In this article, I’m going to be talking about credit scores and how they work. After you read this article, you will understand how credit scores work, how they are calculated and why they’re important in your future. Let’s get started.
How Credit Scores Work
The first topic is how credit scores work. In the credit score world, the term credit simply means your reputation as a borrower, and it has to do with your history of staying on top of loans and credit cards. Some of you may be scared of getting a credit card, or going in debt, simply because of other stories that people in your life have had. But debt is simply a tool to manipulate money. It is not good or bad, but it can be used in great and terrible ways.
Your Personal Credit Report
Before lenders will sign off on loans for you, or open up a new credit card for you, they want to find out your personal credit report. Your credit report tells them your borrowing history. Based on your credit report, the lender determines how much to charge you for the loan, and whether or not to approve you for the loan.
Whether you’re taking a loan out to pay for college, get a new car or a new house, credit scores are super important. Before we got on to how they are calculated, you need to know that a score is like a diploma. It’s just a number that aerages your history.
You can look up your credit report, which has all the information on your borrowing history, just like a grade report. But lenders, like banks and businesses, don’t want to spend 15 minutes analyzing how well you pay back your loans, especially when they might have 300 applicants that day. Instead, credit bureaus use an algorithm which is occasionally updated which gives you a number, a credit score. That number is used by the banks and lenders to assess your credit worthiness.
How Scores Are Calculated
Let’s move on to how scores are calculated. What determines your credit score? Credit scores are determined by credit bureaus, or credit report agencies. To get your credit score, you have to start with your credit report. Credit bureaus are simply companies who gather your financial information and compile it onto a credit report.
In the US there are three major credit bureaus, Equifax, Experian and Trans Union. The fair credit reporting act, issued by the US government, sets standard guidelines for all credit agencies to follow when reporting on your credit. Other businesses, like lenders and banks, can buy your credit report from the credit bureaus. These credit bureaus use computer programs to analyze your credit report and give you a score, as I explained earlier.
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Free Credit Report
That score is calculated by the algorithm that scans the report and determines qualities, patterns and potential pitfalls in your borrowing history. A credit score is usually what most lenders look at. With so many loan applicants they don’t have time to wade through pages and pages of each person’s credit report. They just come up with a number. Credit scores make it easier and faster to determine your loan eligibility for applicants.
What is on a credit report? If you really want to see what is on your free credit report card, there are websites that will give you a free credit report. One of those is freecreditreport.com. They also give you free credit score updates every week. If you don’t monitor your credit report very often, someone could be stealing your identity without you knowing it.
Credit reports have their information about specific credit history events. It lists things about the amounts that you’ve borrowed, your payment history, whether or not you have any outstanding loans, any loans that you’ve had in the past seven years, any current loans and any minimum monthly payments that you’re making. Finally, it lists any instances you have of foreclosure or bankruptcy.
How can we reverse engineer this? What factors make up your credit score? Each credit bureau puts out a credit score, a FICO score. FICO credit scores range from 300 to 850. The scores are made up of the following factors. 10% of it is a type of credit. That would be from an auto loan, a home loan, a credit card, a student loan. This makes a difference, but not very much.
On to the next 10%. New credit is basically your credit seeking activity. Statistically, if you’re seeking lots and lots of new credit in a short amount of time, you’re seen as risky, which makes your score go down. Your interest payments go up. Credit bureaus check these by something called “hard inquiries”, which happens any time a lender checks your score.
The next 15% of the credit score is calculated by the length of credit. This would be the oldest account on your file, your newest account and the average age.
The largest portion of your credit score (35%) is determined by your payment history. This can be good or bad, but it also deletes off after 7 years. If you have a bad payment history with a couple of bad notes, you can actually call some of the lenders and get some of these bad payment histories removed.
The last 30% is the amount owed. This is called “credit utilization”. This is the percentage of how much you’ve actually borrowed, divided by how much you can borrow total. On a credit card where you might have a limit of $1000, if you only use $200 of it, your credit utilization will be 20%. Experts say keep it under 30% to stay in the clear, and under 10% for best results.
What do Credit Scores Mean?
Here’s where the good credit bad credit comes in. A high credit score is a sign of a good borrowing history. The lower your score, the harder it is for lenders to approve your loan. They will see you as risky and they won’t want to give you money. It’s common for lenders to set rules that applicants must fit in order to sign a loan with them. One lender might not approve scores under 650. The same lender might approve scores between 650 and 720, but give them a higher interest rate. Then for scores that are over 720, they might get a low interest rate.
Here’s why credit scores are important in your future. Like we said before, good credit scores are important for securing loans. Securing loans mean that you are better equipped to accomplish your purchasing goals, like buying a house or a car. It includes even paying for college. Let’s face it, if you’re not rich, you’re going to need some type of loan to cover such huge necessary expenses. Even if you do have a ton of spare change lying around, it’s a good idea to keep some credit active to keep your score high.
I want to make this very clear. If you use a credit card correctly, you will not have to pay any interest, but your credit score will increase. Credit is not bad. When you use it irresponsibly, it can have downfalls. For some people like me, paying $400 total interest for a car loan is worth the 100 point increase over 3 years, to be able to get a lower interest mortgage.
I’m going to outline the two main takeaways form this video. The first is “How do I get a copy of my credit report and credit score?” You can get a free credit report by going to annualcreditreport.com. Credit scores are a bit harder to get (hard but not impossible). One easy way to do this is to ask your lender for a score when you sign up for a loan.
How to Improve Credit Score
The next is, “What can I do now to make sure I have a healthy credit score?” It’s never too late or early to start improving your credit score. There are some easy ways to get and keep a good credit score. 18 is the prime age to start working on your credit score. Here are a few suggestions to get you started.
Pay your bills on time. Sounds like a no-brainer, but seriously, this is one of the easiest and most important ways you can have good credit. You can increase the effectiveness of this by having a montly budget track your money.
Diversify your types of credit. This means having different types of credit in your borrowing history. Have different credit cards and different loans. One easy way to do this is to have a credit card, but make sure to pay it down to $0 each month. This will increase your credit score.
Be a wise consumer. If you’re like me, it’s way easier to spend money than to save money. Try to base your spending decision on what you need, not what you want. This will ensure that you don’t overspend or impluse buy, which can cause you to be default on your current loans or payments.
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