What You Need to Understand About Credit Scores

Unlike the score to a basketball or football game, a credit score is often misunderstood. This three-digit number is used by various lenders to determine your creditworthiness, which is the likelihood that you, a potential borrower, will pay back your debt. This number can have major consequences on a person’s life such as the ability to take out a mortgage or open up a utility account, but many people don’t understand how actions impact this number.

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Your score not only impacts your ability to secure a loan, but it also influences certain factors like your interest rate and in some cases, the terms of your repayment. Because it can dramatically impact your bottom line, here are some things you should know about your credit score.

What a Credit Score Says

It’s impossible for a potential lender to contact everyone you’ve borrowed money from to determine how good you are when it comes to repaying debts. The credit score or rating provides an easy snapshot of how responsible you are with your debts. This number offers insight to lenders about your borrowing history. The higher your credit rating, the more trustworthy you appear to potential financiers.

Debtors with higher numbers are usually offered lower interest rates on loans. Those with lower credit scores run the risk of being expected to provide a larger upfront deposit when opening a new utility account. When choosing between two or more possible tenants, a landlord may go with the applicant with the higher creditworthiness, as he or she appears to be more responsible with money.

Not Just One Number

The reality is that you have more than one credit score. Fair Isaac Corporation, also known as FICO, is a company that generates various scores based on different aspects of your borrowing history. They have several models that rate your creditworthiness based on the type of debt.

For example, a person who has never taken out a mortgage but has always paid their credit card bills on time may have two different ratings based on credit card debt vs mortgage debt. A lender offering mortgages may consider one model over another. Your main score may not tell the entire story of your history as a debtor.

Credit Reporting Agencies

There are three major credit reporting bureaus that generate reports that are used to determine your creditworthiness. Equifax, TransUnion and Experian provide reports that include your name, personal info and details about the accounts that you hold. These reports also include information about closed accounts, unpaid debts and bankruptcies. The bureaus use this data to determine your scores. You’re entitled to a free credit report from each of the bureaus through a federally authorized site. Reviewing your reports can alert you to identity theft and fraudulent activity.

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Calculating Your Score

The exact formulas used to calculate your credit score are proprietary information; however, the FICO model is based on the following factors and percentages:

  • Payment History: 35 percent of your score is based on you paying your bills on time consistently. Your payment history is the biggest factor. Late payments and missed payments can really bring your rating down.
  • Credit Utilization Ratio: 30 percent of your score is based on the amount of debt you owe versus your overall available credit. For example, if you have a balance of $2,000 on a credit card with a limit of $10,000, your utilization ratio would be 1/5 or 20 percent. The lower your overall utilization the better. It is recommended that this ratio be no more than 30 percent. If you’ve maxed out your cards and have little to no available credit, this brings your standing down significantly.
  • Length of Credit History: The longer the average age of your accounts is, the better for your score. Having a long positive borrowing history shows that you’ve managed your credit for years. This is why it’s not recommended to close old accounts. Closing accounts lowers the length of your history which accounts for 15 percent of your score.
  • Credit Diversity: 10 percent of your score is based on having what is considered a good mix of credit accounts. There are different kinds of debts with different amounts and repayment periods available such as mortgages, student loans, auto loans and credit card debts. Having a good mix of debt is viewed favorably as long as those accounts are all in good standing.
  • New Credit: 10 percent of your score is affected by the number of recent requests you’ve made for new debt. When several new inquiries are made on your credit in a given period, it can lower your rating. One exception to this is when you’re shopping for a mortgage. Most borrowers need to consider multiple mortgage offers before settling on one, and so multiple credit inquiries of this type are viewed as one inquiry for a particular timeframe.

Credit by the Numbers

You may be wondering what is considered a good number to have. Although each lender has their own internal criteria for the loans and rates they offer, FICO’s ranges are widely considered to be standard.

  • Exceptional: 800 and above (850 is usually the max, though VantageScore, another score-generating company goes up to 990)
  • Very Good: 740 to 799
  • Good: 670 to 739
  • Fair: 580 to 669
  • Poor: 579 and below.

An estimated 90 percent of creditors go by the above ranges when examining your creditworthiness. The average FICO score in the United States is over 700. Having a very good or exceptional score shows lenders that you can be expected to fully repay your loans, making you eligible for preferred rates and terms.
Who knew that a simple three-digit number could have such an impact on your life? Now that you understand your credit score and how it is impacted, you can assess your current habits and their effects on your creditworthiness.

If you have a fair or poor rating, take meaningful steps to improve it. If you wait until you need to take out a mortgage or car loan, that’s too late. Pay your bills on time and make sure you’re reducing your debt with each payment.

About the Author

Jay T. Ripton is a business consultant and freelance business, marketing and lifestyle writer out of Scottsdale, AZ. You can follow him on Twitter @JTRipton.

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