Do you know your credit score? Do you know what affects your credit score? Do you even know what a credit score is?
If you don’t, that’s OK!
Most people don’t really understand the topic of credit. It’s complicated — and unless you studied finance, you probably never learned a thing about it in school.
Your credit is one the most important aspects of your financial life. It affects things like your interest rates, your ability to buy a house or a car, and it can even affect your ability to get a job.
So you need to understand a few things about how it works in order to keep your financial life on track.
This guide covers the two main aspects of your individual credit: your credit report and your credit score.
This isn’t a test, we’re talking real world here, so don’t worry about memorizing definitions and percentages.
Although some of the information can seem complicated, the primary goal is to give you a good understanding of the basics of credit, including how it works, what will damage your score and how you can improve it.
Just remember — you don’t need to know everything, you just need a little Common Cents!
What is credit?
Before we get into credit reports and scores, let’s take a step back — what exactly is credit?
It’s easy to get confused, because the word credit has two meanings:
- Credit is borrowed money that allows you to buy something before you pay for it. So with a credit card, you use it to make purchases and then you pay the money back later.
- Credit also refers to the likelihood that you’ll pay back the money you borrowed and be able to get new loans. So basically, if you borrow money and can’t pay it back, no one else (meaning another bank or lender) will want to lend you money. This is where your credit report and your credit score come in, because lenders use that information to decide whether or not they’ll even loan you money, and then how much money they’re willing to give you and how much interest they’ll charge you for it.
So that’s credit in a nutshell. Now let’s get into credit reports and credit scores.
The difference between credit reports & credit scores
Your credit report
A credit report is basically a file that contains all of the details of your accounts and payment history for each current, paid-off and closed account in your name.
Your credit reports track payments and other information for every loan, credit card, retail card and any other line of credit you have or had in the past. A line of credit is essentially any arrangement between you and a lender (bank, credit card company or other financial institution) that establishes the maximum amount of money you can borrow and get access to, for that specific loan.
Your report contains pretty much all the details of all your accounts, including limits, balances, when you paid on time, when you paid late, when you applied for the credit and more.
Here are a few of the most common types of accounts you’ll see in your reports:
- Car loan
- Student loans
- Credit cards
- Retail store cards
And you actually have three credit reports, which are compiled and maintained by the three main credit agencies:
It’s not something you sign up for either — whether you like it or not, they’ve got all your info. That’s why it’s important to check it and pay attention.
Why you need to check your credit reports!
Many people don’t check their credit reports because they either don’t realize it’s a big deal or they don’t want to face what’s in it. Bad idea! The only way to improve your financial life is to know what’s going with it, so you can take steps to get back on track. Here’s why:
- There could be errors on your report that you don’t know about — maybe you paid off a bill but your report shows that you didn’t.
- You want to find any mistakes as soon as possible — so you can get them fixed and minimize the damage.
2. Old bills you never knew about or forgot about
- Maybe you had a bill from a doctor or a retail store — and you moved, so you never got the bill.
- Even it’s for a small amount, an old unpaid bill could be damaging your credit without you even realizing it.
- If a bill is sent to collections, it stays on your credit report for 7 years — even after you pay it off.
- It causes less damage to you over time, but it doesn’t go away for 7 years.
- So even after you get things together, your credit could still suffer. So the sooner you start paying attention, the sooner you can get your credit on the right track
At AnnualCreditReport.com, you can get a free copy of each of your credit reports once each year. In just a couple minutes, you can see everything that’s going on with your credit. But you can only do this once a year, because doing so more than once per year will ding your credit and cause your score to drop.
You can also monitor your credit for free with a service called Credit Karma, which pulls in your information and gives you a good idea of what’s going on with all your finances and anything that impacts your credit.
This is a good way to keep tabs on everything without pulling your official credit reports.
Your credit score
Your credit score is one of the most important aspects of your financial life — and it’s crucial that you understand both what it means and how it’s calculated.
What you don’t know about credit scores can hurt you.
What makes things confusing is that there are a lot of different credit scores out there, but there’s only a single “real” one that’s used by most lenders. And that one matters most. We’ll get into more details about it, but just remember that not all credit scores are created equal.
To get a good credit score — regardless of whether we’re talking about the real one or one of the not-real ones — you have to actively manage and manipulate your credit. In this case, manipulation does not have a negative connotation — it’s more about how your actions impact your credit score and things you can do to improve it.
All of this stuff can get confusing and overwhelming, but you really just need to know a few basics to start “manipulating” and improving your credit score.
What exactly is a credit score?
Your credit score is a number that represents how well you’ve managed all of your financial obligations — so your bills, accounts and debts — over time. The number is determined by those same three agencies based on the information in your credit reports.
Think of it as your credit scorecard: The higher, the better.
When you go to apply for a credit card or mortgage, lenders wants to know what kind of risk they’re taking by giving you the money — so how likely is it that you’ll pay them back?
If you have a good credit score, they assume they can trust you, and they’ll give you a better deal.
If you have a bad score, getting a loan will cost you a lot more money, or you may not even be able to get one.
Here’s the key – to get a good credit score, you have to constantly keep tabs on everything so you can take steps to manipulate your credit in your favor.
And the way you do that is by understanding what factors make up your score, what damages it and how you can improve it.
Factors that impact your credit score
A lot of people end up with a low credit score because don’t know what actually causes their score to go up or down. Generally, there are five main factors that matter.
1. Payment history: 35 percent
- This makes up 35 percent of your score.
- This is why it’s so important to always pay your bills on time.
- It may not seem like a big deal, but a few late payments can damage your score for years.
- In fact, paying all of your bills on time is the most important rule for having a good credit score.
2. Credit utilization rate (how much debt you owe): 30 percent
- This makes up 30 percent of your score, and it’s based on how much of your total available credit that you’re using.
- In the eyes of lenders, when you’re using a high percentage of all the money you have access to in credit, it makes you look like you’re overextended and like you probably can’t afford to pay all that off and that you’re more likely to make late or missed payments.
- For example, let’s say your credit card has a limit of $1,000 — if you carry a balance month to month of $300, you’re using 30 percent of your available credit.
- You never want to use any more than 30 percent of what’s available to you.
- If your limit on that card suddenly dropped to $500, you’d be using a lot more than 30 percent — and that’s bad because it looks like you’re using the card to pay for things you really can’t afford.
- If you have multiple cards, just add up all the limits and look at it next to the total balance you have on each card.
- It’s important to pay attention to your balances and pay down the total amounts you owe as quickly as you can. If you can’t pay them in full, just try to get the balance down.
3. Credit history: 15 percent
- This makes up 15 percent of your score.
- It’s basically the total length of time that you’ve had credit in your name.
- That’s why it’s a good idea to get a credit card in college, or at least at a younger age — so you can start building credit.
- The longer your credit history, the better.
- This is also why closing a paid off credit card is typically a bad idea — because closing the account will reduce the length of your credit history. So once you pay it off and it’s at a balance of zero, just let it sit there.
4. Credit mix: 10 percent
- This makes up 10 percent of your score – so it’s not a huge a deal in the grand scheme of things, but it’s still important to pay attention to.
- You credit mix based on the different types of credit you have – credit cards, retail cards, a mortgage or installment loans – that’s a loan you pay back over time with a set number of scheduled payments.
5. New credit: 10 percent
- The last 10 percent of your score is based on how much new credit you have and how quickly you got it.
- So you don’t want to apply for a bunch of new credit cards at once.
- If you do that — it makes you look more like a risk to lenders if you’re trying to access a whole bunch of money in a short time period.
Generally, your score is calculated base on those five main things. How much each factor really matters can vary from person to person, sine everyone has different stuff in their credit report.
Your “true” credit score
Your true credit score (the “real” one we mentioned earlier) is a number between 300 and 850 that evaluates your risk as a borrower. Since the number is based on how you’ve managed your money obligations, lenders use it determine how big a loan you can handle and the likelihood that you’ll pay it back.
There is one source and one source only for your true credit score — the Fair Isaac Corporation. Your true score is known as your FICO score.
Since FICO dominates the credit score market, the three credit bureaus (mentioned above) started selling their own version called a VantageScore. This is just one of the many other scoring systems trying to compete with the FICO score.
But the score you want to focus on is your FICO score!
You have a FICO score with each of the three main credit bureaus — Equifax, Experian and TransUnion. Each bureau’s score will vary slightly because of differences in the way they compile information on you. But they’ll all be similar in range. (The credit score most used by lenders is the Equifax FICO score.)
What is a good credit score?
Your true credit score is a number between 300 and 850 — 850 is the highest and best.
The number represents your risk as a borrower. If you have a low score, lenders think it’s riskier to lend you money compared with someone with a higher score.
Having a high score makes you a great credit risk for a lender — meaning they can trust you to handle a loan and pay it back on time, since you’ve demonstrated that in the past (based on your score).
Anything above 700 is good, and anything above 760 is pretty much awesome.
It’s important to keep tabs on your score to make sure it doesn’t prevent you from reaching your big goals.
It’s especially important if you plan to make a big purchase any time soon — because if your score is low, there are things you can do to improve it — and there are also certain things you want to avoid, in order to keep it from dropping.
If you haven’t checked your credit score in a while, DO IT. Many banks will actually now give you your FICO score for free every month.
Once you get an idea of what you’re facing, check out our guide on how to improve your credit score.