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Why are credit scores important? 

why are credit scores important

Credit scores are important because they give financial institutions and lenders a quick summary of a consumer’s financial history, making it easier and faster for them to approve qualified borrowers for loans, lines of credit, and other financial products. According to USA Today, the average credit score in the United States is 702.1

It can catch you off-guard when you realize how significantly your credit score affects so many different aspects of your life. Many people wonder what makes credit scores so important that they carry so much weight. So many opportunities—both financial and otherwise—are dependent on a consumer’s credit score. 

To better understand why credit scores are important, we are going to break down exactly what is included on your credit report and how your credit score is calculated using that information. Additionally, it is a good idea to understand why that information matters to lenders, landlords, and employers.

Why Credit Scores Matter 

Credit scores are widely accepted as a generalized measurement of your financial reliability. Lenders and businesses will often equate your creditworthiness with your responsibility. Good credit is looked on positively by those considering whether they want to lend you money, go into business with you, or lease an apartment to you. A good credit score can open a wealth of opportunities to you while poor credit can greatly diminish them. 

With a high credit score, you are more likely to be approved and offered better interest rates when you apply for lending products like a personal loan, mortgage loans, business loans, auto loans, and credit cards. But credit doesn’t only affect your ability to access lending products. Your financial history has the potential to impact your ability to rent a car, be hired for a job, get insurance, and lease an apartment. 

To improve your credit score, it’s wise to educate yourself on how credit scores work and what information is crucial to their calculation so you can make the appropriate changes in your financial behavior.  

What Is Included in Your Credit Report?

Credit reports are compiled by three credit bureaus—TransUnion, Experian, Equifax. These three credit bureaus gather all information deemed relevant to the entirety of your credit history and organize it into a neat report that can be requested by approved parties using a credit scoring algorithm. Your credit profile is divided into four general categories of information: personal information, credit accounts, credit inquiries, collection and public records.  

Personally-identifying Information

Your personal details are included in your credit profile simply to make it identifiable as yours and won’t be used in the calculation of your credit score. Information included in this section of your report will include your full name, date of birth, address, Social Security number, and employment information. The employment information is typically pulled from credit applications you’ve filled out in the past.

Credit Accounts

All your past and present financial accounts will be included providing important details like the type of account (i.e. credit card, business loan, student loan, auto loan, online cash advance loans), the credit limit or loan amount, date the account was opened, available credit, and payment history. This section of your credit profile plays the biggest role in determining your credit score.

Credit Inquiries

Every time that a credit check is performed, whether by a lender, a landlord, or an employer, a new inquiry appears on your report. Whenever you apply for new credit, you are authorizing the creditor to pull a copy of your report from one of the credit bureaus. This will typically result in a hard inquiry on your credit profile. The exceptions to this include pre-approval offers and when you check your own credit. 

Public Records & Collections

The final pieces of information included on your credit profile are public records and collections accounts. Public records from state and county courts noted by the credit bureaus are ones deemed relevant to your creditworthiness, like repossessions, foreclosures, and bankruptcies. When unpaid debts are passed off to collection agencies, new collection accounts will appear on your credit profile and result in a derogatory mark.

How Your Credit Score Is Calculated

While not all credit scoring models are the same, the FICO score is the most widely recognized and accepted credit scoring calculation. The FICO score is a three-digit number ranging from 300 to 850. Knowing the state of your FICO score is a good tell for your overall credit health. The FICO score breaks down all the information included on your credit profile into five basic categories, each of which accounts for a percentage in the calculation.

Payment History

Your payment history accounts for the largest percentage in your score’s calculation at 35%. Late or missed payments on credit cards or loans will result in harm to your credit  while consistent timely payments will boost it.  

Amount Owed

The total amount you owe on your financial accounts makes up 30% of your credit score calculation. A major factor in this portion of your score’s calculation is your credit utilization ratio. Your credit usage rate compares your used credit to your overall credit limit. Having more available credit is better for the health of your credit score. The ideal credit usage rate is 30% or lower.

Length of Credit History

The age of your credit history makes up 15% of your credit score. The calculation uses the average age of your financial accounts as well as the ages of your oldest and newest accounts. The more established your financial history is, the better.

Credit Mix

Your credit mix is the variety of credit accounts you have and accounts for 10% of your credit score’s calculation. A lack of variety can hold you back so it’s a good idea to have a good mix of different types of credit and financial accounts. 

New Credit

The new credit portion of your credit score is worth 10% in the calculation. New credit will include recently opened credit accounts as well as all hard inquiries appearing on your credit profile. Too many hard inquiries in a short period of time can bring your score down.

Tips for a Good Credit Score

If you’ve experienced the negative effects of a poor credit score, the good news is that there are actions you can take to improve your credit over time. Good credit is within your reach if you alter a few of your financial habits. Every time you borrow money, your credit score will be impacted so it is of vital importance that you prioritize responsibility.

There are several things that financial experts say you can do to achieve a good credit score. Here are some tips that have proven helpful in boosting your credit score so you can access better opportunities:

Tip Category Action ItemDetails
Get Your Free Credit ReportAnnual credit profile check.Check credit reports regularly from all three major credit bureaus under the Fair Credit Reporting Act. Regular checks help monitor changes and stay on the right financial path. 
Dispute errors.Check your credit frequently to catch and dispute any errors or inconsistencies with the credit reporting agency promptly.  
Reduce your Credit Usage Pay off credit balances. Reduce your credit utilization to 30% or lower by paying off credit card balances, which significantly affects your credit score. 
Maintain high available credit. Aim to keep your available credit high and used credit low; pay off the full credit card balance monthly if possible, to avoid interest and improve your FICO credit score. 
Stop Applying for New CreditPause on new financial / credit applications. Take a break from applying for new credit to avoid too many hard inquiries, which can lower your minimum credit score. Give your credit file time to recover before applying for new financial or credit products. 
Never Miss a Monthly Payment Ensure on-time payments. Consistently make payments on time. Late or missed payments negatively affect your credit score, but a history of on-time payments can improve it. 
Patience and consistency. Understand that improving credit takes time. Continue making timely payments, and eventually, negative marks will diminish, leaving a positive payment history. 
Overall Credit HealthLong-term credit management and perseverance. Good credit is the result of long-term responsible financial behavior. It’s central to accessing various financial products, housing, and employment opportunities. Achieving a good credit score opens up a world of opportunities in your financial life. 

Credit Scores: FAQ

What are credit scores?

Credit scores are numerical expressions based on a level analysis of a person’s credit files, representing the creditworthiness of an individual.

How do credit scores affect my daily life?

A credit score can influence the outcome of your loan and credit applications, the interest rates you receive, and may even be considered by potential employers or landlords.

Can a good credit score improve my chances of getting a mortgage?

Yes, a good credit score can significantly improve your chances of being approved for a mortgage and may result in more favorable loan terms and interest rates.

Does my credit score impact my insurance premiums?

In many cases, yes. Some insurance companies use credit scores to determine insurance premiums, with the rationale that a higher credit score indicates more responsible behavior.

How often do credit scores change?

Credit scores can change whenever new information is reported to the credit bureaus, such as your monthly bill payments, changes in credit utilization, or inquiries for new credit.

What’s the difference between a credit score and credit reports?

A credit report is a detailed breakdown of an individual’s financial history prepared by a credit bureau, while a credit score is a numerical value that summarizes that information.

Can closing old financial accounts affect my credit score?

Yes, closing old credit accounts can affect your credit score by potentially shortening your financial history and altering your credit utilization, which can be a negative factor.

Is it possible to have a good credit score without having a credit card?

Yes, it’s possible to build a good credit score through other forms of credit, such as loans or credit-builder programs, but having a credit card and using it responsibly is one of the more common methods.

How can I protect my good credit score from identity theft?

Regularly monitor your credit profile for unauthorized activities, set up fraud alerts, and consider credit freezes if necessary to protect your credit score from the impacts of identity theft.

What should I do if I have no financial history at all?

You can start building a financial history by applying for a secured credit card, becoming an authorized user on someone else’s card, or using a credit-builder loan. It’s important to then use credit responsibly to build a good credit history.

A Word From CreditNinja About Credit Scores 

At CreditNinja, we’re not just about providing installment loans; we’re committed to helping you take control of your finances once and for all! That’s why we offer tons of free resources designed to guide you through the ins and outs of credit, managing a budget, handling your finances, and more! Whether you’re starting from scratch or looking to bolster an already established credit history, CreditNinja has something for everybody! 

References:
1. What is the average credit score in the U.S. by state? | USA Today
2. Why Your Credit Score Is Important | NextAdvisor with TIME
3. Why Do You Want a Good Credit Score? | Experian

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