Credit plays an impactful role in the lives of most consumers. Without it, most people wouldn’t have access to homes, cars, and other necessities. When used responsibly, credit can be leveraged to make investments and gain access to necessary capital to fund life’s ventures.
Alternatively, credit can also be the cause of financial pitfalls when used drastically or inappropriately. It can too easily cause people to overextend themselves with excessive borrowing and spending.
Increasingly, there evolved the need for quick, summary data for financial institutions to rely upon and use to grant credit to.
Enter: credit scores.
Regardless of your current level of knowledge on the topic, it’s our goal to increase your credit score awareness, so you that can use this powerful tool to boost your financial potential.
First, we’ll start with the basics, including:
- What credit scores are and why they’re used
- How credit scores are calculated
- Hard versus soft inquiries
Then, we’ll move to more advanced topics, including:
- How to build an excellent credit score
- How to access your credit report and dispute discrepancies
The Basics: Understanding Credit Score and Why it is Used
First and foremost, it’s vital to understand what credit scores are and why they’re such an important part of the financial world today.
What Is a Credit Score and Why Is it Used?
A credit score is a number between 300 and 850 that allows parties that are authorized to grant credit the ability to ascertain a person’s creditworthiness and reliability.
Lenders, employers, utility companies, and service providers can use credit scores to determine loan eligibility, interest rates, deposit amounts, and a general level of trustworthiness. The higher the score, the more individuals will generally be perceived as being less risky and often offered better terms and rates.
You may have heard the term FICO associated with credit scores. FICO, previously known as Fair Isaac Corporation, was introduced in 1989 as an “impartial tool for evaluating credit risk”.
Your FICO number is determined by analyzing your credit reports from the three main credit bureaus in the United States, TransUnion®, Experian®, and Equifax®. You have three different FICO scores based on these three companies.
Because the three companies have access to different information, are on different reporting schedules, and have different scoring models, it’s normal to have a slight variation in your credit scores.
Your FICO score is ever-changing based on your credit utilization. When you make an on-time payment, it can go up; likewise, if you miss a payment, it can go down.
Credit scores are categorized into five different categories or ranges:
- 300-579 = Poor
- 580-669 = Fair
- 670-739 = Good
- 740-799 = Very good
- 800-850 = Excellent
Credit scores are used because they provide mortgage lenders, landlords, credit card companies, and more with a quick, reliable screening tool. To mitigate the risk involved with lending money, housing, and credit, this figure can tell them how likely (and timely) you are to pay your bills.
Credit scores can also allow consumers to shop around for the best possible rates and terms, especially if they have ‘very good’ or ‘excellent’ credit scores. The unbiased data that a credit score supplies also makes your credit application process quicker.
It’s important to note that credit scores are just one piece of data that lenders, landlords, and other financial institutions look at. While it’s an extremely valuable tool that provides insight, they will also potentially look at your employment history, household income, and other financial factors.
How Credit Scores Are Calculated
Several factors play into your credit score – and they are not all weighed equally. FICO does not share the exact formula they use to determine the scores, but they do share the top factors and an estimate of how much weight each factor has.
Everyone’s score is highly individualized and influenced by different factors depending on their unique credit history.
The five main factors include:
- Payment history (35%)
- Amounts owed (30%)
- Credit history (15%)
- Credit types (10%)
- Recent credit (10%)
The most important factor contributing to your credit score is your payment history. Lenders, landlords, and credit card companies themselves have financial obligations to fulfill. They need to know that you’re reliable and will pay your bills on time, so that they can in turn take care of their finances.
Ensure you’re paying your mortgage, credit cards, loans, etc. on time, every time. A missed payment here or there can be detrimental to your credit score because it’s the strongest predictor of whether or not you’ll be responsible with credit. Therefore, it’s important to be timely in your payments.
This category has several factors at play such as how much total debt you have (and the types of debt), how many accounts you carry with balances, and your credit utilization.
The amount of debt you carry is not nearly as important as how you manage that debt. Your credit report should reflect that you’ve been extended credit opportunities and used them responsibly.
Credit utilization refers to how much debt you’ve been offered versus how much you actually use. For example, if you have a credit card with a $10,000 limit, lenders want to see that you’re not utilizing the full $10,000 every month.
Maxing out credit limits and cards can be a sign of reckless credit utilization, while appropriate credit utilization can boost your score more than never using credit at all.
Since your credit score is based on your history using credit, it can be in your favor to have years on the books. This can reflect that your behaviors have been consistent and can also help shield you from small mistakes, like an accidentally missed payment.
The age of your oldest (and newest) accounts, the average age of your accounts, and the length of time since you last used your accounts all factor into this piece of your credit score. It’s typically best to keep your oldest accounts open, even if you don’t currently use them, in order to keep a strong history on your reports.
Having a mix of revolving accounts and installment accounts can provide a great balance for your credit score. Revolving accounts include credit cards, HELOCs, retail store cards, while installment accounts include student loans, mortgages, and auto loans.
You do not need to carry debt in all of these categories to have a great credit score, it’s simply another factor to help determine how you manage different types of credit accounts.
A new credit application stays on your file for two years, while FICO considers new credit as anything applied for in the past 12 months. Applying for a lot of credit within these periods can bring down your credit score, especially if you have a short credit history.
Being strategic in your applications can greatly impact your credit score. For example, you don’t want to open multiple credit cards before applying for a mortgage. Slow and steady utilization can create strong credit reports and subsequent scores.
Hard versus Soft Inquiries
Hard inquiries happen when financial institutions check your credit report in order to make a decision on an application you submitted. Applications for mortgages, credit cards, student loans, auto loans, apartment rentals, and personal loans can trigger hard inquiries.
Hard inquiries can negatively impact your credit score, especially if you have a relatively short history or a history full of missed or late payments. Many hard inquiries in a short period can reflect high-risk behavior. And as we mentioned above, credit applications can stay on your credit report for two years.
Soft inquiries do not affect your credit score. These inquiries happen during “prequalified” offers and quotes, when you check your credit reports, or when the inquiry is for a background check.
Fortunately, the soft inquiry provision allows you to rate shop as long as the lenders use soft inquiries to prequalify you. The rates and terms may change after an official application is submitted, but at least you can shop around and get prequalified for different rates without affecting your credit score.
Advanced Principles: Building an Excellent Credit Score
How to Build an Excellent Credit Score
First, it’s important to actually have a credit score. It can be hard to build credit without a credit history, so consider co-signing with someone who has a strong history to start building yours. Once you have your history built, there are several strategies you can follow to grow your score:
- Make on-time, full payments
- Keep your credit utilization under 30%
- Strategize your applications
- Be versatile
Make on-Time, Full Payments
As we mentioned above, timely payments make up the biggest percentage of your credit score. Therefore, making on-time, full payments is the best way to build your credit score. Setting up automatic payments can help ensure you never miss a payment.
If you need help with making payments in full each month, consider setting up a budget and focusing on your needs first, then your wants. Late fees and rolling balances can put you into a cycle of debt and slowly bring down your credit score.
Keep Your Credit Utilization Under 30%
Keeping your credit utilization under 30% means that if you have a $10,000 credit card limit, you only use $3,000 (or less) of it per billing cycle. You can set up alerts to warn you when you’re about to hit your self-imposed limit.
You can also periodically call your credit card company and ask for an increase in your credit limit. Not so with the intention to add more debt, but so that your credit utilization goes down even further.
Strategize Your Applications
Slowly building your credit can take time. It’s important to spread out your credit applications to keep your credit score moving in the right direction. Too many hard inquiries, especially before you want to apply for a secured loan (like a mortgage or personal loan), can take a toll on your score.
Additionally, consider leaving your oldest account open. This will boost your credit longevity and positively affect your score.
Your credit mix accounts for a small percentage of your score but it’s still pretty important. If you’re able to responsibly manage a credit card or loan, consider applying for one. A robust credit utilization shows that you can handle different types of financing.
How to Access Your Credit Report and Dispute Discrepancies
Your credit reports are ultimately going to be used to determine your credit score; therefore, you should regularly check your credit reports for any discrepancies.
If there are mistakes on the report, chances are that your credit score isn’t giving an accurate representation of your credit history. It’s recommended that you check your reports annually and before a major credit event, like applying for a mortgage.
You can request free copies of your credit reports from the three major credit reporting agencies TransUnion®, Experian®, and Equifax® every year. You can apply for each the reports by going to Annual Credit Report.com.
Common credit report mistakes include:
- Personal information
- Account balances
- Account status
- Double entries
If you do find an error on one or more of your credit reports, you’ll need to contact the bureau directly with documentation that supports your dispute. For example, an updated balance statement, a form of ID, etc. The credit bureaus have about 45 days to investigate your dispute.
Sometimes a credit report mistake is due to a clerical error, while other times it’s due to fraudulent behavior, such as identity theft. Due to wide scale data breaches, you may even qualify for free credit monitoring. You can also protect your credit reports with low-cost identity theft protection.
Your credit reports typically do not include your actual credit score. You can typically access your FICO credit score from the three credit bureaus from your financial institution, loan statement, credit card companies, and credit scoring websites.
Build Your Credit Score, Financial Future, and More with Lafayette Federal
At Lafayette Federal, we exist to serve our members and guide them on the path to financial success. We offer a wide range of services and financial products designed to help you achieve your financial goals, increase your credit score, and more by offering education, competitive rates, low fees, and a personalized service experience.