When you reduce debt, credit utilization also decreases and in time, your credit score will reflect his.
Experts recommend taking inventory of all current debt and then creating a plan to tackle it. Paying creditors amounts in excess of the minimum monthly requirement is highly recommended. If you have multiple debts, it’s prudent to pay down the highest-interest debt first.
- Contest inaccurate information in your credit report: Credit reports can contain errors and inaccuracies that negatively affect your score. In fact, the FTC has found that up to 25% of all files may have an error affecting FICO score.
If you think this applies to you, immediately contact the relevant credit bureau whose report you’re disputing and clearly articulate your case in writing. Providing copies of supporting documentation is a crucial component to success, and you should be prepared to furnish detailed information on accounts, payments and dates. The Consumer Financial Protection Bureau actually has sample letters you can use to guide you in your efforts. If the credit bureau thinks you have a compelling case, they will conduct an investigation. Once conducted, if the bureau agrees with your assertions you should see changes in your report within a few months; an increase in your credit score should soon follow.
Understanding your credit score and learning how it’s defined is absolutely critical to establishing and maintaining your financial reputation and well-being. And it’s up to you to obtain this knowledge.
Whether it’s reducing your credit card interest rate or garnering more favorable terms when procuring a mortgage, your credit score is a testament to your creditworthiness. And it’s always in a perpetual state of evolution. You may think you’re saddled with a less-than-optimal credit score, but there are things that can be done right now to put yourself in a better position to be eligible for loans at attractive rates tomorrow. It’s never too late to take action to improve your credit.
*GUARANTEED RATE IS NOT A CREDIT REPAIR COMPANY, CREDIT REPORTING AGENCY, BROKER OR ADVISOR. You acknowledge that Guaranteed Rate is not a credit repair company or similarly regulated organization under applicable laws, and does not provide credit repair services. Where available, recommendations, tips and education materials are provided to you at no additional charge, and for educational purposes only. The services are intended to provide you with general information and assist you with identifying your options. The information is provided only to enable you to make your own choices about your personal finance, and is not intended to provide, legal, tax or financial advice. We do not provide any services to repair or improve your credit profile or score, nor do we provide any representation that the information we provide will actually repair or improve your profile. Consult the services of a competent professional when you need any type of assistance. You acknowledge that Guaranteed Rate is not a “consumer reporting agency” as that term is defined in the Fair Credit Reporting Act as amended.