A credit score is a three-digit number that says how likely you are to repay your debts. This score, which ranges between 300 and 850, is an important part of your financial life because it determines whether you qualify for loans and your borrowing rates. A higher credit score can help you qualify for better loan terms and lower rates, while a lower score can make borrowing more expensive or challenging. Keep reading to learn what impacts your credit score, along with the steps you can take to improve and manage it over time.
How Does a Credit Score Work?
Your credit score is derived from information included in your credit report. Lenders typically order a credit report when they’re evaluating the creditworthiness of someone who’s applying for a loan. They can request a credit score as well, which summarizes the information contained in the report.
The FICO credit score was created by the former Fair Isaac Corp. (now FICO) in 1989, and it’s used by 90% of top lenders. Three credit bureaus provide this score: Equifax, Experian, and TransUnion. Each determines its own score based on the information it has on file for a particular consumer, so the scores can be marginally different.
Understanding Credit Score Calculations
FICO scores are based on five categories of information. Each contributes a percentage to the final number.
- Your payment history: 35%
- How much you owe: 30%
- Length of your credit history: 15%
- Your credit mix: 10%
- Amount of new credit: 10%
How much you owe is represented as the percentage of all your available credit that you’ve used. The number is referred to as your credit utilization rate. Your credit mix is the types of loans and lines of credit that you have.
What’s a Good Credit Score?
The number ranges for good, iffy, and poor credit scores vary a little depending on the score being used. FICO breaks them down like this:
- 800 or higher: Exceptional
- 740 to 799: Very good
- 670 to 739: Good
- 580 to 669: Fair
- 300 to 579: Poor
“Each lender has their own internal definition of what their top-tier credit is,” says Christopher Naghibi, chief operating officer at First Foundation Bank. “It’s not a secret, so you can just ask them what credit score you need to get the best rates.”
Factors That Can Lower Your Credit Score
Some actions will almost certainly slash away at that credit score you’re trying to boost. Five common missteps include:
Impact of Payment History on Credit Score
Not making a loan or credit card payment on time is probably the most damaging mistake you can make. The event will remain on your Equifax credit report and damage your score for seven years. Experian will hold it against your score for seven years as well but won’t ding you until payment is at least 30 days late.
Role of Credit Utilization in Credit Score
It’s generally recommended that you use less than 30% of your available credit. Maybe you have one credit card with a $3,000 limit. Never let the balance you owe on the card exceed $900.
Effects of Excessive Credit Applications
A hard inquiry appears on your report every time you apply for credit, and the potential lender requests it. A lot of hard inquiries can tank your score if they’re made within a short period. Hard inquiries remain on your Experian credit report for two years. However, multiple applications for auto loans or mortgages are often treated as just one inquiry if they’re made within 14 to 45 days or so. You can shop around for the loan that best suits your needs without dinging your score.
Consequences of Closing a Credit Card
You might think that closing a card would be a good thing, but it can have a trickle-down effect that will negatively affect your score. You’ll increase your credit utilization ratio if you have a lot of unused credit available on that card. It can also shift the different types of accounts you’re holding, affecting your credit mix. It could affect the length of your credit history if you held the card for several years.
The Impact of Unused Credit on Scores
This might also seem like a good thing. You’re not closing an account; you’re just not tapping into that available money. However, the lender isn’t reporting any activity to the credit bureaus if your balances are paid off, so you’re not even making any payments. Your lender might even cancel your card because it’s inactive.
Monitoring Your Credit Report for Accuracy
It’s important that you know what lenders and others are seeing when they request a copy of your report and what factors are contributing to your score. Is everything on there accurate? Mistakes can be made by your lenders, or you might be a victim of outright fraud.
You can get a free credit report once a year from Equifax, Experian, and TransUnion at AnnualCreditReport.com so you can stay on top of the situation.
The Bottom Line
Managing and maintaining a good credit score can be a balancing act. Life necessitates being able to lay your hands on a little extra cash at times. Handling it properly and to your best advantage can form a safety net for you in the form of a good credit score. Boosting your score requires avoiding a few things and taking some positive actions.