Here’s a question as old as money itself: how han you buy something when you don't have the cash in hand?
The answer is through credit. And chances are you can’t get approved for credit without a strong credit score.
The word "credit" comes from Latin, meaning "trust." Credit is a way for consumers to buy or sell goods and services without exchanging cash. This is a concept pioneered by the ancient Romans that is still important today.
Whether buying a home, car, or college education, there's bound to come a time when you'll need a loan or line of credit. And make no mistake, not all credit is equal.
The APR you're given on a loan or line of credit can make a huge difference in your payment plan. A high APR can end up costing you hundreds of dollars extra in interest each month.
Gerri Detweiler, Head of Market Education at Nav.com, talks about the importance of having good credit:
“Consumers should know that great credit makes it easier to snag credit cards with the best reward programs, including those with lucrative sign up bonuses. In addition, with great credit you're more likely to get offers for low-rate balance credit card transfers, including 0% offers.”
So not only does having good credit enable you to obtain new credit at lower rates, it can also help you obtain offers that come with more rewards and signup bonuses. A win/win.
Breaking Credit Down
It's hard to understand why something matters without fully understanding what it is, so let's take a look at a few credit score facts:
A credit score is a number creditors use to determine their level of risk in lending money to you. In other words, the score enables lenders to predict your likelihood of staying current on payments and your ability to pay off the debt.
Credit scores are typically viewed in ranges, with the classifications being excellent, good, fair, poor, and bad.
A fair credit score is usually in the mid- to high 600's, with 700 and above leading you to "good" and "excellent." If you're below 620, you may have more trouble obtaining new credit or, if you do obtain new credit, it may come with a brutally high interest rate.
How Your Credit Score Can Affect Your Future Mortgage Rate
|Credit Score Range||30-Year Fixed Rate Mortgage||5-year fixed rate mortgage||7/1 ARM|
How Your Credit Score Can Affect Your Next Car Loan
|Credit Score Range||60-Month new Car Loan||40-Month Used Car Loan|
How Your Credit Score Can Affect Your Next General Loan
|Credit Score Range||HELOC||Home Equity Loan|
So the question is, how do you get this score in the first place?
How Your Credit Score Is Calculated
Credit expert at AmeriSell Julie McDonough breaks down how your credit score is calculated:
- Payment history
- Balance owed on accounts
- Length of time you have established accounts
- New accounts
- The type(s) of credit you have
Each of these factors weigh into your score differently (more on that later), but all are important to the overall picture of your credit. McDonough goes on to explain more about how lenders interpret your score:
“Your credit score will define you as either a credit worthy consumer or an at risk consumer. Credit scores-range from 300-850.
The higher the number is, the better the score and a higher probability you will pay your bills on time. The lower the score the higher the risk, so lenders who offer credit will offer it at higher rates.
For example: a consumer with a 750 credit score may be offered a zero interest loan on a new car purchase of $30,000, where as a consumer with a 605 credit score may pay a rate of 5% or above. Over five years, the consumer with a 605 credit score will pay thousands more for the same exact car than the consumer with a 750 credit score. Why? The higher the risk, the higher the interest and fees."
This information can be a tough pill to swallow. It's not easy to realize that someone else might be paying far less in interest than you are, all because of a number that's been assigned to you.
But there's good news. Understanding how your credit score is calculated and how lenders use it will enable you to take control and improve your score.
How Lenders Use Your Credit Score
Let's revisit the five key factors that determine your score, this time with the percentages they make up in your score:
- Payment History: 35%
- Amounts Owed: 30%
- Length of Credit History: 15%
- New Credit Inquiries: 10%
- Types of Credit: 10%
Let's talk about what each of these mean so you can see how you can take action.
Payment history is exactly what it sounds like - and it makes up a huge chunk of your score. Want to improve your score? Simply pay all of your bills on time. It's as simple as that.
How much you owe is also an important part of your score because it shows how much of your available credit you need to use.
If most of your credit lines are maxed out, that doesn't look good to future lenders. But if you can keep your utilization at 30% or below, then you're in good shape to have a higher credit score.
Length of Credit History
Length of credit history simply means how long your accounts have been open. This factor is important because having a detailed picture of your credit habits over time gives future lenders more to work with as they evaluate your creditworthiness.
You can keep this portion of your score high by simply keeping accounts open, even if you're not using them anymore.
New Credit Inquiries
A smaller portion of your score is decided by how many new inquiries you have at one time. People who are applying for a lot of credit cards or loans at one time (potentially common if you're home or car shopping) appear desperate for funds.
Types of Credit
Finally, an also small portion of your score is determined by the types of credit you're utilizing. In other words, do you have credit cards and loans or just one or the other?
If you have student loans, an auto loan, or a mortgage as well as a credit card, then you're already doing well in this category.
All of these factors are things you can work to improve if you need to, but if you stay focused on your payment history and credit utilization, then you'll be on the path to an excellent credit score.
Keep Track Of Your Credit With A Free Report
Now that you have a good idea for how to understand and improve your credit score, the next important thing is to understand how to obtain and improve your credit report.
You can get a free copy of your credit report at Annualcreditreport.com.
Note the site is the only one approved by the federal government to provide credit reports at no cost. Any other site that claims to do the same thing is selling you a bill of goods with plenty of strings attached.
The main reason to check your credit report is to spot errors. Errors can mean your credit has been compromised or that someone else's borrowing behavior has been mistakenly pinned to your report.
If the first scenario happens, you'll need to take action immediately to place protections on all of your financial accounts.
If the second happens, you'll need to dispute the error with the major crediting reporting bureaus so they'll remove it from your report.
Never let an error on your credit report hurt your score. It's something that's preventable and can take your score down for no good reason at all. Stay on top of your report and you'll be in good shape.
Knowing Your Credit Story Is A Necessity
Knowing your credit score and how it impacts your finances is a crucial element of your everyday life.
Your credit score determines whether you can get a mortgage, credit card, apartment, etc. – and it determines how much you'll pay in interest.
The more you work to improve your score, the more credit will be available to you and at a cheaper cost, which means the more financial dreams you can aim for and realistically achieve.
When you think about it that way, knowing your credit health becomes much more than a "should do," it becomes a necessity.