Credit

Why Are Credit Scores Important?

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 personal loans, mortgage loans, business loans, auto loans, and, credit cards. But credit doesn’t only affect your ability to access lending products. Your credit 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. Your credit report 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 report 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 credit 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), the credit limit or loan amount, date the account was opened, available credit, and payment history. This section of your credit report 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 report. 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 report 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 report 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 report 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 score while consistent timely payments will boost it.  

Amount Owed

The total amount you owe on your credit 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 utilization ratio 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 utilization 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 credit accounts as well as the ages of your oldest and newest accounts. The more established your credit 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 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 report. 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:

Get Your Free Credit Report

Thanks to the Fair Credit Reporting Act, every consumer has the legal right to one free credit report every year from each of the major credit reporting agencies. We recommend checking your annual report so you can keep track of the changes in your credit score and make sure you are on the right path. 

Checking your credit as often as you are able will also allow you to catch any errors or inconsistencies as soon as they appear. If you find issues with your credit score, you can immediately dispute them with the credit reporting agency before they have a chance to cause too much damage. 

Reduce Your Credit Utilization

Paying off a portion of your credit card balances can have an impressive impact on your credit score. Your credit utilization ratio accounts for a significant part of your credit score’s calculation so reducing the ratio to the suggested 30% could make a huge difference. 

Keeping your available credit high and used credit as low as possible is a sure sign of responsible credit management. If you are able, most financial experts recommend borrowers pay off the entirety of their credit card balance every month for an excellent FICO credit score. Doing this will also save you a significant amount of money on interest. 

Stop Applying for New Credit

If you are someone who is always looking for the next best credit product, consider taking a break from applying for any new credit. Too many hard inquiries on your credit profile can result in a low credit score. Put a pause on any new applications for loans, credit cards, retail cards, or similar. Once you give your credit file some time to recover, you can begin applying for new products and services again.

Never Miss a Monthly Payment

The true key to a good credit score is to never have a late or missed payment in your payment history. If you already have some negative marks in your payment history, you can still improve it with consistent on-time payments. It’s important to be patient and just keep at it because eventually those late payments will fall off your report leaving only the good marks you’ve been working hard to maintain. 

Good credit does not happen overnight. It takes time and perseverance but it will well-worth the effort you put in. Your credit score is central to so many aspects to your life from what financial products you have access to all the way to where you live and who you work for. Once you achieve the credit score you have been aiming for, an entire world of opportunities will open up to you!

References:
Why Your Credit Score Is Important | NextAdvisor with TIME
Why Do You Want a Good Credit Score? | Experian