There are so many reasons your credit score is relevant in your life.
For example, it’s pertinent if you want to buy a home or even rent one. Maybe you’re ready to sell your old car and finance a new one. Your credit score is important then. In some cases, your score is even relevant to getting a new job or starting a business.
Understanding your credit score is a foundational part of your overall personal finance situation.
With that in mind, the following is everything you need to know.
What is a Credit Score?
A credit score is used by lending and financial institutions to predict how likely someone is to pay back a loan on time. A scoring model is used with information from a credit report to create the score.
Companies use a formula, which is the scoring model.
Individual factors that are part of your score typically include:
- Your history of paying bills on time
- The unpaid debt you have currently
- The type and number of loan accounts you have
- How long you’ve had loan accounts open
- How much of your available credit you’re using
- New credit applications
- Whether you’ve had a bankruptcy, foreclosure or a debt sent to collections
You don’t just have one credit score.
Instead, there are many credit scores often available to a lender.
A credit score depends on the data used in the calculation. Your credit score can vary depending on the data used, the scoring model, the type of loan product, and the day it was calculated.
Major Credit Reporting Agencies
Credit reporting agencies are also known as reporting bureaus.
The three main bureaus in the U.S. are Experian, TransUnion, and Equifax. Each of these three bureaus organizes consumer credit information in different ways, at least slightly.
Some lenders will report to one bureau, while others will report to all three.
These bureaus include:
- Experian: This is the oldest agency of its type. Experian uses a FICO-based scoring system to give consumers a credit score made up of three digits.
- TransUnion: This major credit bureau also offers debt recovery, portfolio management, and fraud management services.
- Equifax: The scores from Equifax range from 280 to 950 and follow a formula similar to FICO.
All three of the major credit reporting agencies do similar things. They collect consumer data and then provide it to lenders. The lenders use the information to make credit decisions.
The three bureaus are all private companies, but they have to follow the rules set forth by the Fair Credit Reporting act.
The Fair Credit Reporting Act
The Fair Credit Reporting Act is a federal law initially passed in 1970. The FCRA is a way to ensure there’s fairness, privacy and accuracy in credit reporting. As a consumer, you’re entitled to certain things under the law.
You are entitled to check the accuracy of your own credit reports when the reports are used for employment eligibility.
You can be notified if you’ve been refused credit because of something on file in your report.
As a consumer, you maintain the right to dispute errors, and negative information is removed after 7 to 10 years.
You can also get one free credit report per agency in 12 months.
Information Collected by Credit Bureaus
The information a credit bureau can collect includes:
- Lender name
- Account age
- Account number
- Credit lender
- High balance
- Payment history
- Last activity date
- Current balance
This information can come from credit cards, mortgage lenders, bank accounts, and other creditors.
Your credit report will also include any information about hard inquiries. Hard inquiries are what happens as you apply for credit, such as a loan or a new credit card.
Credit reports will also have information about bankruptcies.
Credit bureaus will set your information and credit history to the lenders you do business with. When you apply for credit, a financial institution will get a copy of the report. They then use that to decide if they’ll lend you money.
How Long Does Information Stay on a Report?
If you have positive financial information on your report, it will stay on your report over the longterm.
Negative information doesn’t stay on your report forever, on the other hand.
Negative information will usually fall off after around seven years, with a couple of exceptions.
Chapter 7 bankruptcies will usually go away after around ten years, and Chapter 13 bankruptcies disappear after approximately seven years.
Charge-offs occur when a lender writes off delinquent debt. These tend to go off reports after seven years.
If you close an account, it will stay on your report for ten years, and collection accounts will usually hang on for seven years from the last payment date.
A tax lien or judgment isn’t included on credit reports anymore, but they were until 2017.
As we talked about, financial institutions don’t always report to all three bureaus, which is why your credit reports can have different information, at least slightly.
How Are Credit Scores Calculated?
We don’t necessarily know all the details about how credit scores are calculated.
FICO is the most widely known credit score model, but not the only one. There’s also the VantageScore, but it’s less commonly used. FICO stands for Fair Isaac Corp.
FICO produces scores for the three major credit bureaus.
An estimate of how the FICO model calculates scores includes:
- Payment history—this is said to make up around 35% of your score. You have to pay your bills on time not only to avoid late fees but also to have a good score as it’s the number one FICO calculation factor. Even missing one or two payments can have a major detrimental effect on your score.
- Amounts owed—making up 30% of your score, this is the amount of debt you owe compared to your total available credit. We also see this called your credit utilization ratio. A good rule of thumb is to try and keep it below 30%.
- Length of credit history—accounting for around 15% of your score, lenders want to see how long you’ve been using credit. The longer your history, the better for most lenders.
- Credit mix—having diverse accounts is good for your score and makes up around 10% of your FICO calculation. Lenders want to see you can handle a variety of debts, including student loans, a mortgage and credit cards. It’s only beneficial if they’re in good standing.
- New credit—making up 10% of your score, if you have too many hard inquiries or new accounts within a short window of time, lenders may not like it. It could show you’re financially struggling.
Range of Credit Scores
- 800 and above—exceptional
- 740-799—very good
- 579 and below—poor
Excellent is the best level of score you can have. Most of the top credit cards require that you have either good or excellent credit. Even when you have a perfect score, however, it doesn’t inherently mean you’re going to get approved for a credit card or loan.
Other factors are relevant, too, like your monthly housing payments and income.
If your score is fair or poor, along with it being less likely you’ll get approved for loans or credit cards, there are some other ramifications.
For example, you’ll likely have higher interest rates and less favorable terms if you are approved, like high annual fees.
Checking Your Credit Score
You should check your credit score at least once a year. It doesn’t hurt your score to check your own credit.
Most credit card companies will offer free access to your credit scores. Some card companies use FICO, while others use Vantage Scores.
Under the FCRA, you can also view your credit reports for free once a year by visiting AnnualCreditREport.com.
Improving Your Score
The following are tips that help you improve your FICO score and build good credit:
- Pay bills on time. This is the single most effective thing you can do to raise your credit score.
- Keep your credit utilization under 30%. Don’t use any more than 30% of your available credit at any given time. Pay your totals off every month if you can. Then, you’re not carrying a balance which improves your score, plus you don’t have to pay interest charges.
- Start using credit responsibly early on. Even if you have a credit card and you charge $40 a month and then pay it off, it’s going to help you build a good score.
- Diversify your types of credit, and pay it off.
- Be very careful about opening any new accounts.
What’s helpful to understand about your credit score is that the things you can do to raise it or maintain it are good financial decisions overall. When you set having a good credit score as a goal, it will help you have better general financial habits. This will then help you be prepared to make big purchases, like buying a new car or a house.