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When I first started out on my own, I had heard of credit before but didn’t really understand it. Credit was a mysterious concept to me, and I struggled to understand just how lenders determined whether I was worthy of borrowing money.
No one ever explained to me what I could do to make the number increase or even what number I should be aiming for. The whole thing felt like it was shrouded in secrecy, like it was a language that lenders spoke and I could never understand.
Why did I even need credit in the first place? I was told that I had no credit, fair credit, and eventually good enough credit to purchase a home. What does good credit really look like?
Is there a difference between a 750 credit score and a lower number? When I bought my first home, I found out that even though there may be a narrow point difference, it can make a huge impact on your overall monthly payment.
If you’re like me and you struggle to understand your credit score, there is good news. Lenders use a set formula that helps to determine whether you are worthy of borrowing money from them.
Most lenders use the FICO credit score, and you can understand exactly what they are looking at. Once you understand the basics, it becomes clearer what you can do to improve your score.
Let’s take a closer look at exactly what credit is and whether you truly need a perfect score!
What is Credit?
Credit gives you the ability to borrow money with the idea that you will pay the lender back at a later date. You might borrow money for a car loan, a new home, or even just a revolving line of credit in the form of a credit card.
Good credit means that lenders are more likely to extend the offer for you to borrow from them, while bad credit means they are less likely to do so.
A credit score is a number between 300 and 850 that lenders use to determine your creditworthiness. In other words, it is a figure used to tell lenders whether you are likely to pay back the money that they loan to you.
A higher credit score shows that you are more creditworthy and higher scores are more appealing to lenders or credit card companies. A lower score shows just the opposite – that you may struggle to repay the money you borrow on time and that you are more of a financial risk.
Most lenders use the FICO credit score which was created by the Fair Isaac Corporation. On this scale, the ranges of credit scores are often broken down into categories:
- Excellent: 800 to 850
- Very Good: 740 to 799
- Good: 670 to 739
- Fair: 580 to 669
- Poor: 300 to 579
If you have a credit card, you might have access to your FICO credit score as a complimentary service. You should be able to find this information on previous statements or on your online portal. This is how I keep tabs on my credit score.
If this is not available to you, you can still access your credit score starting at $20 per month at myFICO.com.
Once you know what your credit score is, you might be wondering how lenders come up with that number. Your credit score is comprised of five major categories:
- Payment history (35%)
- Credit utilization (30%)
- Length of credit history (15%)
- Credit mixture (10%)
- New lines of credit or recent inquiries (10%)
Payment history makes up the bulk of your credit score at 35 percent. Lenders have determined over time that past history of making payments in a timely manner is the best predictor of whether you will continue to do so in the future.
They want to know that you are going to pay back the money they loan you which is why payment history makes up the bulk of your credit score.
The best thing you can do to ensure a good credit score is to make each and every payment on time. This includes your credit card payments, auto loans, mortgage payments, and anywhere else you might owe money.
Missing even a single payment can ding your credit score and send up a red flag to lenders.Payment history stays on your credit report for seven years, which means that lenders will be viewing that missed payment for years to come.
This single category can make or break your credit score. Even if you do everything else right, lenders are liable to see spotty payment history as a red flag. Focus on this one area first if you want to improve your credit score quickly.
Credit utilization is a close second when it comes to determining your overall score. 30 percent of your score is determined by how much of your available credit you are actively using.
Most professionals will recommend that you keep your credit utilization below thirty percent of your available credit.
What does this mean? Let’s say that you have a credit card with an available credit limit of $1,000. In order to keep your credit utilization at thirty percent or less, you would need to have a balance of $300 or less.
If your credit utilization is too close to the maximum amount you are allowed to borrow, you should consider paying down some debt to boost your credit score.
Length of Credit History
The length of your credit history is also important, making up 15 percent of your overall score. Lenders are looking to see if you can responsibly manage your accounts for the long haul.
Even if you have an old card that you no longer use, it can be a good idea to keep it open because you have such a long history with it. I still have the very first credit card I ever received because I don’t want to cut my credit history short.
Credit cards are one example of a line of credit history that is taken into account, but that isn’t everything. Auto loans and mortgages can also be factored into the length of your credit history.
Did you know that there are different types of credit? There are revolving accounts that constantly change like credit cards. There are also installment loans such as car loans or mortgages.
Lenders like to see that you can responsibly manage both types of accounts. This accounts for just ten percent of your credit score. If you don’t have the need for different types of loans just yet, don’t worry too much. It may only affect your score by a few points.
New Lines of Credit and Recent Inquiries
The number of new credit lines you apply for is reflected in your credit score. Each time you apply for a new credit card or a new loan, lenders are doing a hard pull of your credit.
This gives the lender permission to view your full credit history including:
- Payment history for each line of credit
- Length of time you have had each credit line
- All available open lines of credit or loans
By itself, this can cause your score to drop a few points. If you are doing it regularly and applying for lots of new loans, then you might see a serious decrease in your credit score.
All hard credit pulls will stay on your credit report for two years.
On the other hand, soft credit pulls do not damage your credit score. This gives someone access to check your credit report but is not attached to any sort of application.
You might use a soft credit pull when being hired for a new job or applying for a new apartment. If you didn’t submit an application for credit, then chances are you are undergoing a soft credit pull.
Applying for lots of new loans and lines of credit shows that you might be a financial risk to lenders. It shows that you are borrowing a lot of money all at one time and may have a difficult time with paying your bills later.
It is advised that you wait several months between applying for new lines of credit. New lines of credit and recent inquiries make up 10percent of your overall credit score.
What Does Perfect Credit Mean?
As you might imagine, obtaining a perfect credit score can be quite an undertaking that requires frequent monitoring of your credit report.
It is possible to get that perfect 850, but you will have to do a lot of financial heavy lifting if you want to achieve it and stick to it. According to the vice president of scores and predictive analytics at FICO, just 1.5 percent of people are actually able to achieve this goal.
The good news is that you don’t have to have perfect credit to get a good deal. Most experts agree that having a score in the excellent range (800 and above) will still get you the same deals as you would have gotten with perfect credit.
The fifty-point difference doesn’t matter much to lenders. They still offer better interest rates and lower fees to those with excellent credit.
If having perfect credit is important to you, you need to pay attention to all of the factors that are included in your score. Most notably, you need to ensure that you are making all of your payments on time.
Even a few missed payments can negatively affect your credit and keep you from obtaining a near-perfect score.
Here are a few other things you can do to try to get yourself into this range:
- Create a mixture of credit: This means that you should have more than just a single credit card in your wallet. Vary your lines of credit between credit cards, installment loans (such as auto loans), and even a mortgage. It might seem counterintuitive, but having a few open lines of credit can actually help to boost your score, because it can show that you are able to manage more than just one type of credit. Lenders like to see this, so that they know that you’ve had success with different loan types in the past and should have no problem handling a new loan as well.
- Keep balances low: If you have a mixture of credit, you want to ensure that your total limit is relatively high. You can ask for credit limit increases annually on your cards, or they may be offered automatically to you. However, you never want to max out these lines of credit. Keep your credit limit high but your balances low. You should always aim to keep your credit utilization rate below thirty percent. If it creeps higher than this number and having perfect credit matters to you, set aside some money to start paying down your debt.
- Have long-standing credit history: Some people want to open new cards all the time whenever a good deal arises. Try to avoid this common credit pitfall. Long-standing credit history matters and opening new accounts can actually lower your credit score. Increasing your available lines of credit can help your credit utilization rate and improve your score over the long run, but opening a new card can have the opposite effect on your credit score in the short-term. Closing accounts also means that you are losing access to your history with that card, and this can actually be detrimental to your credit score as well. Keep lines of credit open if possible, but refrain from carrying a balance with them.
What Does Bad Credit Mean?
On the flip side of perfect credit, many consumers are struggling with bad credit. This typically refers to those who have credit scores that come in under 579.
They are likely to have a hard time getting new lines of credit because they may owe too much money on their credit cards or auto loans, their credit history may be short, and they might have several lines of new credit.
Having bad credit is not to be confused with having no credit. When I was first starting out, I was shocked to learn that I had no credit. I had assumed that everyone had credit, but I had no idea how the process actually worked.
I applied for my first mortgage and was denied due to a lack of credit, even though I had the funds for a down payment.
At the time, I had never opened a credit card or financed a car. In other words, I had never borrowed any money so I had no proof that I was a responsible borrower who could pay back my mortgage – or any other loan, for that matter.
If you have no credit, you can get started on the right foot which can be easier than trying to correct old financial habits. Consider applying for a secured credit card where you will make a deposit that is equivalent to your credit limit.
Most credit cards do not require an initial deposit, but a secured credit card does. For example, my first credit card required a $500 deposit and I could spend $500 on it.
This ensured that the lender had some recourse if I stopped paying the bill. Use this card for small purchases and pay it off on time each and every month.
Why Having Better Credit Matters
The reality is that you should want to improve your credit score, no matter where you currently fall on the spectrum. Better credit means that you will be viewed more favorably by lenders and that can save you some serious cash.
People with better credit scores often have lower interest rates across the board which can add up to thousands of dollars saved over the years.
For example, a credit score of 700 might mean you get a 4 percent interest rate on your next mortgage. A slightly higher score of 750 might get you a 3 percent interest rate. Imagine what a difference this 1 percent interest rate can have on your payments.
On a thirty-year mortgage for a $200,000 home purchase, a one percent difference in interest rates could save you more than $30,000 in interest!
In addition to lower interest rates, you might also be able to obtain loans more easily and open new credit cards with greater ease, which can save you both time and money down the road.
With higher scores, you are likely to receive better loan terms. For example, you might get a higher credit limit on your card or reduced annual fees. You might be eligible for rewards cards that help you to earn cashback or frequent flier miles instead of just secured credit cards with no benefits.
The good news is that everyone can obtain better credit. Here are a few tips and tricks to help you do just that.
Set Up Auto-Payments
At some point in your life, you are likely to miss a payment. I know I’ve missed several payments over the years when the bill gets lost in the shuffle or I simply lose track of the calendar. Years ago, I set myself up for success so that I never miss a payment again.
Because payment history is the biggest determining factor of your credit score, this is an ultra-important thing to do. Set up as many of your bills to auto-pay as you can.
For those that don’t allow this option, set a recurring alarm in your phone. This ensures that you will always remember that your bills are due and sets you up for success to improve your score.
If you know that you won’t be able to pay a bill that month, contact your creditor as soon as possible. They may be able to offer you some assistance with paying your bill.
This can keep the bill from moving into collections or from being reported to the credit bureaus and causing your score to take a nosedive.
Keep Credit Lines Open
While you shouldn’t go crazy with opening up new credit accounts, applying for a credit card or two may not necessarily hurt your score. J
ust remember that you should keep new credit inquiries to a minimum. However, new accounts can contribute to your overall length of credit history after a while. They can also lower your credit utilization rate.
How does this work? Let’s say that you currently have $2,000 in available credit and are using $500 of it. That means that you have a credit utilization rate of 25 percent at the moment.
If you open up a new credit card with a limit of $2,000, you now have $4,000 available and are still only using $500. Now you have a 12.5 percent credit utilization rate which can dramatically improve your credit score.
Pay Down Debt and Past-Due Balances
Paying down your debt is a great way to lower your credit utilization rate and increase your credit score. When I was first starting out, I spent money on everything under the sun.
My credit card was almost maxed out and my credit score was a little worse for the wear. I focused on paying down some of what I owed and my credit score took a large leap. It’s okay to keep some money on your revolving credit account but try to pay it off where you can.
If you have past-due balances on some of your bills, pay those off first. Late payments do stay on your credit report for up to seven years, but you can help to rectify them by getting those bills current.
This also keeps you from having more late or missed payments added to your credit report, and it saves you money on late fees.
Monitor Your Credit Report
You are entitled to receive a copy of your credit report from each of the three credit reporting bureaus (Equifax, Transunion, and Experian) each year through annualcreditreport.com.
Take a close look at this for any errors that might have been made. You can write to the credit reporting agencies to have these mistakes corrected which could have a positive effect on your credit score.
Boosting Your Credit Score
Your credit score might have seemed like it was a mystery to you before, but lenders are actually pretty forthcoming about how they calculate it.
Payment history is the biggest determining factor, but credit utilization, length of credit history, credit mix, and new lines of credit also contribute.
A higher score means that you are likely to save thousands in interest rates and may be eligible for better fees and loan options in the future.
Monitoring your credit score is important and you can do a lot of work on your own to boost your score.
Consider what you need to do to make payments on time, build up your credit file, and pay down some of your debt. Receiving your credit report annually is also a great way to keep tabs on your credit.
Even if you have bad credit now, you can still turn things around. By following some of these simple financial moves, you can boost your credit and build better relationships with lenders!
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