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Financial Literacy

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Credit Confidence: What's in the Score?

Cam Mulvey

April 12, 2024

You’ve probably heard of your credit score. If you’re on top of your stuff, you might even know what yours is (this is a bigger accomplishment than you may realize - 42% of Gen Z doesn’t know theirs). But if you’re here, you probably have some questions. Good news for you, I’ve got answers. 

What is your credit score used for? 

Simply put, a credit score is a number that lenders use to determine how "creditworthy" you are - in other words, how likely you are to pay back a loan based on your past financial behavior.

This three-digit number has a huge impact on your financial life. Your credit score is used to decide whether you qualify for loans, mortgages, credit cards, and even things like apartment rentals or cell phone plans. And it also determines the interest rates you'll pay on those financial products. The higher your credit score, the better the terms you'll get.

So what types of loans and financial products require a credit check and credit score review? Essentially any type of consumer loan, including:

  • Mortgages
  • Auto loans
  • Personal loans
  • Credit cards
  • Student loans

Basically, if you're trying to borrow money or get approved for a new line of credit, your credit score will be a key factor in that decision. Lenders use this number to gauge how risky it would be to extend credit to you.

An Example of Credit Scores’ Impact

Let's look at a real-world example to illustrate the impact of credit scores. Imagine two people, Miles and Polly, both shopping for the same new car. They find the exact same model, with the same sticker price.

Graphical illustration of a car, to show how auto loans are affected by good credit scores

However, when they each apply for an auto loan, their monthly payments end up being quite different. Polly, with an excellent credit score of 800, qualifies for a loan with a 5% interest rate. Her monthly payment is $450.

Miles, on the other hand, has a credit score of only 620, which is considered "fair." As a result, the lender approves him for a loan, but with a much higher interest rate of 12%. His monthly car payment ends up being $550 - that's $100 more per month than Polly, for the exact same car!

This example shows how just a small difference in credit scores can have a dramatic impact on the financing terms and costs someone faces. Even though Polly and Miles were making the same purchase, the interest rate they qualified for made a big difference in their monthly expenses.

How is your credit score calculated? 

Now that you understand what a credit score is and why it's so important, let's dive into the details of how it's actually calculated. There are a few key factors that make up your credit score:

Payment History: 35%

This is the single most important component of your credit score. It reflects whether you've made your monthly payments on time, every time. Even just a single missed payment can dock points from your score. Setting up reminders or automatic payments is crucial to maintaining a strong payment history.

Amount Owed: 30%

This looks at how much of your available credit you're currently using across all your accounts. Experts recommend keeping your credit card balances below 30% of your total credit limit. Maxing out or overusing your available credit can significantly hurt your score.

Length of Credit History: 15%

The longer you've had credit accounts in good standing, the better. Lenders view long-term, responsible credit users as less risky. Even if you're just starting out, using a single credit card for small purchases and paying it off monthly can help build up your credit history over time.

New Credit: 10%

Applying for and opening too many new credit accounts in a short period of time can be seen as risky behavior and temporarily ding your score. It's best to limit new credit applications, especially if you're still building up your credit history.

Credit Mix: 10%

Having a diverse "credit mix" - a combination of different account types like credit cards, loans, and mortgages - can help improve your score. But day-to-day responsible usage is far more important than the specific types of accounts you have.

Download on Interest 

Before we dive deeper into credit scores, let's quickly cover the concept of interest. Interest is the fee you pay to someone when you borrow money from them.

When it comes to consumer credit, interest rates can vary quite a bit. Credit card APRs (annual percentage rates) typically range from around 12% all the way up to 23%. The average credit card APR currently sits around 16%.

That means if the average person has a balance of $1,000 on their credit card, they have to pay back $1,160 (their $1,000 balance plus the 16% interest of $160). Note that this example doesn’t include compounding, so their payment will actually be higher. 

What Your Score Does Not Consider 

It's important to understand that your credit score is not a holistic measure of your overall financial health and standing. There are several key factors that your credit score does not take into account, including:

  1. Income - You don't have to be rich to have a good credit score. Your credit score is determined solely by your credit history and activity, not your income level. Individuals from all income brackets can maintain healthy financial habits and build strong credit.
  2. Net Worth - Your credit score does not reflect your total net worth, which is the difference between your assets (savings, investments, property, etc.) and your liabilities (loans, debts, etc.). Net worth is an important measure of your overall financial stability, but it is not factored into your credit score.
  3. Savings and Investments - The amount of money you have in savings accounts, retirement funds, stocks, bonds, or other investments is not considered in your credit score calculation. 
  4. Employment Status - Whether you are employed, unemployed, or self-employed does not directly affect your credit score. However, lenders may consider your employment status when deciding whether to extend credit to you.
  5. Education and Occupation - Your level of education and your occupation are also not factored into your credit score. These factors may indirectly influence your income and financial decision-making, but they do not play a direct role in your creditworthiness.

Remember, your credit score is focused solely on your history of borrowing and repaying debt. Understanding what it does and does not consider is key to maintaining a well-rounded view of your overall financial health and stability.

Strategies for raising your score 

A ranking of what is considered a good credit score

About 40% of Americans pay down every month, 40% keep a balance, 20% don’t have credit. Regardless of which camp you fall into, there are several proven strategies you can use to build and maintain a strong credit score:

  1. Make Payments On Time: Your payment history is the single most important factor in your credit score. Ensure you pay all your bills, including credit cards, loans, and utilities, on time every month. Set up reminders or automatic payments to avoid any late or missed payments.
  2. Lower Credit Utilization Ratios: Experts recommend keeping your credit card balances below 30% of your total available credit. Paying down high balances can significantly improve your credit utilization ratio and boost your score.
  3. Limit New Credit Applications: Each time you apply for new credit, it results in a "hard inquiry" on your credit report, which can cause a small, temporary dip in your score. Limit the number of new credit applications, especially in a short timeframe.
  4. Correct Errors on Your Credit Report: Regularly review your credit reports from the major bureaus and dispute any errors or inaccuracies you find. Even small errors can negatively impact your score.
  5. Diversify Your Credit Mix: Having a variety of different credit accounts, like credit cards and installment loans, can improve your credit mix and demonstrate your ability to manage different types of credit responsibly.
  6. Pay Down High Balances: Focus on paying down high-balance credit cards, as this can significantly improve your credit utilization ratio and boost your score.
  7. Set Up Automatic Payments: To avoid any late or missed payments, set up automatic payments or payment reminders for all your credit accounts.
  8. Consider a Secured Credit Card: If you're new to credit or rebuilding your credit, a secured card (where you make a refundable security deposit) can help establish or improve your credit history.
  9. Become an Authorized User: Ask someone with a long history of responsible credit use, like a parent or spouse, to add you as an authorized user on one of their credit cards.
  10. Negotiate with Creditors: If you have past due accounts or are struggling with debt, try negotiating with creditors for a payment plan or settlement. This can help prevent further damage to your credit.
  11. Avoid Risky "Quick Fixes": Be wary of any companies that claim they can quickly or easily repair your credit score. Building and maintaining good credit takes time and consistent effort.

Credit Score Myths 

Credit Score Myths

Now that we've covered the key factors that influence your credit score, let's address some common myths and misconceptions about how it all works:

  • You Need to Carry a Credit Card Balance to Build Credit: This is false. Carrying a balance and paying interest is not necessary to build a strong credit score. In fact, paying off your credit card balances in full each month can actually have a more positive impact on your score.
  • Checking Your Credit Score Lowers It: This is a myth. Checking your own credit score, whether through a free service or by requesting your credit report, does not result in a hard inquiry that can lower your score.
  • Closing Old Credit Accounts Boosts Your Score: Actually, the opposite is often true. Closing older credit accounts can shorten your overall credit history and increase your credit utilization ratio, both of which can hurt your score. The simplicity of fewer accounts may outweigh this effect, but it's important to be aware of the potential score impact.
  • Paying Off Negatives Removes Them from Your Report: Unfortunately, this isn't the case. Even after you've paid off debts sent to collections or settled delinquent accounts, those negative marks can remain on your credit report for up to 7 years. The best approach is to pay these off as soon as possible, but understand they won't disappear immediately.
  • All Credit Reports and Scores are the Same: There are multiple credit reporting agencies, like Experian, Equifax, and TransUnion, and they may have slightly different information in your credit file. This can lead to small variations in your credit score between providers. It's important to check your reports from all three bureaus.
  • Co-Signing Doesn't Affect Your Score: This is false. When you co-sign a loan for someone else, you become equally responsible for that debt. If the primary borrower misses payments, it can negatively impact your own credit score. Co-signing is a big commitment, so think carefully before doing so.

Understanding these common myths is key to developing realistic expectations around your credit score and how to effectively manage it. Staying informed and focused on proven credit-building strategies is the best path to a strong, healthy credit profile.