How Does a Credit Score Work?
By Mack Bekeza, CFP®
A question I have been asked about lately is, how does a credit score work? If you are someone who is currently in debt or is considering opening a line of credit, you might want to read this!
Why is it important to know your credit score? Knowing your credit score is essential because it is a snapshot of your relationship with credit. Having a high score will generally help you finance a home at a lower interest rate, enjoy lower insurance premiums, get a credit card with generous rewards, and will give a potential employer a sense of your financial responsibility.
What is a credit score? A credit score is a number that predicts the probability someone will be least 90 days behind on a bill within the next 24 months. Credit scores range from 350 (being the worst score) to 850 (“Perfect”).
But you don’t only have one score. There are three credit reporting agencies (Transunion, Equifax, and Experian) that assign you a credit score based on your credit report. Also, there are two credit scoring methods these reporting agencies use. For instance, there is the FICO® score, the most common and conservative scoring method, and the VantageScore®, which was developed back in 2006 and is more lenient in terms of reporting.
What is a high FICO® and VantageScore®?
- FICO®: your score must be at least 670 or above, with 720 and above being considered excellent.
- VantageScore®: your score must be at least 720 and higher, with 760 and above being considered excellent.
What is your score made of and how you can get a high score? Six factors make a credit score
- Credit Card Utilization: This measures how much of your available credit you use in one period of time. For example, let’s say you have a line of credit of $1,000, and you have a balance of $200, your credit card utilization will equal 20%. To have high marks on your credit utilization, keep your use at 10% or less at any given time. The best way to keep this down is by paying the entire balance off frequently (at least every week or two depending on how much you use credit cards).
- Payment History: This is a tally of all the times you made on-time payments, late payments, how many days you were behind on certain debts, etc. The best way to keep this in good order is to pay your balances on time. Pretty straightforward here.
- Derogatory Marks: These represent the darkest days of your finances, such as bankruptcy, tax liens, wage garnishments, repossessions, and foreclosures. Although many reasons cause events like these, the best way to avoid having these is to make sure that you borrow wisely, which means that you should only borrow money when it would be the most beneficial, such as buying a home or rental property within your means and applying for a credit card with a strong rewards program and fits with your regular spending.
- Age of Credit History: This measures how long your relationship with credit has been. The longer it is, the better the marks. Having a well-aged credit history is highly favored by creditors. The best way to keep this “well-aged” is by not closing out revolving lines of credit accounts (like credit cards). Doing this will lower the average age of your credit accounts and tells creditors you have a “shorter” average credit history. Although this does not significantly affect your score over time, keeping this “well-aged” can still help your score.
- Accounts: Your credit score will consider all of the credit accounts you have opened and closed. If you have opened and maintained a few credit accounts and used different forms of credit in the past, you will get high marks in this area. However, this is something that should only get better over the long term; it’s a marathon, not a sprint!
- Hard Inquiries: These are the times that you have applied for credit, and the creditor had pulled your credit report. These tend to stay on your credit report for about 1-2 years, but sometimes they can go away much faster. The best way to keep these down on your report is to apply for credit for something that you can benefit from, such as buying a home or applying for a grocery/gas card to earn rewards. If you apply for credit numerous times in a short period, creditors will see you as desperate and will likely be reluctant to offer you credit.
There is also something called a Soft Inquiry, which is when any entity that pulls your credit report for any reason other to obtain credit (insurance, background checks for employment, checking your credit score, etc.). Soft inquires will not affect you at all, as this not tied with obtaining credit.
So…have you checked your credit score?