Are you wondering why your credit score is important and how you might improve it?
At some point, you will most likely need to apply for credit. Then, when you apply for credit, you must demonstrate to your lender that you can repay the loan. Lenders use a tool to build that trust, among other things, is your credit score.
Your credit score is usually the first thing a lender will check. Specifically, there are 3 primary credit reporting agencies in North America: Experian, Equifax, and Transunion. All three credit reporting agencies are used in the United States, while only Equifax and Transunion are used in Canada.
Lenders may choose to check one or more credit reporting agencies. To make it even more complicated, each credit reporting agency has various iterations of its credit score. So your score may be different, depending on the credit reporting agency.
What Is The Credit Score Made Up Of?
Your credit score is a 3-digit number (Usually between 300-850) and is created by a mathematical algorithm made up of the following (According to FICO):
- 35% – Payment History and for how long. The more “on-time” payments, the better!
- 30% – Credit Utilization – It’s vital that you keep LOW balances. Your credit score will be penalized if your balances exceed 25-35% of your limits. Pro tip: High limits and low balances are essential!
- 15% – Credit History Duration – The longer, the better!
- 10% – Types of credit used – i.e., Credit Cards, Lines of Credit, Installment loans, Car Loans, and sometimes even mortgages.
- 10% – Credit checks – The more you apply for credit, the more you will be seen as a credit seeker, and the lower your score will be.
What does an Excellent Credit Report Look Like?
From my experience working with credit reports, those with the highest credit scores seem to have a few key factors in common:
- They keep very few accounts open (3-4 at most)
- The credit limits are high, and balances are low.
- The accounts have been open for many, many years
- Payments are always reported on time, and
- These consumers rarely apply for new credit (1-2x a year, at the high end)
Why Would You Want a High Credit Score?
Easy and cheap access to financing large purchases when you need it. For example, your mortgage will likely be the single largest purchase of your life, followed by your car, and there’s (almost) nothing worse than being declined for the funds you need to buy your dream home or car. Or worse, having to pay a much higher interest rate than someone with a higher credit score.
If getting a mortgage is essential to you, keeping your credit score as high as possible – will help get you the very best possible rates. Interest rates on a mortgage are very important as they are based on a high amount of borrowing – so even the slightest point difference can make hundreds, thousands, and even 10,000+ of dollars of difference.
Obtaining a credit card with a higher credit score is also usually easy. If you cannot apply for a credit card due to a low credit score, you might consider a secured credit card and pay it off regularly for at least a year. Then, ask for your card to be converted to an “unsecured” version.
Tips For Improving your Credit Report (Quickly)
Look to keep very few (i.e., 3 or 4) accounts open. For example, keep a credit card for daily use which is paid off in full regularly (I.e. NEVER pay credit card interest). Have a line of credit (with a low-interest rate), and keep a low balance. So with that, CLOSE the accounts you don’t use.
If you are VERY good with your money, ask for credit limit increases. ***Careful though, this can be a double-edged sword if you aren’t good with money.
Second, work to pay off your balances as fast as possible. Credit cards, car loans, student loans, etc. As these are paid down, your credit score should rise.
What Happens if I Have a Low Credit Score?
- You’ll be paying more for interest if you are granted credit.
- It will be more difficult to obtain credit when you need it.
- Banks will generally require more documentation (employment info, tax returns, etc)
Having a mortgage and car loan won’t hurt, but be sure to make all your required payments on time. As for old credit accounts, the popular belief is to keep them. I recommend keeping the oldest one and not worrying about the others. I keep the old credit card account open for this purpose – I also keep it as a backup because I’ve had it for 20+ years.
Credit Score Ranges?
- 500-650: Could use some work. The lender needs some help to extend your credit. You’ll likely have difficulty obtaining new credit if you’re in this category. Your credit file is either relatively new or you have some missed payments.
- 750-800: This is the sweet spot. The lender will believe you can pay. At 750, a lender will consider this a “litmus” test and then, subject to their lending criteria, may review other factors (income, employment, net worth, etc.).
- Anything over 800, and it’s irrelevant. It’s true, you’re a Rock Star! Credit is generally easily obtained at this level as the lender will believe you can pay. If you are declined for new credit, it’s likely due to an extenuating circumstance (i.e., you reached an upper limit, threshold, etc).
What Happens If I Miss a Payment?
Missing a payment indicates you might be in a debt spiral. It depends on how many days were missed. For example, if you have a credit card and the statement’s minimum payment is $100, due on March 25, and you pay it on March 26, – there’s likely no issue. Watch out if you are 30, 60, 90, or 120 days late. These are late payments and can significantly drop your score almost overnight. Then, it can take many months and perhaps years for your credit score to recover from such an incident. So, make (at the very least) your minimum payments on time!
Final Thoughts About Your Credit Score
It’s essential to regularly check your credit report. Just like checking your bank balances frequently, errors might come up on your credit report. Those errors should be disputed. This can also help prevent a catastrophe should your identity be stolen.