Financial Literacy
Understanding your credit score is essential to maintaining stable financial health. Knowing the logistics behind the purpose of your credit score, how it’s determined, and its overall impact on obtaining credit may help guide you through major financial decisions like buying a home. If you’re not familiar with how credit works, here’s our guide to understanding credit scores.
What is a Credit Score?
A credit score is a three-digit number that calculates how likely you are to repay your debt. It is derived from credit reports generated by the three main credit bureaus, TransUnion, Experian, and Equifax, and is determined by scoring models such as FICO and VantageScore. Credit scores range from 300 to 850, with higher scores meaning better credit.
How Credit Scoring Models Work
Both FICO and VantageScore consider multiple factors when determining a credit score. Some of the shared factors considered by both scoring models include payment history, length of time you’ve had credit, the types of credit you have, how much debt you currently have, as well as how many hard inquiries have recently been made into your credit history.
FICO credit scores are determined based on the following factors: payment history, credit utilization, length of credit history, new credit, and credit mix. VantageScore differs from FICO in that it incorporates up to 24 months of previous credit activity and also includes rent and utility payments. Total credit usage and credit mix are highly influential in VantageScore’s scoring criteria, while the age of credit history and new accounts are considered less influential.
How to Understand Your Credit Score
Once a credit scoring model such as FICO or VantageScore determines your credit score, it will designate your score as a three-digit number that falls in between the range of 300 to 850. Credit scores below 650 mean bad credit, while scores between 650 and 700 are deemed to be in the fair credit range. Scores between 700 and 750 are in the good credit range, and scores above 750 are considered to be excellent credit scores.
How to Use Your Credit Score Responsibly
Your credit score may increase or decrease based on factors such as credit utilization (the percentage of your available credit being used), debt-to-income ratio (the ratio of the total amount (the sum of your monthly debt payments divided by your gross monthly income), and payment history. You can achieve a higher credit score by paying your bills on time and using your credit cards and other forms of available credit responsibly. Paying off your loan balances every month will help you avoid interest charges while paying your debt down sooner.
If you’re using credit cards, it’s important to keep track of your purchases and statement balances. Left unmonitored, credit card balances can increase drastically as the result of compounding interest. When your loan balances increase, your credit utilization and debt-to-income ratio may increase as well.
Benefits of Having Good Credit
A higher credit score implies that you are a low-risk borrower and are more likely to pay off your debt, so lenders generally offer better financing terms to applicants with good credit scores. If you’re applying for a new credit card, you may be more likely to receive a favorable interest rate with good credit. This can also apply to interest rates on auto loans, mortgages, and personal loans.
Having good credit can also give you more negotiating power concerning interest rates and payment terms. This may also include approval for apartment rentals, reduced insurance rates, and waived security deposits for utilities. Understanding what makes your credit score work may help you maintain a good credit history and reap the benefits.