If you’re early on your financial journey or trying to learn how to better manage your finances, you may be asking yourself: What is a credit score? Your credit score is one of the most important–if not the most important–aspect of your financial life. It affects your ability to purchase a home, take out a loan, buy a car, and more. To understand what it means to build credit and manage your finances, you must first understand what a credit score really is.
What is a credit score?
A credit score is a 3-digit number that summarizes your credit history, represents your financial track record, and lets financial institutions see the risk of lending to you. Think of it as a report card for how you’ve handled money during your lifetime.
What is considered a good score?
Credit scores fall on a scale from 300 to 850. A credit score above 720 is excellent and will help you earn more favorable terms when it comes to establishing future payments and interest rates. A credit score below 620 is considered a bad score and will negatively impact your financial abilities in the future if it stays that way. A score that falls somewhere around 670 or greater is still considered a generally good credit score.
How are scores calculated?
There are 3 main credit bureaus–Equifax, Experian, and TransUnion–that manage credit reports. By law, you are entitled to one free credit report every 12 months from each major agency by visiting AnnualCreditReport.com. It’s a good practice to regularly check your reports for errors and inaccuracies, such as the same debt being listed multiple times. If you find an error, follow the formal dispute procedures.
Your score is determined through a credit report. Your credit report and score are two different things–one is used to determine the other. A credit report evaluates your payment history, types of credit used, length of credit history, account standings, level of debt, and more to determine your score.
Each credit bureau has different scoring models to determine credit scores. All 3 bureaus collaborated to form the VantageScore model in an effort to score more consistently across each. This scoring model is becoming more popular, although a FICO score is the most common score determined by credit bureaus.
Is it normal to have many different scores?
Don’t be alarmed to see slightly different scores based on where your report was run. This is normal. Each of the 3 credit bureaus has slightly different data, which are factored into your reports. Plus, the timing of your report may affect your score since scores are not calculated on a fixed schedule. And finally, each company has slightly different scoring models that are updated frequently and used for different purposes.
For example, if you’re applying for an auto loan, the lender may use the FICO Auto Score 8 model and your score could be 700. If you’re applying for a personal loan, a different lender may use the TransUnion model and your score could be 750. Your scores should generally fall within a similar range–but if you don’t get identical scores from different reporting companies, don’t stress it.
What is the average score?
The average credit score in America varies greatly based on the credit holder’s age, geographic location, and economic opportunity. However, as of 2019, the average score in the U.S. is at an all-time high at 695. Generally, the average score falls between 660 and 720.
What influences your score?
While each credit scoring model is unique and prioritizes different parts of your credit history, there are several factors that typically play a key role in influencing your score.
Your payment history
This is one of the most important factors and can account for about 35% of a FICO score. Scoring models look to your past behavior to predict what you’ll do in the future—and they want to see that you have an established history of making on-time payments. The degree to which a late payment may impact your score depends on multiple factors, such as how recent it is, how frequently you’ve paid late, and how late the payment was.
Percentage of credit limit used
This factor can be highly influential and applies primarily to revolving debt (credit cards). Experts typically recommend that you keep your balances below 30% of your credit limit to prevent your score from dropping. The ratio of balances to credit limit is also known as your credit utilization ratio. For example, if you have three credit cards, each with a $2,000 balance and a limit of $3,000, your credit utilization ratio is 67% ($6,000 total balance divided by $9,000 total limit), which may hurt your score.
Age and type of credit
Another factor that can be influential is the age of your credit accounts. Generally, your score will improve the longer your accounts have been open. Many scoring models also consider the variety of types of credit that you’re using. The models typically want to see that you have an established history of responsible payments across multiple types of credit, from installment loans to credit cards and beyond.
New credit inquiries
When you request credit, the lender will pull your credit report, which typically results in a hard inquiry on your credit report. Hard inquiries usually impact your credit score. If you have a high number of hard inquiries, many scoring models take that as a sign of risk, as you could potentially be loading up on new debt that’s difficult to pay off. It’s important to note that most scoring models understand that you may be comparison shopping for the best terms on one loan, which could result in multiple hard inquiries. As such, most models treat multiple inquiries for the same kind of debt as a single inquiry, as long as they happen within a short time frame. Overall, hard inquiries are less influential than other factors when it comes to your scores. It’s also important to note the difference between hard and soft inquiries. A soft inquiry is made when you check your own credit or when your credit is checked outside of a lender’s decision-making process. For example, if you request offers from a peer-to-peer lending platform such as Prosper, or if a potential employer checks your credit, a soft inquiry would be recorded. Soft inquiries do not impact your scores.
Negative public records on your credit report, such as accounts in collection and bankruptcy filings, can seriously hurt your credit scores as they are related to your payment history—the factor typically given the most weight when calculating your scores.
It’s worth clarifying that several things do not influence your score, including race, religion, gender, age, salary, occupation, employer, and marital status. If you’re interested in improving your score, there are several things you can do, including consolidating your debt and paying down your credit card balances.
What if you don’t have a score?
If you’ve never used credit before, it’s entirely possible that your credit report contains little or no information and you don’t have a score. To start responsibly building a credit history, you can consider several options, including opening a joint account with someone who has solid credit or becoming an authorized signer on their account. You could also open a secured credit card and pay the balance in full each month to start establishing a healthy credit history.
We can all strive to establish excellent credit and an important first step is understanding how scores work. Now that you’re familiar with the basics, you have the ability to build a better score and improve your financial well-being.