Credit score. We all know the term and that we want it to be good. But how is it determined, what is “good”, and does it really matter?
How is it determined?
The most common method to determine credit scores is the FICO method. It was formulated in the early 1980’s between Fair Isaac and the three major reporting agencies: Experian, Equifax, and TransUnion. I am going to be a lazy blogger tonight and share with you exactly how your credit score is broken down, as reported in a Money article (these bullets are literally a copy and paste so I know I’m being lazy, but why recreate the wheel when they explained it so well??):
- 35 percent of the score is based on your payment history. This makes sense since one of the primary reasons a lender wants to see the score is to find out if (and how promptly) you pay your bills. The score is affected by how many bills have been paid late, how many were sent out for collection and any bankruptcies. When these things happened also comes into play. The more recent, the worse it will be for your overall score.
- 30 percent of the score is based on outstanding debt. How much do you owe on car or home loans? How many credit cards do you have that are at their credit limits? The more cards you have at their limits, the lower your score will be. The rule of thumb is to keep your card balances at 25 percent or less of their limits.
- 15 percent of the score is based on the length of time you’ve had credit. The longer you’ve had established credit, the better it is for your overall credit score. Why? Because more information about your past payment history gives a more accurate prediction of your future actions.
- 10 percent of the score is based on new credit. Opening new credit accounts will negatively affect your score for a short time. This category also penalizes hard inquiries on your credit in the past year. Hard inquiries are those you’ve given lenders permission for, as opposed to soft inquiries, which include looking at your own score and have no effect on the score. However, the score interprets several hard inquiries within a short amount of time as one to account for the way people shop around for the best deals on a loan.
- 10 percent of the score is based on the types of credit you currently have. It will help your score to show that you have had experience with several different kinds of credit accounts, such as revolving credit accounts and installment loans.
(this is Anna speaking again!) Your credit report isn’t always going to be accurate because sometimes information is reported inaccurately to Fair Isaac. This could be: a company didn’t correctly report or update your payment history, someone else’s information was accidentally reported on your credit report, or some other fluke caused your information to be incorrect. This is why it is important to take advantage of pulling your FREE report every year. Checking over your report could save you a lot of money in the long run if it means your score will get a boost. (be careful not to get suckered into the monthly credit monitoring for $9.95/month… not worth it)
What is “good” and how do you get there?
Most people have a score between 650 and 750, and anything over 700 indicates good credit management. Getting a good credit score takes time. You need to pay on time, reduce your debt (strive for 25% of your available limit), watch the kind of debt you take on, and follow all the other good advice that I copied and pasted from Money earlier in this post. This is a breakdown of all the ranges:
- Between 700 and 850 – Very good or excellent credit score.
- Between 680 and 699 – Good credit score.
- Between 620 and 679 – Average or OK score.
- Between 580 and 619 – Low credit score.
- Between 500 and 579 – Poor credit score.
- Between 300 and 499 – Bad credit score.
Does it really matter?
Yes, you want a good credit score but having a great credit score may not get you much more. A good score will save you a lot of money — and not just because you will get lower interest rates on loans. These are a few instances where your score matters:
- Loans and credit cards. You will get a lower interest rate, and in some cases a bad credit score will prevent you from being accepted for the loan altogether (and the rejection could also hurt your score). For example, if you are approved for a $100,000 home loan at a 7% interest rate and your friend is also approved for a $100,000 home loan at a 6% rate, your friend’s monthly payment will be $65 less each month than yours.
- Insurers. Car insurance companies may use your score to determine your insurance premiums.
- Landlords. Landlords may want to know if you consistently pay your bills a time. A low score due to late payments could prevent you from being approved for housing.
However, the difference between a great score (above 750) and a good score may be minimal. This is because lenders see the risk of someone with a score of 800 defaulting as being about the same as someone with a score of 740. Therefore, they will both qualify for good interest rates. Don’t get me wrong, the person with a higher score will save more on interest but it will be a much smaller spread than between someone with a score of 740 and someone with a score of 675. The person with a great score might save an additional $10 or $20 per month on a $30,000 car loan.
Do you check your credit report annually?
Have you watched any of the March Madness games today? Which upset did you pick in the tournament? (Matt didn’t invite me to be in his bracket!)