Why Is Credit Score Important?: Your Questions Answered
Your credit score conveys your creditworthiness to lenders. It plays a critical role whenever you’re looking to open a new credit account.
Contributing Writer at Tally
January 19, 2022
When you receive your credit card statement each month, you may notice a section titled, “Credit Score.” In this section, you’ll see a three-digit number along with an indication of whether this number increased or decreased since the prior month.
It’s easy to glance over this number and wonder, “Why is a credit score important?”
We’ll outline what credit scores are, how they work, why they’re important, the impact they can have on your life and how to improve them.
What is a credit score?
A credit score is a three-digit number that serves as a summary of your creditworthiness. It quickly conveys to lenders the likelihood that you, as a borrower, are going to repay loaned money on time and in full.
The higher your credit score, the more willing a lender is going to be to work with you and offer you the best interest rates.
How do credit scores work?
Credit scores work by taking the information on your credit report and converting it to a three-digit number. When there is any sort of activity on one of your credit accounts — good, bad or indifferent — your lender will report it to the credit bureaus.
There are three major credit bureaus:
There are then two major credit scoring agencies that request and use info from the three major credit bureaus to come up with your credit score. Those two agencies are FICO and VantageScore.
The FICO and VantageScore credit scoring models generally consider the same factors but weigh them a bit differently.
Your FICO credit score is calculated based on the following:
Payment history: 35%
Amounts owed: 30%
Length of credit history: 15%
Credit mix: 10%
New credit: 10%
VantageScore doesn’t define the exact percentages they use to determine scores, but the general breakdown of factors is as follows:
Total credit usage, balance and available credit: Extremely influential
Credit mix and experience: Highly influential
Payment history: Moderately influential
Age of credit history: Less influential
New accounts: Less influential
Anything that involves your credit accounts — a missed payment, opening a new account, etc. — can impact your credit score. This, in turn, can have an effect on the rest of your personal finances.
Why is credit score important?
When you apply for a new credit account, your lender is going to look at your credit history and score to determine the likelihood of repayment. If you have an excellent credit score — the highest possible is 850 — then your lender will extend you the most favorable terms on your loan. You’ll probably receive lower interest rates and a potentially longer loan period.
If you have a poor credit score — the lowest is 300 — you will have much stricter terms and conditions.
Whether you have a good or bad credit score, your future efforts to borrow money will be impacted. Your credit score directly impacts your ability to take out:
Lines of credit
Your credit habits and the way you manage your money are important. Your credit score can help or hurt your personal finances depending on how you use it.
How can a credit score help you?
As we mentioned above, a good credit score increases the likelihood of receiving better terms and rates from a lender. This can ultimately save you money on interest.
For example, let’s say you take out a $200,000 mortgage with a 30-year term. At a 3% interest rate, you’ll pay $103,480 in interest. At a 4% interest rate, you’ll pay $143,800 in interest. That’s a difference of more than $40,000!
A strong credit score also offers you buying power on larger purchases, like an auto loan. If you have a poor credit score, you may not be able to find a lender willing to work with you. Having a good credit score provides you with lending options that you do not have if you have a poor score.
How can a credit score hurt you?
A poor credit score can become a hindrance. As we mentioned above, you will likely receive less-than-favorable terms from your lender. You may find yourself paying more in interest or struggle to find a lender willing to work with you at all. This could have a direct impact on your life, as it can affect your ability to buy a car or a home.
How can you improve your credit score?
If you don’t have a great credit score, there are some things that you can do to improve it. Keep in mind that it may take at least 30 days for changes to show up on your credit report.
Improving your credit score takes time and will not happen overnight. But, implementing a few of the following ideas and concepts can help you build credit.
Make on-time payments
When you borrow money, you will have monthly payments due. Missing these payments will harm your credit score. At the very least, try to make the minimum monthly payments each month. This goes for everything from your credit card to your mortgage.
If possible, paying more than the minimum is also a good idea since it can save you money on interest in the long run. Ideally, you would pay off your credit card statement in full every month to avoid debt.
Keep your credit utilization rate low
Your credit utilization ratio measures how much of your total available credit you’re using.
Your total available credit is the sum of all of your credit limits. For instance, let’s say you have three credit cards: One has a limit of $5,000; the other two have limits of $2,500. Your total credit limit would be $10,000.
Your credit utilization ratio divides the portion of your credit being used by the credit limit. Let’s say, for simplicity’s sake, that you have maxed out all of the credit cards listed above. Your credit utilization ratio would be 100%.
If you want a better credit score, it’s recommended to keep your credit utilization rate below 30%. Based on the example above, in order to maintain a 30% ratio, the total sum of your balances should not exceed $3,000. Paying down balances or requesting a credit limit increase can help improve your utilization rate.
Review your credit report
You’re allowed access to one free credit report each year from annualcreditreport.com. Reviewing your credit report allows you to identify inconsistencies that could be pulling down your score. More than 34% of respondents in a Consumer Reports study found at least one error on their credit report.
Use a secured credit card
A secured credit card is one in which you put down a security deposit that acts as collateral. This security deposit becomes your credit limit. You can borrow against the limit continually.
If you max out the card, you will need to pay down a portion of the balance before you can borrow against it again. A secured card can be a useful tool when it comes to building credit.
Your credit score impacts your financial future
As a borrower, it’s important that you are aware of your credit score. Your credit score conveys to lenders how likely you are to repay borrowed funds. The higher the score, the more favorable terms you may receive from a lender. A higher score also increases the likelihood that you’ll be able to secure lending for major purchases.
If you’re looking for more financial resources, tips and tricks, be sure to subscribe to Tally’s free email newsletter.