Why Your Credit Score is Important
Why Your Credit Score is Important
A credit score is just one of those essential numbers that is needed to become an adult. This three-digit number, ranging from 300 to 900, is an indicator of how trustworthy you are as a borrower and represents the overall health of your finances. Credit scores are intended to help alleviate financial risk and to help companies “take a risk” on you. This risk might be providing a loan to you (can they make sure you will pay it back on time and in full?), offering to give you a new credit card (will you be able to consistently make the monthly payments?), or even providing you a line of credit (can you afford to pay it back?). Credit scores are designed to help predict the chance that you as an individual will be able to pay back the amount of money borrowed.
you have low credit score, meaning below 500, or even no credit score as you
haven’t started building it, you are considered high risk and if you decide to
buy a house, rent an apartment, take out a line of credit or even try opening a
credit card, it will be very difficult for you and more expensive as companies
will not know if you have the means and the history to pay them back. This will
lead to one of two outcomes: either they will decline you or they will just
offer you a high interest rate. This is done so that they can make sure that
they get a maximum amount of their money back right from the start rather than
worrying that you might default (stop paying or cannot pay anymore) and they
are left with nothing.
credit score is a number that will help dictate your future by allowing you the
chance to get a lower interest rate and a larger grace period if you do end up
forgetting to pay for a credit card bill once. Knowing where your credit score
lies on the range is very important. Depending on where you are, this might be
the difference between paying $1000 a month on a mortgage and paying $1200 a
month on the exact same mortgage on the same house or apartment.
What Do These Numbers Mean?
average, the credit score ranges from 300-900 and it is broken down like this:
Terrible: Less than 500
individuals who have a credit score of less than 500 tend to be those who do
not pay their bills monthly, have high levels of debt and no income to pay down
this debt. You also find individuals who are just starting to build their
credit score. Those in this range will not get approved for new credit and
should seek out ways to improve their credit score.
Very Poor: 500-579
in this range are similar to the 500 or less range, they will rarely get
approved for anything but they are able to begin repairing their credit as long
as they can show proof that they can slowly chip away from their high levels of
debt. People in this range that want to improve their credit score can ask for
a pre-paid credit card where you are able to pay the bank before spending money
on your credit card so that you can rebuild your credit and the bank does not
need to worry about you paying them back as you have already paid them in full.
who are found in this category are considered high risk, it may be difficult to
obtain a loan. If you are approved for any sort of credit, you will be offered
a high interest rate as you are a credit risk to the lending institution.
range is considered to be good, individuals will receive a slightly higher
interest rate than those with better scores but should have little to no trouble
in getting approve for new credit. If you are just starting to build your
credit score, this is the point where you will be able to drastically improve
your credit score quickly as long as you pay off all of your debt monthly and
do not purchase more than you can afford.
that fall into this range have good credit and will have little to no trouble
getting approved for new credit. These are the individuals that tend to receive
more exclusive offerings of new credit cards or phone calls from companies
wanting to provide them with new credit cards or lines of credit.
Very Good: 720-799
range is almost perfect. These individuals will benefit from reduce interest
rates and are considered to be the gold standard for credit scores. They will
enjoy some of the best interest rates available.
who fall into the ‘excellent’ category will enjoy the lowest interest rate on
the market and will typically always be approved for a loan as they are
considered trustworthy and not risky at all.
you can see, the different ranges are all very subjective. You might have been
an individual who was in the average range and forgot to pay a credit card bill
on time. By not paying, you are considered to be slightly more risky than you
were before and you might be demoted to poor. So now, how does this score
actually work? Is it only based on paying my bills completely every month or is
there more to it than just that?
that Affect Your Credit Score
Now determining a credit score is a lot tougher than just looking at a person’s ability to pay their bills every month. There are actually 5 main factors that affect how your credit score is calculated. If you want to improve your credit score, these are the areas that you definitely need to focus on.
Payment History (35%) – Determined by payments that you make to your lender or
to your creditor. This basically reflects how often you pay your bills or loans
on time. If you are trying to improve your credit score, you should always make
your payments on time every month or every 2 weeks depending on what you have
agreed to. This is probably the easiest factor to improve your credit score, as
it is something that can be worked on every month by paying off your bill in
Debt / Credit Utilization Rate (30%) – This shows the amount of outstanding
debt you currently have as a consumer compared to the amount of available
credit you have. As an example, if you have a total credit limit of $10,000 and
every month you use $4,000 of your available credit, than you have a credit
utilization rate of 40% ($4,000 / $10,000) and your credit score will be
negatively affected. To improve your credit score or to keep a good credit
score, make sure you pay down your debt and the rule of thumb is to never have
more than a 30% credit utilization rate. Keeping with the example above, if you
expect to consistently spend $4,000 a month, find a way to increase your
available credit to more than $13,333.33 so that you can remain below the 30%
credit utilization rate.
Credit Length (15%) – The longer you have had a credit account (credit card,
line of credit, mortgage etc) open, the better it is for your credit score.
This is because it is good when a lender can see that you have had a long
history of borrowing than paying back fully. This helps them feel like you are
not overly risky and allows you to borrow more money in the long-term. Please
note that if you are looking to cancel a credit card as an example, make sure
you do not cancel an old card as this would negatively affect your credit life
as you would go from a longer credit history to a shorter credit history once
that old credit card is gone. If you need to cancel a credit card, go with your
newest and shiniest credit card.
New Inquiries (10%) – Every time you ask for a new financial tool like a credit
card, the potential lender or creditor will pull your credit score which will
cause a temporary and small hit to your score. But fear not, this small drop is
only temporary and will not drastically affect your score as long as you are
not applying to a bunch of lenders within a short time period. This is because
other lenders will be able to see if you have applied for other credit recently
and they might be worried about your ability to pay them back if they are
worried you are opening lines of credit with multiple lenders. As an example,
when you begin (in a couple of years) to shop around for a mortgage, the rule
of thumb is to only check with 2 banks and/or financial institutions in a one
month period as any more than this might send red flags to other institutions
and will lower your credit score and raise your base interest rate which is not
good for you.
Diversity (10%) – The more diverse your open credit accounts are, the better it
is for your credit score. This is because potential creditors can see that you
are able to juggle different types of credit accounts and that you can pay them
all on time. What we mean by diverse credit accounts is that an individual who
has $10,000 in credit through 2 credit cards (each at $5,000) is going to have
a lower credit score than someone who has $10,000 in credit through 1 credit
card ($5,000) and 1 line of credit ($5,000). Even though they both have the
same amount of credit, the diversity gives an extra boost of confidence to the
creditor and increases your credit score.
there we have it, these were the 5 factors that affect your credit score. If
you take a moment, you can see that the first 2 factor – Payment History &
Debt / Credit Utilization Rate – are worth the most and are also the ones that
you can begin fixing immediately just by paying off your debts on time and not
going too much into debt. The other 3 factors – Credit Length, New Inquiries
& Diversity – are factors that can be improved over the long-run as they
take time to improve. To help you get a better grasp of seeing the benefits of
a strong credit score, I have included an example below.
those of you like myself who prefer to see the numbers behind all of these
words, let me give you an example. So there are 2 people, Person 1 and Person
2. Person 1 has an average credit score of 650 and Person 2 has a very good
score of 750. They are the same age, gender and both of the same after-tax
income. Other than their credit score, they are the same. They are both looking
to purchase the same house, a beautiful 2,000 sq. ft. for $500,000. They both
have a down payment of $100,000 (which is a 20% down payment that is the norm
usually when you are purchasing a house so that we can avoid mortgage
insurance). Now let us break it down:
- Down payment - $100,000
- Mortgage - $400,000
- Amortization Period – 25 years (# of years to pay down the mortgage)
Frequency – Bi-Weekly (every 2 weeks)
Person 1 (Credit Score - 650)
Person 2 (Credit Score – 750)
5 Year Fixed Mortgage Rate
$896.26 / Bi-Weekly
$816.62 / Bi-Weekly
let us go over what the table above means, assuming both Person 1 and Person 2
purchase identical homes with the same down payment and use the same bank for
their mortgages but at different rates respectively. So Person 1 with an
average credit score of 650 gets a 3.24% fixed 5 year interest rate and pays
896.26$ every 2 weeks compared to Person 2 with a very good credit score of 750
with a 2.39 fixed 5 year interest rate and pays $816.62 every 2 weeks.
Person 1 pays every 2 weeks $79.64 more than Person 2. Now this might not seem
like that a big enough deal to try and push to get a better credit score as 80$
every 2 weeks seems negligible for the effort it will take to improve your
credit score. But, if you take a look at the interest payment column above, you
will notice that these small $79.64 differences every 2 weeks actually grow to
be over $51,700.20 ($182,501.13 – $130,800.93 = $51,700.20). Wow! That tiny
change in your interest rate purely based on your credit score could save you
$51,700.20 on the total cost of your mortgage! So think about it, $51,700.20
you would save divided by the original $400,000 mortgage would be like paying
off 12.92% of another $400,000 mortgage without getting the same amount of
house. I hope this example shows you the incredible power of a small change in
interest rate as only 0.85% led Person 1 to pay an additional $51,700.20 in
Couple of Ways to Improve Your Credit Score Quickly
Increasing your credit limit: One of the easiest ways to increased your credit
score quickly is to increase your credit limit as this will decrease your
Credit Utilization Rate. As long as you can make sure that you do not
overspend, this is a great and quick way to get a credit score boost. Depending
on the person and where you are located, increasing your credit limit could
boost your credit score anywhere from 25-75 points.
Setting up automatic payments: One of the easiest ways to ruin your credit
score is missed payments. By setting up automatic payments, this will take off
some of the pressure off remembering when you need to pay bills and help
prevent missed payments which could negatively affect your credit score.
Have any more questions on credit scores? Want to know a rough way of finding your own credit score? Does something not add up or just want to chat? Let me know down in the comments!