What Is a Credit Score? Why is a Good Credit Score Important?
A credit score is a number that third parties, primarily lenders, use to calculate the risk of lending you money. The score is one way by which banks, credit card companies, and other institutions calculate the possibility that you can or will be able to pay off any debts you accumulate. A high credit score means that your present financial situation and behavior strongly suggest a capacity and willingness to pay off any loans you may be approved for.
Why is a Good Credit Score Important?
Credit scores are very important because lenders use them to determine whether to approve you for a loan or credit card and to decide what interest rate to give you. Companies may also use your credit scores to decide whether to rent you housing or offer you a job or how much to charge you for auto insurance.
In the United States, you will hear about the most is the FICO score, which is the credit scoring system. FICO score used by the major credit agencies to rate your creditworthiness. Your FICO score will be between 300 and 850 with a higher score being superiors.
When it comes to your credit, lenders may occasionally refer to it in terms of Credit Level or Credit Quality such as Poor, Fair/Average, Good or Excellent with each category referring to a range of FICO scores.
- Poor credit is recognized anyone with a FICO score under 580
- Fair or Fair credit rating will be between 580 and 669
- Good credit is between 670 and 739
- Very Good credit is between 740 and 799
- Excellent credit is anything above 800
How Your Credit Score Affects Some Financial Products
Your credit score likely has an impact in two ways: Whether you can get approved for a financial product in the first place, and what interest rates you may have to pay if you are approved.
The higher your FICO score the more chance you are to get approved for a credit card or loan, and will usually decrease the interest rate associated with that particular loan or card. Lower scores may unfit you for a product or service completely and can increase your interest rates significantly differently.
For various credit cards, primarily the most profitable rewards cards, the cards are offered only to consumers that meet a minimum credit quality. Many of the best cards are exclusively marketed to consumers with excellent credit scores.
When it comes to credit cards your credit score can define the breadth of options you can choose from. Maximum cards are also marketed with a range of interest rates/APRs. The real interest rate on your specific card will be inversely related to your credit score with higher creditworthiness receiving more negligible interest rates and vice versa.
With auto loans and mortgages, lenders act similarly. Your credit score is used as an ingredient of whether or not a bank will decide to approve a loan or may force you to make additional grants for approval. It can and usually will move the interest rate you pay on the loan as well.
The Components Of Your Credit Score
The structure of your FICO score is split up into a bunch of major portions: Debt Burden (30%), Payment History (35%), Length of History (15%), Types of Credit(10%), and Recent Credit Searches(10%). Let’s take a look at how these components fit into building your overall credit profile
Payment History
Credit scores are planned to predict if you’ll make payments on time, so it’s no surprise that late payments in your credit history put down your credit scores.
In your FICO score, your payment history is by and large the largest single component. The best way to think of your payment history is to analyze it a track record of all the things you’ve done wrong when it comes to credit and a measure of how you behave when it comes to your debts. You don’t get a boost for paying things on time as much as you get penalized for not doing so.
A history marked with negative information would intimate that the person often faces difficulty meeting their debt responsibility, or rather someone that has a risky attitude when it comes to their credit. Both are signals to the lender that they may want to be more careful when it comes to making additional credit available.
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Late Payments
The most common issues consumers face in the payment history component is the late payments. Though it was because you simply forgot or were struggling to make ends meet, being late on a monthly payment for your credit card or a loan will normally cause a negative adjustment on your credit score.
How much of an impact can also depend on how late you were with the FICO score making larger falling adjustments the later it is. You will see this revealed on your credit report with late payments marked under categories like 30-days or 60-days etc. One thing to be aware of is missed or late payments on what may seem like small amounts can be just as damaging.
One significant reason for holding the number of credit cards and accounts you have at an easy level is to avoid these issues. It’s way too easy to open up a store credit card, make a charge on it, and solely forget about the account. Even if you’re making thousands of responsible payments on all your other accounts, forgetting to pay off the $40 you spent on that one-off charge can dramatically hurt your credit score.
Credit Utilization
Credit Utilization or Debt to Limit ratio is often taken up when reviewing the Debt Burden component. It is one of the sections that make up this part of your FICO score and is a measure of the total amount of debt on your credit card accounts against the total limit permitted on those accounts.
A lower credit utilization, determining your average balance is lower relative to the total amount you could have on your cards is better for your score.
This ratio can come into play when you might unless consider canceling an existing credit card. Even if you don’t use that card, as long as it doesn’t have any fees connected with having it around, your credit utilization pictures look better because of the larger total credit limit overall.
This also indicates that requesting a higher credit limit on existing credit cards can help your credit score since it will help lower the overall ratio.
I assume that the reason this measure is used as a factor is that it’s a helpful indicator of how much exciting room you have when it comes to your finances. If you’re only using a small piece of what the card companies have estimated you to be capable of paying off, then small modifications in your personal finances or incremental debt may not put you at much more risk.
Debt Burden or Accounts Owed
The other significant component category of your credit score is the split-up of your existing debt burden including how much you owe in total, what types of loans you have, and any other quantitative indicators about your overall debit/credit profile. As an indicator of your creditworthiness how much you owe and how it’s split up across the various types of loans acts as a sign about your capacity to manage your current debt.
When it comes to how this works into your credit score, it’s probably not worthwhile to think of it was higher/lower = better. In all probability, the FICO calculation doesn’t evaluate your debt burden in isolation but estimates it in relation to things like your payment history. For example, let’s consider a credit profile of someone who has large amounts of debt but a long and clean payment history.
This might show that the person is financially well off and the debt burden is a sign that any additional loans might be obligations they can easily handle.
Take the same level of debt on a profile with a recent history of payment difficulties, and the higher quantitative portions should be a major red flag. This consumer may be having trouble making ends meet and even a small amount of additional credit might be a risky proposition.
Length of Credit History
Your credit score accounts for the length of time the several accounts under your name have been around, including the average amount across all the accounts as well as the length of your oldest open account.
The length of your history helps to show how representative the other portions of the score are about your creditworthiness. The older your accounts and you are all up a credit history, the larger the time frame from which a company can literally judge both your finances and behavior towards credit.
A few years of data about consumers is a better sign of how they may act in the future than having only a few months of information. You have to consider the Age of the account when canceling your cards.
The credit history length can come into play when analyzing how you should deal with something like an old credit card. In many examples, the first credit card a consumer gets may no longer be the most suitable option going forward.
This is usually the case for someone that may have had no credit history to address when getting a card and have over time built a great credit history for themselves.
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Types of Credit
The most trivial component of your credit score, your FICO score takes into account the various types of debit or credit used. Your accounts are split into things like spinning credit (credit cards), mortgages, consumer finances, or installment loans and a history of having a broader DISCLOSER may be a positive signal.
Why should taking a history with more credit types matter? Having an existing history of disclosed to various types of credit is a helpful sign that a consumer is familiar with the various financial products and can manage them properly.
Consumers also may not have the same stance towards paying off a credit card vs. their mortgage. So, a lender might want to be more careful with someone with a narrower appearance history
Much like the Length of history component, the types of credit component is likely used as a benchmark for how typical your existing credit history sample size will be about your future behavior.
A broadly typical history will in most cases be a better predictor of how a consumer will act in a large range of credit conditions in the future.
You can check your FICO score on their website.
