It may sound hard to believe, but in the United States there is almost no score more important than your FICO score. Having a high FICO score can mean the difference between getting a loan and not getting a loan, getting low interests on a loan instead of high-interest rates, and even getting a job! Some people say it’s an unjust system, but the truth of the matter is if you play your cards right (pun intended), in time you will see your score soar through the roof, and you can be eligible for almost any type of credit.
In this article, I will cover all you need to know regarding credit scores from what it is, how it is measured, and how to raise your score. Here are some typical questions I will address in this article: What exactly is a FICO score? Why is it so important? Does everyone have a FICO score? How can I check my score?
The purpose of a credit score is for lenders to know whether a consumer is eligible for borrowing their money. This means that when a person applies for a loan, mortgage, or a credit card, lenders want to know if the consumer is financially responsible enough to handle the loan they may issue to them. Lenders decide whether the consumer is responsible enough based on their credit score or their credit report. If the consumer has a low score, they are deemed irresponsible and will either be denied credit or offered a smaller loan. The score aids lenders in evaluating a credit report because the number summarizes the risk.
A FICO score is a credit score that lenders use to measure an applicant’s risk and whether they are eligible for credit (loan, credit cards, and mortgage). It is created by the Fair Isaac Corporation (FICO). FICO has multiple scoring models, however, the most commonly used and important model is the FICO®Score 8 model.
Base FICO Scores range from 300-850 and industry-specific scores range from 250-900. A Base FICO Score is designed to predict the likelihood of paying on time on any type of credit, whereas the industry-specific FICO Score is designed to predict the likelihood of paying on time on a specific type of credit. Base FICO Scores are a component of industry-specific scores, and as a consequence, are highly correlated with one another. The chart below defines the range you fall in based on your score. A 670 or above is what every consumer should at least aim for to qualify for any type of loan.
For starters, NOT everyone has enough information to have a FICO score. However, the majority of adults do have scores. In order to be eligible for a score, you must have a credit card account (that has been reported to a credit reporting agency) opened for about six months. The credit report must also show an account that has been updated after six months. After these six months, you will have an official FICO score.
Lenders also report your credit usage and information to consumer reporting agencies. Consumer reporting agencies are the corporations that use the FICO scoring models (or Vantage scoring models) to determine your score. According to FICO’s website, 90% of major lenders use FICO Scores to make their lending decisions. There are three national consumer reporting agencies in the United States: Equifax, Experian, and Transunion. Most of the consumer information collected by the bureaus are similar (and they usually use similar scoring models) resulting in similar scores within all three bureaus. However, not all lenders report to all three agencies so there are oftentimes discrepancies between the bureaus. This can result in different scores. Some of the bureaus may also store information differently from one another, again resulting in slightly different scores.
When determining a FICO Score, there are five key components: payment history, credit utilization, length of credit history, new credit, and types of credit.
- Payment History (35% of score) - It’s as straightforward as it sounds. This factor looks at the history of your payments. In other words, it focuses on whether you paid your bills on time, or whether you have any debt, foreclosures, bankruptcies, etc. If you have any of the above, your score will dramatically decline. So the key to having strong payment history is to always pay on time and make sure you don’t have any outstanding debt. Also, if you have accounts that have gone to collections, you will appear far less attractive as a consumer. Since it compromises 35% of your score, it is the most important factor and should be a consumer’s top priority when borrowing credit.
- Credit Utilization (30% of score)- This takes into consideration your debt-to-credit limit, or the ratio of what you use to the limit you are loaned. The less you use the better, but it is better to use a little bit than nothing at all. The key to an optimal score is using less than 10% of your utilization. But if you are satisfied with a fair score than use no more than 30%.
- Length of Credit History (15% of score)- Simply put, the longer your credit history the better. This means those who have been using credit for longer periods of time, have the oldest accounts, and have a higher average age of accounts, are at an advantage. According to creditkarma.com, having an average age of nine or more years means an excellent length of credit history (while zero to two years is very poor, two to four years is poor, five to six years is fair, seven to eight years is good).
- New Credit (10% of score)- Another component of your credit score is how many new accounts you have, and the most recent time a new account was opened. If you opened too many new accounts in a short period of time, you are thought to be at a higher credit risk and your score may be lowered. So the key here is to have some new accounts once every so often.
- Types of Credit (10% of score)- Finally, FICO also determines your score by determining the variety of credit you have. If you have a multiplicity of credit, such as installment loans, mortgages, and credit cards, the higher your score will be. It also looks at how many total accounts you have. It is not advisable to open different types of accounts just to raise your score. If you don’t need a loan, don’t take one.
Credit scores are incredibly important, and there are many perks associated with having a high credit score. The higher score you have, the lower interests rates you get on a mortgage. This tends to be overlooked but in the long run you will save thousands of dollars. You also have a much better chance of getting approved for a loan, as well as a higher credit limit which leads to an even higher score because of a there being more credit available (debt-to-credit limit). Another advantage of a high score is negotiating power. Since you’ve proven to the lenders that you are financially responsible, you can negotiate with your lenders asking for lower interests rates on your credit cards. Since they are competing for business, if you tell them you found a better rate somewhere else, they will likely lower their rate just to keep your business.
As aforementioned, having a poor credit report has been associated with unemployment. While companies do not have access to the scores themselves, they have access to the reports. Certain companies will not hire you just based on your report, because poor credit is often linked with theft and misappropriation of funds. Additionally, hiring someone with a poor credit report may cause a company to suffer litigation from “negligent hiring.” As a result, it is more than crucial to focusing on building a strong credit report.
Any consumer must know that there is something known as an “inquiry”, which is the authorization you give to the bureaus to release your credit report. There are two types of inquiries: a “soft inquiry” and a “hard inquiry”. A “soft inquiry” is when you are not authorizing your lender to review your report, but rather you are authorizing it for yourself. Soft inquiries may be pulled at any time upon request, and do not affect on your score. A soft inquiry is also when a business makes credit checks or offer your services or promotional offers. Hard inquiries are inquiries where you authorize a lender to view your credit report to see determine your eligibility for credit. This happens whether you are applying for an auto loan, credit card or mortgage. This will negatively impact your score and it is best to have fewer hard inquiries. However, if you are “Rate shopping” for the best interest rates for a specific type of loan in a period of 45 days, that will only be treated as one hard inquiry and will have little to no impact on your score.
Every year, every consumer is entitled to one free credit report a year. These credit reports may be found by visiting annualcreditreport.com. This is the safest site to view your credit report as it is endorsed by the Federal Trade Commission. Other sites may be out to steal your identity, so stick to that website to ensure safety. It is highly suggested to view your credit report every few months to make sure there are no derogatory marks and theft on your report. It is quite common to have errors on a report which can severely impact your score, so definitely order your free report. To check your scores, you can purchase a monthly or yearly package from any (or all) of the three credit bureaus. Some offer trials for $1 where you can check your score and report and cancel the trial before the period ends to avoid monthly charges.
While the more accounts you have the better, there shouldn’t be too many opened in a short period of time. There is no rule of thumb as to how many accounts you can open without a huge impact, but opening a few in a few years is the safe route to take. According to FICO, “people with six inquiries or more on their credit reports are eight times more likely to declare bankruptcy than people with no inquiries on their reports.” As a result, they are seen as more vulnerable.
The most important lesson from all this is to not spend what you don’t have! Unless it is a case of emergency, no should EVER spend more than they can afford to pay back. Keep in mind interest rates are high on credit cards, so you will owe even more than you borrowed if you can’t pay your bills on time. Play by the five rules above and you will have a high credit score.