Do you know your credit score? If not, it's important to understand that this is a number you don’t want to neglect. Your credit score is the key to borrowing money inexpensively (or at all), and building and maintaining good credit can have a significant impact on your future. If you are young and starting out on your own, the time to start establishing good credit is now. For those of you who have a low credit score, don't panic.
It may take some time, but there are ways that you can improve your score which will benefit you greatly down the line.
Why you need good credit:
Are you in the market for a new home or looking for a new apartment to rent? Or perhaps you are shopping around for a new credit card with a low APR, applying for college loans, or hoping to purchase a new insurance policy.
In all of these situations, your chances of borrowing money are much greater if you have good credit. The reason why is because a person with a high credit score is considered to be much lower-risk than a person with a low credit score. Those people with low credit scores are often turned down for credit or require a co-signer.
Because your credit score has such a significant impact on several important areas of your life, it’s important to understand how your credit score works and how it is determined.
Measuring credit using a FICO score:
Most likely you’re familiar with what is called a FICO score. FICO, which originally was known as the Fair Isaacs Corporation, was shortened several years ago and has been known as FICO ever since.
FICO uses information from one of the major credit reporting agencies- Equifax, Experian, or TransUnion- to create your credit score. There are many things that can be derived from this information. Lenders are better able to better identify if someone is likely to pay their bills on time and if they are a good candidate for having their credit increased.
Alternatively, the information can also serve as an alert to lenders that a borrower is not likely to pay their bills on time, or at all.
While FICO isn’t the only credit scoring system, it is the one that is most used by the largest credit reporting agencies in the U.S. Each credit scoring system should give you a nearly identical credit score number, but due to the different models and algorithms used by each agency, the number may not be exactly the same.
How your FICO score is calculated:
Your FICO score is calculated based on five different categories, each of which are assigned different weights:
1. Your payment history accounts for 35% of your total credit score. Repaying past debt is the most important factor when calculating your credit score. The reason for this is because according to FICO, past long-term behavior is used to forecast future long-term behavior. Remember, this includes your entire debt repayment history including your credit cards, student loans, and mortgages.
2. How much you owe you- your debt amount- accounts for 30% of your total credit score. A borrower’s total outstanding debt is the next biggest category from which your credit score is derived. For example, if you are one who typically maxes out your credit card or gets close to your credit limits, this could be a red flag for lenders and lead them to believe that you can’t handle your debt responsibly. A good rule of thumb is that what you owe on each individual credit card shouldn’t be more than 30% of your credit limits.
3. Your length of credit history accounts for 15 percent of your credit score. 15% of your credit score will be based on the length of time each account has been open, along with how long it has been since the account’s most recent transaction. For this reason, it’s difficult for any person who is new to credit to have a perfect credit score. Once you have a longer credit history, there will be more information to determine an accurate credit score. This is why it's important to start establishing credit early.
4 and 5. Your new credit and credit mix each account for 10 percent of your credit score (totaling 20%). While it’s important to establish credit, it’s just as important not to have too much credit or open too many credit lines at the same time. This could signal that you are in financial trouble and need a lot of credit to cover the majority of your expenses. FICO suggests that borrowers only take on additional credit when they must have it or when it makes sense financially.
Credit mix is just what it sounds like- holding various forms of credit. Borrowers with a good credit mix are more likely to appear able to repay different varieties of debt which in turn represents less risk for lenders.
How you can obtain your credit score:
If you don’t know your credit score, it's easy to access your score from one of the three major credit reporting agencies. Experian offers access to your FICO score, and TransUnion, and Equifax offer access to a score based on their own scoring models. You can also go to Myfico.com., or check with your bank or credit card company. In most instances there will be a fee for obtaining your credit score, but it will be well worth it. If you are looking for an entire report on your credit history, check out annualcreditreport.com.
Do you know your credit score? It's best to check your score on an annual basis. If you are working on rebuilding your credit, consider checking your score on a monthly basis.
To learn more: Why Your Credit Score is a Number You Need to Know
