Understanding your credit score is one of the most important steps you're going to take towards repairing it, if necessary. Your credit score has a profound impact on all of the biggest purchases you'll make throughout your life, along with many other interactions you'll have with banks or other lenders.
It's absolutely something to take serious, especially when you learn that having a better credit score can save you $100,000 on the cost of your home (We'll show you the math in a moment.)
You may only get a little nervous or anxious before looking up the day's sports scores to see how your teams did, or waiting to see how your favorite stars scored on DWTS. But when it comes to checking what score you have in regards to your credit, it can be downright crippling for many people. If you already have an idea that your credit isn't great, actually checking the official number is something that takes a lot of guts. But you know what? That feeling of being too terrified to check your credit history is the exact reason that you need to do it as soon as possible.
This isn't something that gets better on its own, but it is something that you can improve more easily than you may think. We've put together a great resource on the topic of credit repair which we encourage you to visit to learn more about, but today we're going to cover on your credit score in general – good and bad – and how it's calculated. You can't fix it until you know what it is, right? And you never know, you might be doing a lot better than you thought, so give yourself some credit and don't be too hard on yourself until you've actually inquired as to what your score is. We'll also be going over some basic things you can do to get a better score, which are all very worth looking into, as they can save you a fortune in the long run.
There are 5 main criteria that make up your score, and they're weighed differently from each other. Some things are more important than others, thus they have a larger proportional impact on your overall score.
The Fair Isaac Corporation Score (FICO)
You may not have heard them called by that name, but you've probably heard of your “FICO Score” before. Your credit history is used to determine how risky it is to lend you money. Understanding how each of the following factors are broken down, and sorted based on their impact, is crucial in getting ahead of the game. FICO has been around since the mid-1950s, and uses the following formula to calculate your creditworthiness:
- Payment history – 35%.
- Outstanding debt – 30%.
- Age of accounts – 15%.
- Newest information – 10%.
- Types of credit – 10%.
Naturally, you want to focus the most on the ones that make up the biggest % of your overall score, but don't neglect the smaller ones, either. There are some of these that you can immediately impact, and others that take some time. Even if something takes time, that's not a good reason to not at least get the ball rolling, because it's going to take the same amount of time regardless of when you get started. Even if you're feeling overwhelmed, you've got to just bite the bullet because knowledge is power. The longer you put it off, the worse it'll sting.
We're going to be referring to credit agencies a lot, so before we go any further – let's talk about the main credit agencies.
In the United States, the 3 big Credit Bureaus are:
- Experian
- Equifax
- Transunion
Each of them has their own proprietary ways to calculate your score, but it all comes back to FICO, and slight modifications thereof.
1. Understanding your payment history
From cellphone and cable companies, to landlords, to credit cards…there are many different groups who report to the credit agencies, and all have an impact on your score. The highest-weighted section of your credit score is your payment history, which accounts for over a third of your overall score.
Different groups will report missed or late payments at different times. Some will wait until you've missed two, maybe even three payments. Others will rat you out to the credit agencies almost immediately. As such, it's a good practice to always be in touch if you're going to miss a payment. Get out ahead of it, and you'll often find a bit of leeway. If you know a particular lender is much more aggressive in their reporting, it's a good idea to take care of them first, for the sake of avoiding the hit to your score.
You can hide from your debts, but you can't run for long! It's better to face them head on.
The worst thing you could do is to disappear off the face of the planet, and let those envelopes stack up month after month. Not only will the stress cause you harm, but you'll just end up digging a deeper hole. Nobody likes dealing with collections agencies, they can be aggressive, unethical, and downright mean, but they do hold some power over you so it's best to just get things sorted out. Arrange payments, make a plan, make a budget.
Even if you have a long history of bad financial choices (or just being put into bad situations that were out of your control – no judgement here), you can still make things better. Granted, maybe not perfect, since this particular category has a big influence on your overall score, but making a dent in improving the blemishes on your payment history is a great step to take towards getting everything else in order.
2. Understanding your outstanding debt
Your outstanding debt is another huge factor, carrying only slightly less importance than your payment history, and at least double the impact as everything else that we'll be looking at in a moment. Your score in this department is calculated by taking the total amount of money that you currently owe, and weighing it against your total available credit.
For example, if you have a total limit of $20,000 across your credit cards and they're always maxed while you struggle to make the minimum payments, that's going to raise some flags and look riskier than if you're paying them all off on time. There's a bit more to it than that, of course, but generally speaking this 30% of your overall credit score is determined by how much money you currently owe and how well you're servicing said debt. Someone with a $1,000 limit on their card who never misses a payment and pays more than the minimum looks safer to lend money to than somebody who has the same $1,000 limit card but constantly has it maxed out and/or misses payments.
3. Understanding your age of accounts
There aren't really any ways to skip forward in time to make your accounts older, but keep in mind that they look at the average age of your accounts. If you have an older credit card, for example, try to avoid closing it down and replacing it with a new one. Also, try to avoid opening too many new accounts at once, especially if you don't have a long credit history.
Opening new accounts will reduce the average age of your accounts overall, as will closing down the oldest ones if you don't have to. Even if you keep a low or zero balance, it can be beneficial to keep an older credit account open just for the sake of it's age. Now, this category accounts for 15% of your total, so if there's a really beneficial reason to open a new account, like a much better interest rate, it can still be the right move to make. The general advice of trying to avoid opening newer accounts isn't written in stone, the idea is generally to not go out and open up 5 new credit accounts out of nowhere, because that will tank your average age.
The ‘younger' your accounts are, the less of them that they have, the biggest hit you'll take by opening new ones.
4. Understanding your newest information
Weighed at only 10%, this isn't a huge factor, but it does matter and it can be enough to tip the scale. Contrary to the last section, which advised against opening up too many new accounts if you don't have a very long history, it can actually be beneficial to open new accounts in some cases. Taking out a new loan actually shows the credit agencies that lenders are willing to give you money, and that's a plus. It can seem like a bit of a catch-22, because if lenders rely on the credit bureaus to determine your creditworthiness, and the credit bureaus are taking cues from the lenders, that can be a vicious cycle for someone who can't get credit. However, once again, this section is weighed very lightly.
Shopping around for different types of loans can make an impact on your newest information. Some experts recommend to spread out this search, so that you're only shopping for one financial product at a time. Otherwise, you'll end up with a lot of hits on your account that can look like you're scrambling for as much credit as you can get, all of a sudden, which can potentially raise red flags.
5. Understanding your types of credit
There are numerous different products which fall under the category of a loan. From mortgages, to credit cards, to store cards, car loans, student debt, and more. They're not all the same when it comes to your credit score and as such, they're not treated the same either.
Now, let's return to the big picture…
We've broken down the ways that your overall credit score is determined, and looked at practical tips and advice to help you to improve in each of the five categories. Next up, let's go over some more key information.
Keep in mind: Those 5 things aren't necessarily the ONLY factors that will determine your creditworthiness. Typically, the number if your score will be somewhere in the 500-800 range. Higher is better. We'll explain the numbers and their meanings shortly. There are all sorts of things that can leave negative marks on your score, including if you've gone bankrupt in the past, or have a judgement. If your wages are garnished, or there's a lien against your property, this all comes into play as well.
The truth about fixing your credit score
At the end of the day, fixing your “score” is really about fixing the contributing factors that are stopping it from being higher. We've gone over many strategies which you can employ in order to get rid of those stains on your score, and eventually replace them with things that will impact it in a positive way. You won't see the changes immediately, however we've highlights steps you can take immediately. The sooner you plug the ship's leaky holes, the sooner you can start emptying out all the water. Even thought the results aren't instant, that's no reason not to get started ASAP.
But is it really worth all the effort?
What if you just say, “forget about it…” and decide to not bother with any of this? It might not have a huge noticeable impact on your day to day life, but in will certainly make a big difference in the long run. Here's the thing… the difference between a good and a bad credit score isn't just a matter of whether or not you'll get approved for a mortgage or other loans, it also impacts how much you'll pay in interest. If you already have a good score, it's absolutely worth aiming for great.
You can save tens, or even hundreds of thousands of dollars through the life of your mortgage, for example, by having a slightly better interest rate. The way that interest compounds over the course of decades is absolutely staggering, and with a higher interest rate – it's working against you. Even if you don't plan on buying a home right away (or if you already have), small improvements to tidy up your report can make an immense difference.
Entrepreneur Magazine did an excellent comparison showing the impact that your credit score and interest rate can have on your mortgage payments. We've borrowed those same numbers to highlight the financial benefits of having a higher score.
Let's take someone with excellent credit to start this example (In the 800 range.) Let's say they're applying for a 250k mortgage at a 30-year fixed-rate. Their interest rate is 5.9%, thus their monthly payment is $1,482,84.
If someone else had a credit score in the 670 ballpark, they might get an interest rate of 6.51%. Their monthly payment would be $1,581.81.
If you're in the lower 600s and receive an interest rate of 7.49%, you're looking at a monthly payment of $1,746.32. Every single month. For the next 30 years. That's almost an extra $300 per month, right in the pocket of the person with the better credit score.
Over the entire term of the mortgage, the person with the lower credit score is going to pay nearly $100,000 extra in total.
Now, if you could save yourself $100,000, or even a slice of that, and all you had to do was make some phone calls, arrange some payment plans, and start being a bit more strict with your budget, wouldn't that be a no-brainer?
By the numbers…
Just because you have a bad score now, that isn't a life-sentence. Every day people make improvements to their scores. You can't erase history, but you can change things around for the future. Here's a breakdown of what the different scores mean:
- 300 – 579 (Very Risky): When lenders see scores around 500 or lower, it means you probabally have some items on your credit report that are less-than-ideal. Don't get discouraged, it also means there's a lot that you can do to start improving things to get out of the “red zone”.
- 580 – 669 (Below Average): If you started in the Very Risky group, and made even a few small changes in the higher-weighted categorys that we outlined above, you could very well see yourself starting to slip into this bracket. It's still not ideal, and there's more work to do, but you're on the right track.
- 670 – 739 (Good): It's not amazing, it's nothing to write home about, but your score is good if you fall into this category. You shouldn't have too many issues security a wide assortment of credit, however you won't be getting the absolute best interest rates. It's serviceable, but if you've looked over your report and determined that there are things you can do to improve it, they're still worth doing!
- 740 – 799 (Very Dependable): This score shows you to be someone who can be trusted to pay their debts on time. You'll be getting good interest rates, and shouldn't have any issues getting approved for things like credit cards and mortgages.
- 800 – 850 (Exceptional): This is great. We've already highlighted how much money you can save by having an exceptional credit score, but you've still got to work to keep it. Make sure you're very diligent with all of your bills and payments, because even having one late payment reported can take a chunk out of your score.
How soon can you actually see improvements?
Your credit score could, hypothetically, get updated on a daily basis. It depends on how often it gets reported to. If you have a lot of lenders that are reporting on a regular basis, you could see changes to your score every every day. It may go up or down 20 points, but that's nothing to get alarmed about. Look at the overall pattern and trend in the long-term to really get a clear snapshot of your progress.
Taking Action to Improve your Credit Score
There are different options when it comes to doing this. You can tackle it yourself, or you can hire a company that specializes in this to help you. The DIY approach is, of course, less expensive since you're doing all the work yourself. Here's an idea of some of what's involved:
- Dealing with debt validation letters,
- Dealing with the credit bureaus,
- Verifying debt in a timely manner to avoid negative impacts…
Many consumers choose to hire a company to help them with this. There are a handful of leaders to choose from, and we've already reviewed them and chosen the very best options. These companies do this sort of work all day, every day. They know all the correct forms, they know how to get them filed quickly and correctly, and they know how to deal with all of the involved parties. It can be nice to have a degree of separation from it all. For the most part, there aren't all that much harm you can do if you unsuccessfully attempt this yourself, but just be careful when it comes to pinging your credit score at all, because that can have an impact. Not filing certain paperwork on time can also have a negative impact, which is why many people choose to let the professionals handle it for them.
