Every major purchase you make as an adult will be affected by your credit score. Those three digits will dictate whether you can rent an apartment, buy a car, or purchase a home. Your credit score is a measure of the likelihood that you will pay back money loaned to you. It is dependent on many factors and changes based on your fiduciary actions. Understanding your score is the first step in trying to improve it for your financial future.
Deciphering the Score
Ninety percent of lenders use FICO scores to judge the financial viability of a loan applicant. FICO stands for Fair Isaac Corporation, which is the original name of the company that created the credit-risk model to assess financial risk in lending. A FICO score is a complex calculation based on a consumer’s credit report provided by the three main credit bureaus: Equifax, Experian, and TransUnion.
Credit scores range from a low of 300 to a high of 850. Anything below 580 is considered a poor score and below the average of most consumers in the country. A person with a score below 580 would pose a high risk of future loan delinquency. A score between 580 and 669 is a fair score, although below the average. Most consumers that fall in the 670 to 739 range are thought of as good credit risks. Anything above 740 shows a consumer is dependable and would be a low risk to lenders.
If you’ve never held credit, you won’t have anything in your credit report that can be used to calculate a score. Consumers typically need at least one open account that has been active for at least six months and one account that has been reported to the credit agencies within the last six months. These are the minimum requirements needed to establish a score. Continuing to use credit wisely over time will increase your score and your credit history.
Although many people may think purchasing items with cash and having zero debt is fiscally responsible, this will not help your credit score. There is no history of credit usage and repayment to offer lenders a look into how likely you are to pay back a loan. Lenders need historical data to judge your risk. When you pay cash, there is no paper trail for lenders to follow.
Calculating Credit Worthiness
Many factors go into the calculation of a credit score. These include:
- The amount you owe
- Your payment history
- The types of credit accounts you have
- The number of new credit inquiries on your report
- The length of your established credit
The most critical factor in determining a credit score is your payment history, as that makes up 35% of the calculation. The next important component is the amount you owe, which makes up 30% of your score. The length of your credit history accounts for 15% of the calculation. The number of credit inquiries you’ve recently made as well as the types of accounts you have open each account for 10%.
The exact numerical score a lender will accept can vary greatly. For example, if you’re purchasing a car, the minimum credit score at a dealership for luxury vehicles may be higher than the required score at another dealership that specializes in economical cars. The same is true for mortgages. Many mortgage lending companies will relax their requirements for first-time homebuyers but may hold buyers of million-dollar homes to a higher standard.
Variances also exist among credit bureaus, which may each have different information cataloged for you. The inconsistencies may be due to name differences. Perhaps one credit bureau has accounts associated with your maiden name while the others do not. Sometimes the variances are due to errors. Someone else in your family with the same name may appear on your report. Make sure to monitor your credit for these types of issues to ensure any financial responsibilities that are not yours are removed. Establishing a good credit history is the key to reaching your financial goals.
Monitor your credit reports for accuracy and to keep you on track. Understanding what goes into a FICO score will help you govern your financial decisions and help you plan for large purchases.