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Understanding Credit Score

Credit chart

Your credit score is one of the most critical factors in your financial life because it determines whether your credit application will be approved, what loans you will qualify for, and the interest rate you will pay. In essence, the higher your credit score, the more competitive interest rates and terms you’ll be offered on homes, vehicles and credit cards because of your credit advantage. In essence, this means that borrowing will be relatively cheaper for you. Essentially, improving your credit score provides tremendous advantages.

The opposite is also true; the lower your credit score, the more credit risk you will represent, and the higher the rate of interest you’ll pay, which means the more expensive it will be to borrow. Interestingly, most employers now check your credit score before hiring.

To give you an idea of how important it is to have a good credit score, consider this: improving your FICO credit score from 501 to 661 can save you approximately $315 per month over the life of a 30 year mortgage. You will also get a better interest rate on your credit cards, personal loans, car payments and insurance premiums.

The difference in savings between good and bad credit is huge. Having a good credit score can also mean the difference between getting and not getting your dream job. Improving your credit score can quite literally, change your life!

What is Credit Score?

Credit score is a mathematically calculated number developed by the Fair Isaac Corporation (FICO) that is used by lenders to evaluate potential customers. It is a dynamic number, changing according to what you pay off or charge up. Using a statistical program, creditors compare this information to the loan repayment history of consumers with similar profiles.

For example, a credit scoring system awards points for each factor that helps predict who is most likely to repay a debt. A credit score helps predict how creditworthy you are: how likely it is that you will repay a loan and make the payments when they’re due. Essentially, a lower score limits opportunities for competitive credit offers and makes you more susceptible to predatory lending. Now just to be clear, FICO itself is not a credit reporting agency. Lenders merely use FICO credit scoring model to determine future credit risk. A FICO score places a value on the types of credit accounts you hold or have held, and your credit history in maintaining those accounts.

According to MyFICO.com, your credit score or credit rating is determined by using five main criteria. Here’s a breakdown of how your FICO score is calculated:

credit score graph

  • Payment history (35%): As you would expect, paying your bills on time gets you a good score, while paying them late on a consistent basis will mark down your FICO score. The activity within the most recent two years carries the most weight in factoring your credit score. If you have had debts referred to a collection agency, this is worse still, while declaring bankruptcy is the worst of all. So if you’re good about making payments on time, your credit score will increase. According to the site: “A few late payments are not an automatic ‘score-killer.’ An overall good credit picture can outweigh one or two instances of late credit card payments.”
  • Amounts owed (30%): Lenders want to know how much you owe. It is not just what you owe already that affects your FICO score. Also taken into account is the amount of credit available to you. For example, if you have a credit line of $5000, but have so far only used $1000, that will be taken into account. Your total amount of credit will be totalled, and compared to your annual income. So, loans such as car loans, mortgages, credit cards, store cards, will all be added together. The key here is to never max out your credit cards. Those who use most or all of their available credit will get a lower rating for this part of the FICO score calculation.
  • Length of credit history (15%): A longer credit history will increase your FICO score, according MyFico.com. The longer your credit history, the better for your FICO scores. Additionally, though, a long history with any particular lender will be good for your credit score. FICO also takes into account how long you’ve been actively using those accounts.
  • Types of credit (10%): For example, do you have only high risk unsecured type credit, or do you also have some solid secured loans such as a home mortgage? Those consumers who have a mix of credit have higher a FICO score. It also looks at the amount of accounts you have open. MyFico adds that closing an account doesn’t make it go away; it will still show up on your report.
  • New credit (10%): Whenever you fill out an application form for new credit or get a credit check, it is a hard inquiry. The number of hard credit inquiries you have, as well as when the last hard credit inquiry occurred is factored into your credit score. Typically the activity within the last two years is noted, with the hard inquiries of the past year having the most impact. A lot of inquiries into new lines of credit can lower your score because it puts lenders “on alert” that something may be wrong.

The FICO credit score model ranges from 300-850 with 850 being an excellent score and 300 being the worst. The higher the credit score, the lower the interest rate you will receive for a loan or line of credit. Your credit score changes due to updates to your credit file which changes based on account activity such as balance changes or additions to your credit file (i.e. new accounts or deletion of older negative accounts more than 7 or 10 years old). As a result, you may see a difference in your score from one month to the next.

Here is a breakdown of the credit score ranges. Your credit score will vary from one bureau to the next because each agency collects their own data from various sources and may collect different data for the same account. These are not set in stone because each lender will have their own definition of what is a good, excellent or bad credit score, and your score can vary anywhere from 5-40 points between the three credit bureaus.

  • 781- 850: Excellent: – this will get you the very best rates.
  • 661-780: Good – you’ll need at least a 680 Fico score in order to get a good car loan. Just a few points below and you’ll be considered a higher credit risk consumer, which translates into much higher rates.
  • 601 – 660: Fair – although you’ll still get credit with some lenders, you’ll be paying very high interest rates.
  • 501 – 600: Poor – you’ll find it difficult to get credit, and even when you do, the rates will be astronomical for everything you don’t pay for in cash.
  • 500 or less: Bad – this means your credit score is well below the average score of U.S. consumers. Lenders will consider you to be a precarious borrower, and you will find it very hard to obtain credit..

The three major credit bureaus Experian, Equifax and TransUnion use the FICO credit score model. Your 3 FICO scores make all the difference. This will affect both how much and what loan terms (interest rate, etc.) lenders will offer you at any given time. Each credit bureau subscribes to the Fair Isaac’s FICO model of scoring and then integrates their own version of a consumer’s FICO score. Equifax uses the Beacon credit score, Experian uses the Fair Isaac or Plus score and TransUnion uses the Empirica score. The Equifax Beacon score ranges from 340-820. The TransUnion Empirica score ranges from 150-934. The Fair Isaac or Plus score ranges from 330-830.

The higher your credit score, the lower your risk. This means consumers with higher scores are more likely to get approved for credit with the best interest rates when they do. To put this into perspective, consider this: if you’re buying a car and have bad credit, you could end up paying more than $5,000 more for that car over the life of the loan than if you had good credit.

Contrary to popular belief, the following criteria are not factored in when calculating your credit score:

  1. Your age, race, gender, marital status, religion or national origin.
  2. Whether or not you rent or own your own home.
  3. Your salary, occupation, title or employer.
  4. How long you’ve been at your current job.
  5. Where you live.
  6. How long you’ve been living at your current address.
  7. Whether or not you’ve been denied credit.
  8. Any information that is not found in your credit report.

Note however, that the above may be considered in addition to using your credit score by lenders when considering your application for credit or a loan.