Credit card companies, auto dealerships, mortgage bankers and other lenders use credit scores to determine the risk of loaning money to a borrower, how much they will loan, and the interest rate they’ll charge.
Most lenders use FICO scores, which range from 300 to 850, to gauge creditworthiness. The higher your score, the more credit-worthy most lenders will deem you to be.
Borrowers actually have three FICO scores, one for each of the three credit bureaus: Experian, TransUnion, and Equifax. Each score is based on information maintained by that credit bureau.
Why credit scores matter
If you need a loan to buy a car or house, your credit score may be more important than you realize. Just a few points one way or another can affect your eligibility to get the loan, as well as the interest rate you’ll be offered. That’s important because a higher interest rate on your loan can leave you paying more each month, plus more over the life of your loan.
What’s a good credit score? The historical cutoff where you can expect to get the best rates without any negative rate adjustments by the lender is 720.
Conversely, if you are someone who avoids credit, you won’t have a credit history, and that can hurt you. Your score will be on the low side, which can impact you in many ways. Landlords, employers, and utility companies all run credit checks. Your credit score can even affect which cell phone plan you’re offered and your auto insurance rate.
What affects your credit score?
Your FICO score is made up of five factors, and some carry more weight than others.
1. Your payment history: 35% of your score
Your record on bill paying represents the most important element of your credit score, accounting for 35% of the overall score — so it’s important that you pay bills on time. A simple way to ensure you never miss a due date is by setting up automatic payments that come directly out of your checking account. Charge-offs, debt settlements, bankruptcies, foreclosures, lawsuits, wage garnishments or attachments, liens, or public judgments against you are red flags to lenders, and may impact your ability to secure future credit or to secure credit on the most favorable terms.
2. Your credit utilization: 30% of your score
Maintaining good credit is all about credit utilization, or the amount of available credit you’re using. A good rule of thumb is to keep credit utilization under 30%. Credit utilization is the amount of your credit card balance compared to the card’s credit limit. To keep credit utilization under 30% on a card with a $1,000 limit, you should keep your balance under $300. That ratio applies to all of your cards and credit lines.
3. How long you’ve had credit: 15% of your score
A lengthy credit history shows lenders that you’ve been disciplined about making payments on time, but even a short history — without late payments or other negative factors — is helpful. To keep older cards active, you may want to put a recurring cost, like a utility bill, on those you’re not using regularly. It can have a negative impact on your credit score when you close older lines of credit or have them canceled, which can be detrimental if you plan to make a big purchase like a house.
4. New credit: 10% of your score
When you apply for a new credit card or loan, lenders do a hard inquiry or “hard pull” of your credit, which temporarily lowers your credit score because it signals to lenders that you are considering taking on more debt. If you’re thinking of applying for a car or home loan, you’ll want your score to be as high as possible to get the best interest rate, so you might want to avoid applying for new credit in the months leading up to your big purchase.
5. Types of credit: 10% of your score
The final factor determining your credit score is whether you have a mix of different types of credit, such as credit cards, store accounts, installment loans and mortgages. The total number of accounts you have also comes into play. Since this is a relatively small component of your score, don’t worry if you don’t have accounts in each of these categories, and don’t open new accounts just to increase your mix of credit types.
Improving your score
If you plan to make a major purchase, you’ll want to find out your credit score about six months in advance so you’ll have time to correct any possible errors and, if necessary, take steps to improve your score.
It’s fairly easy to find out your score. Some credit card companies and banks already include your score on monthly statements or make it available online. You also can purchase your credit score from one of the credit bureaus or FICO.If your score seems low, you can request a free annual copy of your credit report from each bureau at AnnualCreditReport.com or by calling 877-322-8228. If you spot errors, you can submit a correction request to the bureau(s). Be sure to include copies of all the documentation you’ve kept in correspondence with the creditor.