A credit score is, in effect, a numerical representation or accounting of your financial trustworthiness. Your score takes into account various credit-related behaviors, such as credit utilization, the age of your credit, and your payment history.
This information is aggregated into your credit score. This can be used to, among other things, help lenders decide whether to offer you a loan and, if so, what caveats should be attached to it, such as a higher interest rate.
Below is a breakdown of what your credit score affects, how your score is calculated, and strategies to improve your credit if needed.
What Does Your Credit Score Affect?
A credit score typically affects financial transactions, especially the ability to borrow funds. However, this ability — or lack thereof — can have a profound influence on a variety of seminal life events, such as:
- Getting a job: Many employers require a soft credit inquiry in order to observe a candidate’s past financial behavior. This can serve as an indicator of their competency and trustworthiness.
- Getting approved for a loan: Whether you’re applying for an auto loan, school loans, a mortgage, or any other personal loans, having good credit can expedite the loan approval process and ensure that you’re accepted.
- Getting good interest rates: If you have bad credit, even if you’re approved for a loan, the interest rate will likely be egregious. For example, the average car loan interest rate jumps from 5% to 12% when your credit shifts from good to fair.
- Getting a rental unit: When renting a house or apartment, landlords will often require a credit check. Much like an employer, this is to confirm that past financial behavior ensures responsible future payments.
- Getting a business going: If you want to start a business, chances are you’ll need funding. Business loans are typically obtained through a bank. The higher the interest rate, the more you’ll pay in interest, leaving less money to funnel towards your fledgling company — if you’re even approved for the funds in the first place.
- Getting access to credit card reward programs: Many credit cards come with lower interest rates, cash-back programs, and other rewards. However, they often cannot be accessed unless you have good credit.
If you have a good credit score, it can help with many different aspects of life, from housing and employment to entrepreneurship and even simple things such as saving on interest.
How Does a Credit Score Work?
If you want to cultivate and maintain good credit, it’s essential that you understand how a credit score is calculated.
There are three credit bureaus — Equifax, Experian, and TransUnion — who generate separate credit reports, each of which are used to determine your credit score. While each bureau uses its own unique formula to generate these reports, there are five general categories that each organization takes into consideration:
- Payment history: Being able to make payments on time is a critical aspect of your credit score. In fact, it’s the number one most important factor, accounting for 35% of your overall score.
- Credit usage: The amount of your available credit that you use makes up your credit utilization ratio. Ideally, you should use 30% or less of your available credit (e.g. if you have $10,000 of available credit, don’t use more than $3,000 at a time).
- Length of credit history: The longer your credit history, the better your credit score. This is partly why it’s often recommended to leave unused credit cards open in order to maintain older available credit.
- Credit mix: Your credit mix consists of the different kinds of credit that you maintain. Among other things, your mix may include credit cards, a mortgage, and auto or student loans. A healthy mix is preferred.
- Recent applications: When you apply for a loan it often leads to a hard credit check. This reduces your credit score for a period of time. Multiple hard checks are not preferable. However, if you make several hard credit checks within a 45-day period (such as when you’re applying for loans) they will collectively count as one inquiry.
While the specific combination of factors may vary from one bureau to the other, each organization tends to prioritize these five factors as key ingredients for an accurate credit report.
Improving Your Credit
If you have bad credit, or even fair credit, and you want to improve your credit score, there are several ways to do so:
- Regularly review your credit score and credit report to curb unwanted financial behaviors and dispute errors with the credit bureaus.
- Make all of your payments on time by setting alarms and turning on notifications.
- Reduce your credit utilization rate by either paying off debt or opening up a new line of credit — just be careful not to use the new credit to increase your spending.
- Rather than canceling them, keep old credit cards open and unused to boost your credit utilization ratio.
- Practice wise financial habits, such as only taking a loan when you need it, sticking to a budget, and creating short- and long-term financial plans.
- Avoid hard credit inquiries unless they’re necessary in order to keep your score from going down without a good reason.
If you can actively work to improve and then maintain your credit score, you’ll equip yourself with an invaluable financial tool. Whether you’re applying for a mortgage, looking for school funding, pursuing a career-changing job, or finally starting that business you always dreamed of, if you have good credit to back you up, it will streamline the entire process.
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