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If you live in the US, sooner rather than later you get acquainted with the concept of credit score. But although everyone talks about it, and every institution asks for it, chances are you don’t really know how does credit score work in real life.
A credit score shows lenders how likely you are to repay any loans – like a mortgage or car loan. Credit Scores range from 300, to over 800, and a higher score means your monthly payment will most likely be lower than someone with a 300 score.
On top of covering the basics of credit score, we’ll show you what it takes to keep it optimal or recover from bad credit.
What Is A Credit Score?
Your credit score is a number that ranges from 300 to 850 representing how likely you are to repay your loans.
Can lenders rely on you to repay the money that they let you borrow? The higher your credit score is, the more likely you are to qualify for loans and better terms.
The credit score that you are most likely to hear about is the FICO score, created by the Fair Isaac Corporation.
This is a standard score that most lenders rely on.
How Important Is A Credit Score?
Credit scores are now used more than ever before, not only for approving credit applications but also as a way to check the background of potential employees or buyers.
Once, people could largely ignore their credit scores if they didn’t need to borrow money or get a credit card.
Today, though, you may have a hard time enjoying basic necessities without good credit.
Here are some examples of the importance of credit score:
- Getting hired – Employers may check your credit scores before hiring you as a way of ensuring that you are responsible and reliable. A bad credit score can send red flags and ultimately lose you the job.
- Choosing a phone plan – Enrolling in most cell phone plans, with operators such as Verizon and AT&T, requires you to pass a basic credit check. If your credit score is bad, you’ll be asked for a security deposit. Of course, prepaid services provide alternatives for people who can’t get approved for a regular plan, but the prices can be higher and more limiting.
- Renting a home – Real estate agents and landlords usually check credit scores as part of the application process. If your credit score is low, you may have to choose a home based on who will let you rent from them, instead of finding the home that’s best for your family. Or, you may be required to put down a larger deposit before you move in.
- Getting the best insurance rates – While you don’t need good credit to purchase insurance, a good score often helps you get better rates, so you have more money left to spend and invest where you choose.
On top of these examples, credit score directly affects loan approvals, interest rates, and terms. Namely, for my very first credit card, I had a 28% APR.
How Is Your Credit Score Calculated?
Understanding how is credit score determined is the first step to getting help with your credit score.
It will better position you to take the necessary steps to improve your credit score, no matter how challenging it may seem at first. So let’s get started!
FICO credit scores are calculated using only information from credit reports.
Some lenders use specialized versions of the FICO score, such as the FICO Bankcard Score or the FICO Auto Score, but the most common is the standard FICO score which uses the following information to determine your credit score:
- Payment history is the most important aspect of your credit score, accounting for 35% of your total rating. Lenders want to know if you’ve paid your debt on time since it indicates how much risk they would be taking if they lend money to you.
- Amount owed accounts for 30% of your FICO score. It’s an essential part of your rating because it indicates how much of your available credit you’re using. If you’re using all the credit you have available; it tells lenders that your budget may be stretched to its limits.
- Length of credit history shows the age of your oldest and newest accounts, how long your accounts have been established, and how long it has been since you’ve used your accounts. The length of your credit history accounts for 15% of your FICO score.
- New credit accounts for 10% of your credit score and indicates whether you’ve recently opened several accounts within a short period. Opening too many new accounts is a red flag to lenders that tells them you may be high risk.
- Credit mix determines 10% of your FICO score and evaluates what combination of credit types you use, such as credit cards and specific types of loans and financing. If you successfully manage several types of credit over a period of time, it tells lenders that you are likely responsible when it comes to managing money.
However, FICO clearly states that the following factors do not affect your credit score:
- Age, race, color, religion, national origin, sex, or marital status.
- Receipt of public assistance
- Any employment history including salary, occupation, job title, and employer
- Credit card interest rates
- Child support or other family obligations
- Consumer-initiated credit inquiries (requests you make to check your own credit report)
- Promotional inquiries made by lenders, such as pre-approved credit offers
- Employer inquiries
- Any other information that is not proven to predict your credit performance
What Is A Good Credit Score?
FICO assigns credit scores ranging from 300 to 850, with higher numbers indicating better credit ratings.
A high credit score naturally means that you are good at making payments.
Since it demonstrates to lenders that you are able to use credit in a responsible manner, you’re a worthy i.e. low-risk candidate for extending credit. It encourages them to offer you the best credit card rates and benefits.
Since a low score indicates that you’re unable to make payments on time or even at all, naturally creditors are wary of extending credit to you.
Given your likely history of missed payments, even if they do, it will be at a higher rate of interest to compensate for the high risk.
So, in order to enjoy good credit rates and the best possible perks, you should aim to boost your FICO score to the high 700’s, so you can receive the best interest rates from lenders.
Understanding Your Credit Score
Let’s break down the credit score chart and understand what the numbers mean.
- 300 – 579, Very Poor: It’s unlikely that you’ll get approved for any type of credit. A very poor credit score makes you vulnerable to scams and traps such as payday loans and unreasonably-high interest rates that can keep you in debt, “underwater,” for years.
- 580 – 669, Fair: At this level, you’re considered a “subprime” borrower, and if you can get approved for credit through a legitimate lender, you’ll pay higher interest rates.
- 670 – 739, Good: A score in this range tells lenders that you’re very unlikely to fall too far behind on your accounts since only 8% of people in this range become seriously delinquent on payments.
- 740 – 799, Very Good: This credit score range is where you want to be to enjoy lower interest rates when borrowing. It also allows you to get better credit cards that offer cashback rewards and awesome travel perks.
- 800 – 850, Exceptional: This is your ultimate credit goal. Building an exceptional credit score means you get the lowest interest rates and can expect approval in most credit situations.
According to a recent report, only 22% of Americans have exceptional credit scores (800 – 850 FICO) and 25% have very good credit.
Basics For Loan Types
Whether you need a student loan, mortgage, or even a credit card, being approved or denied would depend on your current credit score. So let’s find out the usual credit score needed for the most common types of loan.
The minimum credit score you need to buy a home varies depending on which lender you use. However, most lenders require a credit score of at least 620 to get a mortgage loan.
But to get a decent interest rate you should aim for a minimum of 740.
Don’t worry if you don’t fall in that bracket – FHA, VA, and USDA loans allow people with lower credit scores to get mortgage loans.
For example, FHA loans are a government program meant to assist first-time homebuyers – you’ll need a lower downpayment compared to other lenders.
- A FICO credit score lower than 580 means you’ll need a minimum 10% downpayment for an FHA loan.
- A FICO credit score of 580 or above means you’ll need a minimum 3.5% downpayment for an FHA loan.
Caution: Low down payments on home loans mean paying tens of thousands of dollars more in interest and private mortgage insurance over the lifetime of your loan.
That’s why, instead of rushing to buy a home before you’re ready, we recommend that you improve your credit score and save a down payment of at least 20% before buying.
Your credit score needs to hit at least 700 to qualify for an auto loan with competitive interest rates from a traditional lender.
If your credit score is lower than 600, you may find a way to qualify through an auto dealership that provides special financing, but beware of high-interest rates that may make your loan difficult to pay off.
To get a credit card with lower interest rates and perks such as cashback, rewards, and spending bonuses, you’ll need a very good FICO score of about 750 or more.
While you might be able to qualify for some credit cards, despite a poor credit rating, you’ll end up paying unreasonably-high interest rates on those types of cards — in some cases 10 – 30%.
High-interest credit cards are not a good choice for people with the Minority Mindset who want to build wealth because they often trap people in a never-ending cycle of debt.
Remember that just because you CAN find a way to qualify for credit doesn’t mean you should.
How To Improve Your Credit Score
The first step toward boosting your credit score is to take control of your finances. If you have bad credit, the first step should be to review how you manage your finances.
If you’re in debt, begin with these steps for managing your finances:
- Take time to think. When you’re broke or in debt, it’s natural to constantly have your defenses up because you’re often consumed with thinking about your next bill or payment. Carve out a few minutes of each day to think about how the system works and how you might create new opportunities for wealth-building.
- Make a plan. Create a monthly budget that accounts for every single dollar that you earn. So, if your net income is $3,000 a month, you should plan out how you’ll spend that money before it hits your bank account.
- Track your money. Record how you spend every single dollar you receive, so you can look back and make adjustments and improvements.
- Allocate your income. Spend no more than 75% of your net income, so that you have 25% left to save and invest.
- Find ways to earn extra cash. If you’re in debt, do everything you can to make some extra money and pay off your bills.
Improving your credit score takes time, but many people often begin to see a difference in just 5 – 6 months.
Besides the tips for money management, we just went through, dive deeper into the matter, and discover the best ways to improve your credit score in a legit and easy way.
Understanding Your Credit Score – Final Thoughts
Understanding how does credit score work is the first step to owning and managing it.
Now that you know what is a credit score and how does a credit score work really, it’ll be easier for you to take the reins in your hand and keep those numbers as high as possible.