“You can’t judge a book by its cover” – this is why banks, and other lenders, cannot determine your credit worthiness based on the way you look. Instead, lenders will look at your credit score to determine how reliable you are. It’s important that lenders trust you to pay back a loan or your chances of getting one will greatly decrease! This article will educate you on credit score basics and how your credit score works.
Credit Score Basics: What is a Credit Score?
Your credit score is a number that ranges from 300 to 850 and is composed of many different factors. Lenders use this number to determine your credit worthiness and if there is a chance you will default (not pay back) on the loan.
The higher your credit score, the better credit you have, leading to a ton of future benefits! Here’s a break down of the credit score range and the type of credit each score represents –
- 300-580 = Bad Credit
- 580-640 = Poor Credit
- 640-700 = Fair Credit
- 700-750 = Good Credit
- 750-850 = Excellent Credit
What Determines Your Credit Score?
Your credit score is determined by a number of financial factors. Some of these factors are more important than others, but knowing them all will help you understand your credit in depth.
- Payment History – This has a high impact on your credit score. Do you pay your bills on time? If you have a history of making late payments, you will have a lower credit score resulting in higher interest rates or getting declined credit all together.
- Credit Utilization – This also has a high impact on your credit score. How much of your available credit are you using? Maxing out your available credit will reduce your credit score. The more debt you have, the harder it gets to pay back, making you a riskier borrower.
- Derogatory Marks – Once again, this has a high impact on your credit score. This number represents the number of accounts you have in collections, foreclosures, or bankruptcy. Derogatory marks show a lender you have failed to pay back money in the past, resulting in having a bad credit score.
- Age of Credit History – The average length that your accounts have been open. The longer your age of credit history, the better. This shows banks you have had debt before and you know how to mange it. A short credit history along with a bunch of loans is a red flag for lenders.
- Credit Inquiries – The number of hard inquiries (applying for a new line of credit) you have had in the past 2 years. A lot of inquiries will make it look like you are applying for credit but not getting approved. Keep this number low.
- Total Accounts – Total number of opened and closed credit accounts you have had. Having a variety of credit accounts shows lenders you have experience which different types of credit. Which shows other companies trusted you.
Why You Want a Good Credit Score
A good credit score is essential to anyone who needs to buy something but doesn’t have the money to do so. This is relevant when buying a home, car, or any big-ticket item most people can’t buy outright with cash.
Most importantly, having a good credit score shows that you are responsible and follow through on deals you make. Too many people think bills are just bills, when really they are legal obligations you agreed to.
GOOD CREDIT SCORE = LOWER INTEREST RATES
Here’s an example of 3 friends, all buying the same $20,000 car, but each person has a different credit score; therefore get different interest rates on their auto loans. The total amount of money they spend on a car over the life of the loan includes all principle and interest payments –
- Friend 1 has good credit (3% interest) and pays a total of $21,562.46 for the car
- Friend 2 has fair credit (6% interest) and pays a total of $23,199.37 for the car
- Friend 3 has poor credit (12% interest) and pays a total of $26,693.30 for the car
- Check out the full article on interest rates and how they affect your purchase here.
The difference between having a good credit score and having a bad credit score couldn’t be anymore obvious with the example above! Understanding this basic example in credit score basics will help you make better financial decisions.
Credit Score Basics: Having a Bad Credit Score
In simple terms, having a bad credit score means everything will cost you more. What do I mean by this? Having a bad credit score leads to higher interest rates when you need a loan to make a purchase.
As the example above shows, higher rates mean you spend more on your purchase in the long run. Besides receiving bad loans, you might not even get approved for new credit by having a bad credit score.
In conclusion, I hope you learned some credit score basics and why this number is not one you want to ignore. With simple education, anyone can be an expert on credit and how your credit score works! This is just another step to managing your personal finance responsibilities.