Ed Note: You know your credit score is important — but maybe you’re not quite sure why. Or maybe you’re not sure what goes into that three-digit number or how that information is used. You’re not alone: according to a recent study by the Consumer Federation of America, a staggering number of people still fail to understand important pieces of the credit score puzzle (and very few seem to comprehend how costly a low credit score can be). Luckily, Bethy Hardeman of Credit Karma is here to explain the basics. Consider this your crash course in credit scores.
Your credit score can either help or hurt you the next time you apply for credit or even an apartment. While you may not need to apply for credit now, learning what goes into a good credit score and how to get one will benefit you in the future.
What is a credit score?
A credit score is a three-digit number that is used by lenders to determine your creditworthiness, or the likelihood that you’ll pay your debts in a timely manner. Credit scores are based on the information in your consumer credit report – it’s a numeric way to sum up your credit history.
When a lender looks at your credit score, he decides two things based on that number:
- Whether or not you’re approved. While most lenders typically don’t publish the credit score ranges that they consider for approval, mortgage lenders do give us a few details. To get approved for a conventional mortgage, you’ll need a score of 620 or higher. Lower than that, and you’re in the subprime category.
- How to set your rates, terms and credit limits. Still taking the common example of applying for a mortgage, a credit score of 720 will typically get you the best rates. If your score is higher than that, you’ll probably still get the same rates. But if your score is lower, you’ll end up paying more in interest in the long run.
What factors make up a good credit score?
There are a few consistent factors that influence your credit score:
Payment history. This is a run-down of whether or not you’ve paid your bills on time. Most score models take into account the past seven years of your history. Keeping up with your bill payments is the best way to get and maintain a good credit score. To make sure you do, set up automatic bill payments.
Credit utilization. This percentage is your total credit card balances divided by your total credit limits. When it comes to creditworthiness, having some credit utilization is a good thing – it shows lenders that you’re consistently using credit. However, having a high credit utilization rate can make creditors wary. Keep your credit utilization rate to less than 30 percent of your total limits. You can monitor your credit utilization regularly on Credit Karma.
Derogatory marks. These are negative items on your credit report. They include accounts in collections, bankruptcies and liens. They can take seven to ten years to clear from your credit history. It’s best to avoid derogatory marks if at all possible. They’ll do a lot of damage to your credit score and some will make it difficult for you to gain access to credit in the future. If you have a collections account on your credit, do your best to settle it and get it removed.
Average age of open accounts. The longer your credit history, the more accurate the assessment of your creditworthiness over time. By seeing you’ve managed your credit over a longer period of time, lenders can get a better idea of how you’ll manage credit they extend to you.
Total accounts. People who have more credit accounts typically have a higher credit score. They have more on which to base creditworthiness. Also, having a good mix of different types of credit accounts is good for your credit score.
Why is it important to have a good credit score?
In a nutshell, a good credit score will save you money. Taking the mortgage example, someone with a good credit score will receive lower rates and pay less in interest over the life of the loan. In contrast, someone with a low credit score will pay more in interest.
Remember that working toward a good credit score takes time. If you keep up the healthy habits we described above, you should see a gradual improvement in your overall credit health.
Bethy Hardeman writes on credit, personal finance and the economy for CreditKarma.com, a free credit management website that helps more than 8 million people access their credit score for free.