Almost everyone intrinsically understands the ways grades work in school: we receive A’s when we do great, F’s when we fail, and various letters with plusses and minuses in between. Our financial scorecard is not quite as straightforward. So, how should you understand your credit score and its impact on your finances?
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The credit score reflects our past financial decisions, but it also has significant influence on our future finances as well. The implications between good credit and bad credit scores can be fairly drastic, so it is important to understand how this score is determined and its consequences for you.
What Is a Credit Score in Simple Terms?
A credit score is a snapshot of your financial behavior. It tells financial institutions, lenders, and other potential service providers how you have behaved in the past and are likely to continue doing so in the future.
The score is a three-digit number that ranges between 300-850. The higher the score, the better your credit. Scores above 740 are considered very good, and those north of 800 are thought to be exceptional.
Those falling between the range of 670-739 are classified as good, while ones between 580-669 are fair. Anything below 580 is considered poor.
Your credit score is one of the principal pillars that potential lenders will examine when deciding whether or not to offer you financing. Simply put, it is an indication that tells the prospective lender how likely you are to repay your obligations on time.
How Is the Credit Score Calculated?
There are two main companies that score credit, Fair Isaac Corporation (NYSE:FICO), which uses the FICO score, and VantageScore. Their scoring and grading systems differ slightly, but they overlap with their focus on your payment history and credit utilization.
The FICO score is more widely used by lenders, and it is calculated based on the following:
Payment history (35%): Your history repaying your debts has the largest impact on your overall score. This is a direct reflection of your past behavior, and a strong indication of your ability going forward to meet your financial obligations on time.
Amounts owed (30%): This is the amount of debt you have in your various accounts. This includes both installment loans (i.e., mortgages or auto loans) and revolving accounts (i.e., credit cards). Even if you are paying off your credit card on time, your FICO score will be impacted by the percentage of the available credit that you are using. Using too much can be a sign that you are overextended, which can indicate that you are at a greater risk of defaulting on your payments. It is therefore considered good practice to keep this ratio for your revolving credit under 30%, meaning that if you have a $10,000 limit you should avoid holding a balance greater than $3,000.
Length of credit history (15%): This is simply a function of the length of time you have been building your credit history. This portion is based on the age of your oldest account, your newest account, and the average age of your accounts. It is therefore a good idea to keep your oldest account open, taking special care to always pay this account on time. Having a minimal, recurring transaction on this card is a great way to ensure that it is positively supporting your credit score.
New credit (10%): This takes into account any recently opened accounts. Opening up a new account will trigger an inquiry into your credit. Making multiple inquiries in a short period of time will signify that you are about to take on additional obligations, which can lower your credit score. Inquiries will stay on your record for two years, though only those from the past 12 months will be used as part of the calculations that determine your credit score. In addition, opening a new credit card will decrease the average age of your accounts, which also will impact your credit score (see above).
Credit mix (10%): This is an overview of the variety of financial products that you are using. The ability to juggle multiple types of financial accounts and obligations simultaneously can signify to creditors that you are a reliable partner. These can be revolving accounts providing credit such as credit cards or retail store cards, or installment accounts where you are paying back loans such as mortgages, student loans, or auto loans.
How Does Your Credit Score Impact Your Financial Situation?
Lenders and businesses will use your credit score to make decisions regarding whether or not to provide you with financing or take you on as a client. It will also affect whatever terms they are prepared to offer.
Your score is a real-time reflection of your finances and sets the parameters for any future financial engagement. A high credit score signifies reliability, which will make lenders more eager to work with you. Thus, the better your score, the more advantageous the financing terms you will be offered.
The opposite, however, is also true. Those with lower credit scores will find that their financing options are fewer and tend to be more expensive, as prospective lenders view them as riskier clients.
Even a small difference in the interest rates you are charged can have huge implications over the life of a loan. Consider a 30-year mortgage for $500,000. Obtaining this mortgage with a 5% interest rate will end up leaving you with monthly payments of $3,030, translating into $466,279 in total interest payments over the life of the loan. A slight bump up to 6% will increase these payments to $3,343.75 a month, costing you $579,191 in total interest payments.
Entering different figures into the TipRanks’ mortgage calculator can give you a sense of how these different rates will impact your loan payments.
Conclusion: Know Your Score
Being aware of your credit score can help you understand both your financial proclivities as well as your prospects for obtaining financing in the future. Once you know your score, you can take steps to either keep it high or work to improve it.
For those in good standing, there is something comforting in knowing that your responsible actions will be rewarded. However, if your past activities have left you with poor credit, this can also serve as a strong incentive for you to change your behaviors.
At the end of the day, financing institutions are reliant on these credit scores to make decisions that will have serious repercussions on your life choices. Make sure that you are doing everything in your power to help them help you.
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