WHAT IS A CREDIT SCORE?
A credit score is a number that determines how likely you are to repay a loan on time. Your credit score is based upon your history repaying loans. Banks use your credit score to decide whether or not to loan money to you and, if they make the loan, what interest rate to charge. Your credit may also be used to determine if you get an apartment, insurance or even a job.
WHY DOES IT MATTER?
As I mentioned above, your credit score may matter if you apply for a job or insurance, and it definitely matters if you ever need a loan. If you don’t establish a good enough credit score, most banks won’t give you a loan for a car, home, or business. And the higher your credit score is, the less interest bank will charge you for the loan. This is very important because the lower your interest rate the less you will ultimately pay over the life of the loan. For example, the difference in total interest payments on a $250k, 30-year mortgage between a 5% interest rate and 8% interest rate is about $179k. That is the cost of less-than-perfect credit.
WHAT’S A GOOD CREDIT SCORE?
A question everyone wants to know. Unfortunately, it’s also hard to answer. There are two primary reasons for this:
- Different companies calculate your credit score differently (and on different scales).
- [highlight]Your credit score is a ranking, not a rating (it’s like test scores put on a Bell Curve).[/highlight]
Every time you apply for credit, you don’t know which scale(s) your lender will use to pull your credit score. In addition, you don’t know what their criteria are. For example, over the past couple of years the standard for a “good FICO score” has increased somewhat dramatically.
Note: FICO stands for Fair, Issac and Company, the providers of the some of the most commonly-used credit scoring algorithms. Your FICO score is just another way of saying your credit score (like Kleenex vs. tissue).
But with that disclaimer in place, you can be confident that a score of 720 is “good” on most scales, while a score of 800 is “very good” on most scales. Scores in the high 600s aren’t necessarily bad, but they won’t qualify you for all loans or the best rates. Finally, it’s important to note that once your credit score approaches the high 700s to low 800s, any further increases won’t do much for you…banks will already give you the best rates. (It’s like if a prof awards an A+ to numerical grades of of 97-100, once you hit 97 there’s no additional benefit to getting a 98 or 99, etc.)
HOW TO GET A GOOD CREDIT SCORE
There are three big factors to a good credit score:
- Establishing credit over time.
- Paying bills on time.
- Staying out of credit card debt.
The first step is often can be a little weird because you need to get credit before you have a credit score. There are several ways to establish credit for the first time, but it’s arguably easier to do when you’re young and either in college or still dependent on your parents. For example, you can:
- Ask a parent to make you an authorized user on one of their credit cards.
- Take out a federal student loan.
- Take out a loan with a cosigner.
- Get a secured credit card.
Once you have one open account, its not as tough to get additional accounts. Over time, you’ll get the best credit score when you have a couple of credit cards and one or two loans (like student or auto loans). That said, more accounts is not necessarily better. Finally, a key part of credit scoring is time. It typically takes several years to develop a good credit score.
Paying Bills on Time
Did I mention that paying your bills on time was important? Well let me do it again. Nothing builds credit more reliably than paying your credit cards and loans on time every time. Not surprisingly, nothing will wreck your credit score faster than failing to pay these bills on time. The longer you take to pay them (and the more often you’re late), the lower your credit score will fall.
Staying Out of Credit Card Debt
Carrying credit card debt is bad It’s bad for your finances in general and it’s bad for your credit score.
Credit card utilization (or how much of a balance you carry in relation to your credit limit) impacts your credit score. The higher your combined balances in relation to your combined credit limits, the more your credit score will suffer. For the best credit score, you want to keep this “utilization ratio” as low as possible.
And, for advanced credit score hackers, there are other things to take into account here, like the fact some credit cards that don’t report credit limits can negatively impact this ratio and, thus, your credit score. That said, the bottom line is having a credit card or two is good for your credit score, but carrying credit card debt is not.
HOW DO YOU FIX A BAD CREDIT SCORE?
The exact same way you build a good one! Pay your bills on time and stay out (or get out) of debt.
Unless you’ve been the victim of identity theft or otherwise have errors on your credit report, the only way to “repair” your credit is to pay your bills, pay down debt over time, and avoid applying for new credit. Expect it to take between one to two years of responsible credit management to make an impact on a troubled credit score, and be wary of anybody who tries to sell your shortcuts to a better credit score.
HOW DO YOU GET YOUR OWN CREDIT SCORE?
There are a ton of companies that offer “free” credit scores/reports. They will ask you for your credit card information and tell you that you can cancel within 7 days if you do not want to keep the credit monitoring service. I typically do not recommend going this route, as it can be a pain once you try to actually cancel. Alternatively, I would recommend trying www.creditkarma.com its one site that is actually indeed truly free. No Card info required. No hidden Fees. Just FREE. It will provide you with your credit score. You can also download your credit report annually for free from www.annualcreditreport.com but this will not provide you with your score. Just a record of your outstanding accounts and balances.