Understanding Credit Scores: What They Are and How They Work

Your credit score impacts many areas of your life, both now and later. From getting the best rates when buying a home to opening a new cell phone plan or getting better insurance rates, your credit score can help or hinder you. Increasing your score can give you leverage to save money on interest costs, and help you get approved for things you apply for, like an apartment or auto loan.

What's the Purpose of a Credit Score?

A credit score is a simple way to show how you’ve managed credit over time. It helps lenders quickly understand how likely you are to repay money you borrow. Your score plays an important role in everyday financial decisions, like getting approved for a loan, qualifying for better rates, or securing an apartment.

Why a Good Credit Score Matters

If you want to buy a house or a car, you probably know your credit score will be a factor in the process. Based on how high the number is, you can get approved for better interest rates. The lower your score, the more likely you’ll be paying more on interest over the duration of your loan. For example, if you have a $350,000 mortgage, over the lifetime of the loan you could save more than $16,000 on interest if your credit score is at 760 instead of 700.

You may not realize there are many other things impacted by your credit score. If you want to rent an apartment, landlords typically will use your score to decide who can rent from them. Cell phone companies will also offer you the best plans if your credit score is high enough. You can also negotiate better home or auto insurance rates if you have a higher score. It pays to keep track of your score and make sure you are increasing your score if it is low.

Your credit is checked when you apply for things like:

• A loan
• An apartment
• Insurance
• Phone plan

What's a Good Credit Score?

So what number are people looking for when they reference your credit score? Here’s a simple breakdown of common credit score ranges:

• Excellent (800–850)
  You’re considered a very low risk to lenders and are likely to qualify for the best rates and terms.

• Good (670–799)
  You’re in a strong position and will usually qualify for loans and credit with favorable terms.

• Fair (580–669)
  You may still be approved for credit, but you might pay higher interest rates or have fewer options.

• Poor (300–579)
  It may be more difficult to get approved for credit, and if you are approved, rates may be much higher.

What Determines a Credit Score?

The most commonly used model to determine credit is the FICO score. Its base credit score ranges from 300 to 850. When you are at 690 or above, lenders are more likely to lend to you because you are considered less of a credit risk. The average credit score is 700, which is considered a ‘good’ credit rating.

There are several factors that create a credit score. Here is a look at how it is calculated:

• Payment history: Accounts for 35% of your score by checking to see that you consistently make payments on time.
• Credit utilization ratio: Makes up 30% of your score and looks at how much credit you are currently using compared to the total of all your revolving credit limits.
• Credit history length: Accounts for 15% of your score and takes into consideration your oldest credit account, newest credit account and average age of all accounts.
• Credit mix: Makes up another 10% and is impacted by different credit accounts you have open, including a car loan, credit card, student loan, mortgage or other credit products.
• New credit: Makes up the final 10% and looks at the number of accounts you recently opened and hard inquiries lenders make when you apply for credit.

How to Increase Your Score

If your score is lower than you want it to be, there are a few ways to increase your number. Paying your bills on time is the easiest way to build your credit score. You can also watch your number increase by using your credit cards and paying the account balances in full each month. Even if you don't use a credit card you have anymore, keeping it open can maintain or improve your credit score, as it builds credit history.

Monitoring your credit score for errors can also help your score increase. By keeping a close eye on your credit score, you can quickly identify any errors that could be bringing your score down or help you catch signs of identity theft. You are able to request your credit score at no cost by going to AnnualCreditReport.com. Simply checking your credit score will not cause your score to lower.

Tips to increase your credit score:

• Pay bills on time
• Pay full balance
• Keep credit cards open to build credit history (don't close them)
• Don't open too many credit cards or lines or credit all at once
• Monitor your credit report for unusual activity

Why Did My Credit Score Change?

Your credit score can change over time based on new activity in your credit report. Here are some common reasons you might see it go up or down:

• A payment was made late (or on time)
  Payment history is the biggest factor, so even one missed or late payment can cause a noticeable drop, while consistent on-time payments help your score improve.

• Your credit card balance changed
  Using more (or less) of your available credit can impact your score. Higher balances may lower your score, while paying them down can help it go up.

• You opened or applied for new credit
  Applying for new accounts can cause a small, temporary dip due to a hard inquiry and shorter average account age.

• An account was closed
  Closing a credit card, especially an older one, can affect your credit history length or increase your utilization, which may impact your score.

• Information on your credit report was updated
  Lenders regularly update your account activity, so changes like paying off a loan or correcting an error can shift your score.

The Bottom Line

While having a low credit score may not keep you from being approved for credit, there are many benefits to increasing your score. A higher credit score can help you find the best rates on your next home or auto purchase which will help you save money over the length of those loans. By getting into healthy financial habits now, you will see your score start to improve.