Understanding Credit Scores: How They Work and Why They Matter
Credit scores are an essential part of the financial world, yet many people don’t fully understand how they work and why they are so important. If you’re looking to take control of your finances and make informed decisions about credit, it’s crucial to have a clear understanding of credit scores. In this guide, we’ll break down the basics of credit scores, including how they are calculated, what factors affect them, and why they matter. By the end of this guide, you’ll have the knowledge you need to take control of your credit and make smart financial choices.
What is a credit score?
A credit score is a numerical representation of a person’s creditworthiness. It is a three-digit number that ranges from 300 to 850, with higher scores indicating a greater likelihood of being approved for credit and lower interest rates.
Here’s a breakdown of the different credit score ranges:
- Poor: 300-579
- Fair: 580-669
- Good: 670-739
- Very Good: 740-799
- Excellent: 800-850
Credit scores are calculated using information from a person’s credit report, which includes their credit history, payment history, and other financial information. The most commonly used credit scoring models are FICO Score and VantageScore.
Having a good credit score is important for many reasons. Credit score is used by lenders and creditors to evaluate your creditworthiness, which can impact your ability to get approved for loans, credit cards, and other financial products. In addition, your credit score may be used by landlords, insurance companies, and even employers to evaluate your reliability and responsibility. Having a good credit score can help you rent an apartment, get better insurance rates, and even land certain jobs. A high credit score can result in lower interest rates and better terms on various types of loans and credit cards, which can save you money in the long run.
To maintain a good credit score, it is important to make payments on time, keep credit card balances low, and avoid opening too many new credit accounts at once. It is also important to regularly check credit reports for errors and to dispute any inaccuracies.
How many credit scores do we get?
National credit reporting agencies – Equifax, Experian and Transunion – collect credit information from creditors and disseminate credit scores and credit reports back to the creditors. So each one of us gets three credit scores. There are, however, different credit scoring models used by different lenders and credit bureaus. The most commonly used credit scoring models are FICO Score and VantageScore, which each have several versions tailored to specific industries, such as auto lending, insurance, mortgage loans, or credit cards. This results in each person having multiple different credit scores for different purposes. FICO is often seen as the gold standard of credit scoring, and many lenders use FICO scores when making credit decisions.
Therefore, it is important to realize that there is not just one credit score that applies to everyone. Your credit score may vary depending on which scoring model and credit bureau is being used, as well as other factors such as the type of credit product you are applying for.
How are credit scores determined?
Generally speaking, credit scores are determined based on the following factors:
- Payment history: This refers to whether a person has made on-time payments on their credit accounts. Late or missed payments can negatively impact a person’s credit score.
- Credit utilization: This refers to the amount of credit a person is using compared to their credit limit. High credit utilization can indicate that a person is overextended and may be a riskier borrower.
- Length of credit history: This refers to how long a person has had credit accounts. Generally, a longer credit history is seen as a positive factor.
- Types of credit: This refers to the different types of credit accounts a person has, such as credit cards, installment loans, or mortgages. A mix of different types of credit can be beneficial for credit scores.
- Recent credit inquiries: This refers to how often a person has applied for credit recently. Too many inquiries in a short period of time can be seen as a red flag and can negatively impact a credit score.
Please note that each credit scoring model may weigh these factors differently and may consider additional factors.
What is a good credit score for a mortgage loan?
The minimum credit score required to qualify for a mortgage varies depending on the type of loan and each lender’s requirements. In general, a higher credit score will make it easier to qualify for a mortgage and may help you get better interest rates and loan terms.
For conventional mortgages, a good credit score is typically considered to be 620 or higher, although some lenders may require a higher score. FHA loans, which are backed by the Federal Housing Administration, may be available to borrowers with credit scores as low as 500, although a higher score is typically required to qualify for the lowest down payment option.
To get the best mortgage rates and terms lenders typically require a credit score of 740 or higher. However, even if your credit score is lower than this, you may still be able to qualify for a mortgage, although you may need to pay a higher interest rate and/or make a larger down payment. Check with individual lenders for their specific credit score requirements.
It is important to understand that your credit score is just one factor that lenders consider when evaluating your mortgage application. Lenders will also look at your income, employment history, debt-to-income ratio, and other factors to determine your ability to repay the loan.
Is shopping for the best mortgage loan rate going to hurt my credit score?
No, shopping around for the best rate for a mortgage should not hurt your credit score. In fact, it is a good idea to compare rates and terms from different lenders to ensure you are getting the best deal possible.
When you apply for a mortgage, most lenders will check your credit report and score as part of the application process. Each credit check can potentially have a small, temporary impact on your credit score, but multiple credit checks for the same type of loan within a short period of time are usually grouped together and treated as a single inquiry.
To avoid any negative impact on your credit score, it is best to limit your mortgage rate shopping to a focused period of time, such as 14-45 days. During this time, multiple inquiries will be grouped together and counted as a single inquiry, which should minimize any potential impact on your credit score.
How often is my score updated?
The frequency at which your credit score is updated depends on a few factors, including the credit reporting agency and the frequency with which your creditors report your account activity.
In general, your credit score is updated each time new information is added to your credit report. This could include new account activity, such as a new credit card or loan, or updates to existing account information, such as changes to your credit limit or payment history.
Creditors typically report account activity to the credit bureaus on a monthly basis, although some may report more or less frequently. As a result, your credit score may be updated monthly, but the exact timing will depend on when your creditors report your account activity.
How do I check my credit score?
You can check your credit score from a variety of sources, including credit reporting agencies, credit monitoring services, and some credit card companies. Here are a few ways to check your credit score:
- AnnualCreditReport.com: This website allows you to request a free credit report from each of the three major credit reporting agencies (Equifax, Experian, and TransUnion) once per year. While your credit score is not included in your credit report, you can see your credit history and check for errors or discrepancies.
- Credit monitoring services: There are several credit monitoring services that allow you to check your credit score and receive alerts when there are changes to your credit report. Some popular options include Credit Karma, Credit Sesame, and Experian.
- Credit card companies: Some credit card companies offer free credit scores as a perk to their customers. Check with your credit card issuer to see if they offer this service.
- FICO Score Open Access: FICO has a program called FICO Score Open Access, which allows lenders to share your FICO credit score with you for free. Check with your mortgage lender to see if they participate in this program.
How can I improve credit scores?
There are several ways to improve your credit score:
- Make on-time payments: Paying your bills on time is the most important factor in determining your credit score. Late payments can have a negative impact on your credit score, so make sure to pay your bills on time, every time.
- Reduce credit card balances: High credit card balances can hurt your credit score. Try to keep your credit card balances low, ideally below 30% of your available credit limit.
- Do not close credit accounts: Closing credit accounts can actually hurt your credit score. Keep old credit accounts open, even if you are not using them, to maintain a long credit history and a good credit utilization ratio.
- Limit new credit applications: Each time you apply for credit, it can have a negative impact on your credit score. Try to limit the number of new credit applications you make, especially if you are already struggling with your credit score.
- Check your credit report: Errors on your credit report can damage your credit score. Check your credit report regularly to ensure that all the information on it is accurate. If you do find an error, dispute it with the credit bureau to have it corrected.
- Consider a secured credit card: If you are having trouble getting approved for a traditional credit card, consider applying for a secured credit card. These cards require a security deposit, but they can help you build credit over time if you use them responsibly.
Improving your credit score takes time and effort, but it is worth it in the long run. By following these tips and practicing responsible credit habits, you can improve your credit score and gain access to better credit options.
Should I freeze my credit?
Freezing your credit can be a good option if you want to maintain integrity of your credit report. Here are some reasons why you might consider freezing your credit:
To prevent identity theft: If someone obtains your personal information, they may be able to open new accounts or apply for loans in your name. By freezing your credit, you can prevent anyone from opening new accounts in your name without your permission.
To protect your credit score: If someone opens new accounts in your name and then fails to make payments, it could significantly hurt your credit score. By freezing your credit, you can prevent unauthorized accounts from being opened in your name and protect your credit score.
To control access to your credit report: When you freeze your credit, only companies that you have authorized can access your credit report. This can help you control who has access to your personal information.
Please note that freezing your credit can make it more difficult to apply for credit or loans in the future, since you will need to lift the freeze temporarily if you want to apply for new credit. However, the process of lifting a freeze is relatively easy and can usually be done online or over the phone.
Check with the three major credit reporting agencies (Equifax, Experian, and TransUnion) to understand their specific policies and procedures. They may charge a fee to freeze and unfreeze your credit, and there may be some exceptions for certain types of credit checks, such as those performed by current creditors or employers.
While having a credit score is not mandatory, it can make a big difference in your financial life. If you plan to borrow money, rent an apartment, or apply for certain jobs or insurance policies, it is a good idea to understand and work to improve your credit score.
It is important to remember that each credit scoring model uses a slightly different algorithm to calculate credit scores, so a person’s credit score may vary depending on which model is being used. Additionally, each lender may have their own criteria for evaluating creditworthiness beyond just the credit score.
It is a good idea to regularly monitor and track changes to all of your credit scores and credit report, regardless of which scoring model is being used. Consider signing up for credit monitoring services that provide alerts when there are changes to your credit report. This can help you protect your credit report, stay on top of any errors or discrepancies and take steps to improve your credit score over time.
Please reach out to me with any questions relating to your credit report and scores at 312-296-4175 or email me at email@example.com. I lend in all 50 states and I am never too busy for your referrals!!
I have been in the mortgage industry since 1997 and I understand the anxiety that comes with making the most expensive investment of a lifetime. My objective is to be your advisor, to educate you and to make the mortgage loan transaction as transparent and as stress-free as possible. I enjoy establishing personal connections and work mostly by referral. I thoroughly explain the process and available options, and guide my clients to make choices that best fit their needs and financial goals. Once the underwriting begins I communicate regularly and keep my clients apprised of the loan status from the beginning through the end. My relationship with clients does not end at the closing table. You are my client for life and I am always available to answer your questions and provide you with guidance.