Back to Basics: Learning About Credit

by nrichardson
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Red notebook titled credit score 101 next to two pencils, an eraser, and a yellow post-it note reading FICO.

You know you have a credit score, but where did it come from and what exactly does it mean?   It can all seem like a pretty big mystery, but it’s a mystery worth solving because your credit score can play a big role in your ability to obtain and manage credit.

Today, we’ll give you a quick rundown of credit and break down the basics of understanding your credit score.

Why it matters

Your score is important because it is used as a data point to determine how likely you are to repay money you borrow or the credit you are given. Just as students are assessed on their GPA (grade point average) in college applications, a credit score is used by businesses, banks and insurance companies to determine if you’re a reliable person to do business with. A good score can help you get better deals when taking out a loan or getting a credit card, with higher credit score numbers equating to better interest rates, loan amounts, and options. Lenders and others want to make sure that you won’t skip out on paying them back, so they use your score to make sure you’re a safe bet. A good credit score can also save you money on insurance premiums! 

So, what’s the deal with your credit score?

Each of the three national credit reporting agencies (NCRA’s): Equifax, Experian, and TransUnion calculates and assigns you a credit score. There are also other scores like a FICO score or a VantageScore which are largely based on credit reports from the NCRA’s.

Your scores with each of the NCRA’s and your other scores may be different because they may use different data points and those data points may be contributed from different data providers. Scores can also differ because the data points may be used to determine different performance target(s) (e.g. likelihood of default within a certain period of time, first time default, etc.). However, credit scores in general focus on “creditworthiness” and how responsible you are with your accounts and credit.    

Let’s take a look at your FICO score

FICO, for example, evaluates people in five major categories:

1. Payment history (35%): 

This one is pretty obvious, but if you aren’t paying your bills on time, it can seriously affect your credit. Never missing a payment will make you appear more dependable, thus boosting your overall score and offering you new opportunities. For example, if each time you lent your friend your car it came back with a new ding, scratch, or other minor defects, at some point you’d stop letting your friend use your car! Maybe not right away, but you’d definitely start to take notice of a pattern. It’s the same with credit. If you’re not paying back your loans, credit cards, bills, etc., on time, banks, creditors, and even insurance companies will be less likely to extend credit or services to you in the future.

2. Amounts owed (30%): 

Credit utilization is a big part of your score. The goal should be to keep your credit use below 30%. This means that if you were to divide your current debt by the total credit you have available, it would equal less than 30% in total. Any higher, and you’ll likely begin lowering your score. For example, you have two credit cards, each with a $1,000 limit. If you have a $500 balance on both cards, for a total of $1,000 of debt and $2,000 in credit, your credit utilization is 50%. Lenders, banks, and others will view you as high risk if your accounts are maxed out.

3. Credit history (15%): 

Everybody’s got to start somewhere, right? If you’re new on your credit journey and just beginning to build up your score, you’ll be considered more of a risk since this factor is looking at the average age of all your accounts. Naturally, no one knows much about the new kid on the block. Give it time, establish your credibility, and you should see your scores increase! Patience, young grasshopper!

4. New credit (10%): 

Just as in life, it’s important to pace yourself. The same can be said about credit. Opening too many accounts, cards, or loans all at once can be a significant red flag. Take it easy and pace opening new accounts.

5. Credit mix (10%): 

The last piece of the pie would be your overall credit list. Creditors will consider how many credit cards you have, any loans you have out, and even a home mortgage if you have one. All things being equal, the more diversified your credit, the better your credibility. Being able to balance various forms of credit (and being in good standing) is a solid sign that you’re responsible with your money. 

What is a good credit score?

Depending on the NCRA, most credit scores range from 300 to 850. The lower your score, the higher your risk to the lender (the higher the number, the better).

Just like with letter grades, there is a range in scoring that typically follows these guidelines:

580 or less: Poor
580 through 669: Fair
670 through 739: Good
740 through 799: Very good
800 through 850: Excellent

Get that number in the 700-800 range and you’ve just earned a whole lot of trust from creditors!

Get your free credit report

To get one free copy of your credit report every 12 months (from each of the three NCRA’s), you can call 1-877-322-8228 or go online: https://www.annualcreditreport.com/index.action


Feeling like a credit expert yet? If this article has left you inspired to begin building or boosting your own score, check out our article How to Create a Budget 101, to begin facing your finances with confidence.


Sources:

What’s in my FICO® Scores?myFico
What is a Credit Utilization Rate? – Experian
Your rights to your free annual credit reportsAnnualCreditReport.com
What Does Credit Mix Mean?myFico

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1 comment

Mary Clark January 21, 2021 - 4:30 am

Great explanation
Thank you

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