Understanding Your Credit Score

Understanding your credit score is essential to maintaining stable financial health. It may help guide you through major financial decisions like consolidating debt or buying a home. In this article, get to know how your score is determined, specific factors that can impact it, and how it plays into obtaining credit.

What is a Credit Score?

A credit score is a number between 300-850 that lenders use to determine how likely you are to repay your debt. It comes from credit reports generated by TransUnion, Experian, and Equifax credit bureaus and is calculated with FICO® and VantageScore® scoring models. If you don’t know your credit score, you can always check it for free at Best Egg Financial Health, set goals to improve it, and even see exactly what factors are impacting it.

How To Understand Your Credit Score

No matter which credit scoring model is used, the result will be part of the criteria lenders will use to gauge your creditworthiness. Credit scores below 650 indicate poor credit, while scores between 650-700 are deemed to be in the fair credit range. Scores between 700-750 are in the good credit range, and scores above 750 are considered excellent. The higher your score, the more likely you are to repay your debt and the less of a risk you may be to default.

How to Use Your Credit Score Responsibly

Your credit score may go up or down based on factors such as credit utilization, debt-to-income ratio, and your payment history. When possible, pay off the total monthly balance of your credit cards to keep it from ballooning as the result of compounding interest. Tracking your credit card purchases and statement balances is critical to good credit management. When your loan balances increase, your credit utilization and debt-to-income ratio may also increase, which has a negative impact on your credit score.

Benefits of having good credit

A higher credit score implies you’re a low-risk borrower and more likely to pay off your debt. Lenders often 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, mortgage, and personal loans.

Having good credit score impacts your 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.

How credit scoring models work

Before we review factors and their impacts on your credit, it’s crucial to review the existing credit scoring models and their differences.

FICO® and VantageScore® consider multiple factors when determining a credit score. The scoring models share some similar factors, including payment history, length of time you’ve had credit, the types of credit you have, how much debt you currently have, and how many hard inquiries have recently been made into your credit history.

VantageScore® models differ from FICO® in that they incorporate up to 24 months of previous credit activity and include rent and utility payments. Total credit usage and credit mix are highly influential in VantageScore®’s scoring criteria, while the age of credit and new accounts are considered less significant.

FICO® credit score	VantageScore® 3.0 credit score
•   35% payment history •   30% amounts owed •   15% age of credit •   10% credit mix • 10% credit inquiries	•   40% payment history •   21% age and type of credit •   20% percent of credit used •   11% total balances/debt •   5% recent credit inquiries • 3% available credit

Payment history

Before approving you for a loan or a line of credit, lenders want to know that you’re a responsible borrower who will pay them back on time. Your payment history is the most telling factor they can use to determine that.

Proof that you’ve repaid previous lenders in full and on time significantly impacts your score and is the key to getting approved for any credit you’re looking for.

Factors that can negatively affect your payment history:

• Late payments: Even 1 late payment can drop your credit score dramatically. The later you pay, the worse the impact may be. Do your best to pay your bills on time, even if you can only afford the minimum payment.
• Accounts in collections: Most lenders look for safe bets when it comes to borrowers. Collections on your credit report may be a major red flag that you may not repay them.
• Settlements, bankruptcies, and foreclosures: These negative marks on your credit report signal that you could have trouble paying lenders back and make them think twice about lending to you.

Time plays a significant role in how severely these factors affect your score. If you had accounts sent to collections a few years ago but have had an excellent payment history since lenders may be more likely to consider your more recent behavior. In other words, time and responsible use moving forward can heal even the deepest credit wounds.

Amounts owed

Another major factor that affects your credit is your credit utilization ratio. This ratio measures the level of debt you have compared to your available credit limits. It is calculated by adding the total balances on your credit cards and dividing them by your total credit limits.

Lenders see low credit utilization as a sign that you’re keeping your spending in check and avoiding overspending. The fact that you have access to more money but aren’t using it is a good indicator that you’re using your credit responsibly.

Lenders may believe borrowers with high credit utilization ratios already have more debt than they can effectively manage. If a borrower uses $9,500 of their $10,000 in available credit, it’s not a far leap to assume they may have difficulty repaying an additional financial obligation.

Most financial experts agree that using less than 30% of your available credit limit is ideal for your score and borrowing potential, but it’s not a hard-fast rule. Typically, the less you owe, the better. That said, having a $0 balance on your accounts won’t necessarily be helpful for your score. Lenders want to see that when you borrow money, you pay it back. If you never borrow, there won’t be any payment history to consider.

Length of credit history

Why is the length of your credit history important for your score? It’s simple – the longer your history of using credit, the more experience you have using it. If a lender is deciding between 2 borrowers, they will look at both borrowers’ credit histories. Someone who made on-time payments throughout their 6-year credit history has more evidence of responsible credit use than someone with no history at all. That’s why, generally, the longer your credit history, the better it is for your score.

Pro-tip: Rather than close your unused credit card accounts, consider keeping them open. An older account may increase the average age of your credit history and ensure you have access to a larger amount of available credit–both of which could improve your credit score.

Mix of credit

Credit scoring models consider whether you have a mix of different types of credit (credit cards, retail accounts, installment loans, and mortgages) when calculating your credit score. The more diverse your credit, the better your score.

Important note: Avoid opening new accounts just to improve your credit mix. As you’ll learn next, opening multiple new accounts in a short time could actually hurt your credit.

New credit

Generally, when you apply for a loan or line of credit, lenders will check your credit reports and information during the application process. This is known as a hard inquiry or hard pull.

Hard inquiries may drop your credit score slightly, though the impact is usually minor. Scoring models likely assume borrowers who open many new accounts within a short timeframe are having money difficulties and may be a greater credit risk.

If you’re seeking new credit, don’t let the potential negative impact of a hard inquiry stop you. Your score may drop a few points temporarily, but as long as you use your new credit responsibly, it’ll be back up in no time.

Conclusion

Whether you’re rebuilding your credit or simply hoping to better understand how credit works, knowing the factors that affect your credit score is a great place to start. Hopefully, you’ve learned ways to improve your credit score and continue your journey to financial confidence.

This article is for educational purposes only and is not intended to provide financial, tax or legal advice. You should consult a professional for specific advice. Best Egg is not responsible for the information contained in third-party sites cited or hyperlinked in this article. Best Egg is not responsible for, and does not provide or endorse third party products, services or other third-party content.