Contributing Writer at Tally
August 7, 2020
Your credit score plays a huge role in your everyday life. Whether you’re applying for a loan, looking for a lower interest rate or even interviewing for a new job, your credit score can be a deciding factor.
Having a good credit score is a foundation for success.
Below, we'll explore what a credit score is, how it's calculated, and what qualifies as a good credit score. We’ll also look at what it takes to build a good credit score and what benefits it offers.
Your credit score is based on your credit report, which is essentially a financial report card. Your credit report shows your ability to handle personal finances — specifically your ability to manage debt.
There's a wide range of credit reports available. But the most important ones are from the three major credit bureaus: Equifax, Experian and Transunion.
Your credit report includes 7-10 years of personal and financial information, including your:
Applications for new credit
Current and previous addresses
Current and previous employers
Your credit score is a number that’s calculated based on the information in your credit report. It considers a wide range of factors within your credit history, including payment history, amount of debt relative to your credit limits, new credit and credit applications.
If you have a low credit score, lenders may view you as a higher credit risk, which means you're more likely to default on a loan or credit card. With a higher credit score, lenders view you as a low risk of default, meaning you’re more likely to fulfill the loan or credit card terms.
There's a wide range of credit scoring models, and each calculates your credit score differently. The most commonly used system is the FICO Score, which was developed by the Fair Isaac Corporation.
FICO Score 9
FICO Score 10
FICO Score 10 T
The most widely used credit scoring model is the FICO Score 8. This model is what most consumers and lenders mean when referring to FICO Scores.
Your FICO Score is calculated using five weighted variables. These variables and how they're weighted when calculating your score are:
Payment history (35%): This looks at your current payment history to ensure you make on-time payments. Any payments made 30 days or more after the due date may be reported as a late payment and may negatively impact your credit score.
Amounts owed (30%): Your FICO Score doesn't drop just because you owe money. However, your credit score may drop if the balances on your revolving credit accounts, like credit cards, are higher than 30% of your credit limit. This is known as credit utilization.
Length of credit history (15%): This considers how old your credit accounts are and how frequently you use them. The older the credit accounts and the more frequently you use them, the more positive the impact on your credit score. The length of your credit history includes the age of your oldest and newest accounts, the average age of all your accounts, the age of specific types of credit accounts and how long it's been since you used each account.
Credit mix (10%): This looks at the different types of credit accounts you have. Having a balance of different types of credit — credit cards, retail accounts, installment loans, etc. — can help your credit score. Whereas, having too much of one type of debt may hurt on your credit score.
New credit (10%): This looks at three areas. First, it considers how many recent
you have — the fewer, the better. Next, it considers the number of new credit accounts you've opened — the fewer, the better. Finally, it considers the amount of time it's been since you opened your last new account — longer is better.
The FICO credit score ranges and classifications are as follows:
Under 580: Poor credit
580-669: Fair credit
670-739: Good credit
740-799: Very good credit
800 and up: Exceptional credit
FICO considers a good credit score anything between 670 and 739. FICO Scores above 739 are also technically "good," but FICO classifies 740-799 as a “very good” score. And 800 or higher is an exceptional credit score. Some even consider an 800 or higher a perfect credit score.
Not all lenders follow FICO guidelines. Each lender is free to create its own categorizations for credit score. Many use different terminology altogether. For example, some lenders use the term "prime" to represent good credit and "subprime" for fair or worse credit.
If you monitor your credit score, the ups and downs may seem random and hard to follow. However, there are clear-cut methods to building a good score over time.
Since payment history makes up 35% of your credit score — the largest percentage of all the scoring factors — making on-time payments is the best way to increase your credit score.
First, make all your existing debt payments on time. If you’ve fallen behind on some monthly payments and can’t afford to get them current, contact your creditors and see if they offer any programs to help you get back on track.
If you have a credit card, you can use it to make purchases each month and pay off the statement balance by the due date. Over time, this will build a record of on-time payments that may help increase your credit score.
If you don't have a credit card and are having trouble getting approved for one, look into a secured credit card. Secured credit cards are available to those with fair credit, bad credit or no credit. Like traditional credit cards, secured credit cards report to the major credit bureaus. However, they require a security deposit that matches the credit limit.
There are also other ways to build credit without a credit card.
The amount of debt you owe makes up 30% of your credit score, making it the next heaviest factor in your FICO Score. So, this should be your next focus.
This doesn't necessarily mean the total amount of money you owe. Instead, it looks more closely at your credit utilization ratio, which is the amount of revolving debt, like credit card balances, relative to your credit limit.
For example, if you have a $1,000 credit limit and charge $750 on that credit card, you now have a 75% credit utilization ratio.
Keeping this number at 30% or lower is the target for improving your credit score.
To lower your credit utilization rate, consider two of the most popular debt payoff methods: the debt avalanche method and the debt snowball method. You can also take out a debt consolidation loan to convert those revolving debts into installment credit.
It may be tempting to close some of your old credit card accounts when looking to improve your credit score, but this can negatively impact your score.
If you close an old credit card account, you may shorten your average length of credit history, which makes up 15% of your FICO Score. Instead of closing that old account, leave it open to take advantage of its age.
Also, avoid opening too many new credit accounts. New credit accounts will lower the average age of your credit history.
The new credit factor plays just a small role in determining your credit score — it only carries a 10% weight — but you have a direct impact on it by limiting the number of credit applications you submit. With each credit application comes a hard credit inquiry.
Each hard inquiry takes five points or fewer from your FICO credit score. One credit inquiry may not matter, but too many can have a big impact. By keeping these to a minimum, you may not increase your credit score, but you'll avoid doing more harm.
If you already have a lot of credit inquiries negatively impacting your credit score, your best plan of action is to avoid any additional inquiries for 12 months. FICO only considers inquiries from the past 12 months in its scoring model.
Keep in mind, checking your own credit is a soft credit inquiry, which has no impact on your FICO Score. Credit monitoring also has no impact on your FICO Score.
Credit mix accounts for only 10% of your credit score, but it’s still worth improving when you want to get a good credit score.
To build a good credit score, you want a mixture of credit cards, store credit cards and installment loans (personal loans, mortgages, etc.). Pull your credit history and check how many of each account you have. If you find there’s a dramatic imbalance toward one type of debt, you may want to open another type to balance it out.
For example, if you have five credit cards, two store credit cards and no installment loans, your credit score may benefit from you taking out a small personal loan.
There’s no need to aim for perfect balance in your debts. You only need to show some variation in the types of debt you have.
The benefits of having a good credit score include getting approved for loans and credit cards, but it goes well beyond that. It can even impact where you live and the job you get.
The best-known impact of having a good credit score is easier credit approval. With a good credit score, you represent a low credit risk to lenders, making them more willing to do business with you.
Your good credit score eliminates the need to scour various lenders trying to find one that'll accept a bad credit score. Instead, you can spend your time finding the lender with the most favorable terms.
A good score also gives you access to some of the best credit cards, including those with special interest rates, strong credit card rewards and other perks.
Having a good credit score also helps you get lower interest rates. Your interest rate is the amount the lender charges to lend you money, meaning you can save a lot of money over the course of a loan if you get a low rate.
For example, let’s say you get a $10,000 5-year auto loan. If you have a fair credit score and get a 9% interest rate, you'd pay $2,455 in interest over the course of the loan.
But if you have a good credit score and get a 5% interest rate on the same loan, the total interest you'd pay would fall to $1,323.
A lower interest rate also results in a lower monthly payment.
Using the same $10,000 5-year car loan, you'd pay $208 per month at 9% interest and $189 per month at 5% interest.
Most jobs ask for your Social Security number for tax purposes and, in some cases, a background check. Certain jobs, like working at a bank or as a law enforcement officer, may also require a credit check before you're hired. They use these credit checks to look for signs of financial distress that may lead to you acting dishonestly at work.
These employers look beyond just your credit score, but having built a good score means you likely have none of the financial red flags they’re looking for like bankruptcy, collections accounts or several maxed-out credit cards.
Many auto and homeowner insurance companies include your credit history when determining your insurance premiums. So, your good credit score may help lower your insurance premiums.
There are exceptions, though. California, Massachusetts and Hawaii forbid auto insurers from using your credit to calculate auto insurance rate. And Maryland and Hawaii don’t allow homeowners insurance companies to use your credit score to determine your rates.
A good credit score is something to be proud of, but it doesn't mean you're guaranteed approval. Your credit score is just an indicator of your credit risk. Lenders will look beyond that score and deeper into your credit report to find other red flags.
For example, you may have an excellent credit score due to great payment history and a low credit utilization rate. But your debt-to-income ratio — the amount of total debt payments you have relative to your income — may be too high for a lender to approve you for a loan or credit card.
You now have the basics of a good credit score, what goes into building one and the benefits of having one. Now it's time to step out and start building that score yourself.
You can get a free credit report and credit score estimates from a wide range of providers online. While this won't be an exact match with your FICO Score, it'll give you an idea of where your credit pain points are.
Use this to develop an action plan, using the credit-building tips above to get the good credit score you deserve.