Your credit scores can have a major impact on your financial life. This three-digit number can influence whether you are approved for a loan or credit application, the terms you are offered on loans, and much more.
Even if you aren’t planning on applying for a mortgage or a loan anytime soon, your credit health can determine other crucial aspects of your finances and life, such as the rates you are offered for car insurance and how easy it is to get approved for a rental apartment.
At first, learning the ins and outs of what your credit score means can be confusing. However, understanding what impacts your credit is a powerful tool for optimal financial health.
Let’s take a look at what you need to know about credit scores.
What Is a Credit Score?
Your credit score is a numeric rating between 300 and 850. This number intends to depict how creditworthy a consumer is.
The higher your credit score is, the more appealing you are as a borrower to potential lenders. Lenders interpret lower credit scores as an indication that they are taking on more risk by accepting you as a borrower.
There are two primary models through which credit scores are calculated. Known as FICO and VantageScore, these two companies use similar but slightly different methods to calculate your score.
How Credit Scores Are Calculated
Your credit score is determined by a number of different factors, some of which are weighted more heavily than others.
The three major credit reporting agencies in the U.S. are Equifax, Experian, and Transunion. These bureaus report, store, and update the credit histories of consumers.
There can be some differences in the information that these three agencies collect. However, there are five primary factors that are used to calculate your credit score.
Payment History
The most important factor that impacts your credit score is your payment history. This is true for both the VantageScore and FICO scoring models.
Your payment history is weighted so heavily because it indicates how likely you are to pay back a loan to a creditor or lender. Ideally, you will have a history of on-time payments in order to achieve the highest possible credit score.
Credit Utilization or Usage
Another important factor in calculating your credit is your credit utilization. This is determined by taking your total credit card balances and dividing this number by your total credit card limits.
(If you’re shopping around for a new credit card, the first step is to understand the different types of credit cards available. Check out this guide to learn more.)
If your credit utilization rate is on the higher side, it can indicate to lenders that you might not be able to pay back a new credit card balance or loan. For this reason, a higher credit utilization rate can lower your credit scores.
Length of Credit History
Your credit scores can be increased by having a longer credit history. This indicates that you have more experience using credit and can therefore influence your scores positively.
Both the length of time your accounts have been open and the last time they were used are included in your credit history. For this reason, it’s best to avoid closing older credit accounts if you can avoid it.
Types of Credit
Having a diversity of types of credit can help to build your credit scores. When you have a healthy mix of accounts, it shows lenders that you are capable of managing and paying back different types of credit.
Newly Opened Credit Accounts
Every time you apply for a loan or credit, a hard inquiry will be conducted on your credit. This inquiry shows up on your credit report and can be factored into your score.
When you open a number of new accounts within a brief period of time, it can indicate to lenders that you are having financial difficulties.
Understanding Your Credit Score Range
Every creditor and lender defines its own range for credit scores. However, the general rule of thumb is that the higher your credit score, the more creditworthy you are in the eyes of potential lenders.
To help understand the basic range structure for credit scores, the FICO model is commonly used:
- Poor: 300 to 579
- Fair: 580 to 669
- Good: 670 to 739
- Very Good: 740 to 799
- Excellent: 800 to 850
Where you fall on the spectrum from poor to excellent credit can significantly impact your financial life. While there are a number of factors that lenders consider when denying or approving an application, your credit score plays a key role in their decision.
What Is Considered a Good Credit Score?
You will find some sources that say that a credit score of 700 or above is typically considered good. Others refer to the FICO score model and state that a score of 670 or higher is a good score.
When you have a credit score that falls within the range of good to excellent, it can be a game-changer for your financial life. When you have a higher credit score, you are more likely to be approved for loans or credit. It can also unlock the door to more competitive terms and lower interest rates.
What Is Considered a Bad Credit Score?
Individuals that have credit scores that are below 640 are commonly referred to as subprime borrowers. Because lenders believe they are taking on more risk when they extend credit or loan money to these borrowers, they often charge a higher interest rate. The terms offered to subprime borrowers are also frequently less favorable than those given to people with good or excellent credit.
Credit Scores: Improving Your Score Can Save You a Fortune in the Long Run
Over the span of your life, your credit scores can end up saving you or costing you a lot of money. When you maintain an excellent credit score, you’ll find it easier to borrow money and will likely be offered lower interest rates and better terms when you do.
Managing your credit score can seem tedious and abstract, but it can have a very real impact on your quality of life. Understanding the different factors that contribute to your credit score is the first step in learning how to build better credit.
One of the ways that you can work to improve your credit is to responsibly use credit cards. For more resources and offers regarding credit cards, check out our library of articles here.