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Understanding Credit Score and Why It’s the Key to a High Quality of Life

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Your credit score is a valuable financial asset and an integral aspect of your life because of the level of influence it wields on practically every aspect of your daily life.

There are different credit scoring models, and if you’re getting a loan such as a car loan or mortgage, the scores will vary according to the type of loan you’re getting. E.g., auto lenders often use FICO Auto Score, which is an industry-specific FICO score version that assigns you a level of creditworthiness for auto loans. On the other hand, most credit card issuers use FICO Bankcard Scores or FICO Score 8. Other lenders may use the VantageScore system, which is becoming widely used in the United States.

What exactly is a FICO credit score?

Credit score is a 3-digit number between 300 and 850 developed by FICO based on the information provided in your credit report by credit bureaus (Experian, Equifax and TransUnion). The traditional FICO model is used by lenders to evaluate your creditworthiness and decide whether to extend credit to you and at what interest rate.

FICO looks at a range of information submitted by credit bureaus and uses that to create scores that help lenders predict consumer behavior, such as how likely they are to pay their bills on time. Your may find that your score is different for each bureau because not all creditors report to all three bureaus. The higher your credit score, the less of a risk you pose to potential lenders.

What is FICO?

The name FICO comes from the company’s original name, Fair, Isaac and Company. It became the company’s official name several years ago. To be clear, FICO itself is not a credit reporting agency. Lenders merely use the FICO credit scoring model to evaluate the creditworthiness of prospective customers. According to their website, FICO claims to be used in 90 percent of lending decisions.

Though a FICO credit score is the most widely used among lenders, there are other scores lenders can choose from, such as the VantageScore. VantageScore was created by a collaboration of all three credit bureaus as an alternative to FICO.

What areas of your life can be affected by your credit score?

The higher your credit score, the easier it will be to get approved for credit, and the less difficulty you will face in all aspects of your financial life.

Here are 7 aspects of your life that can be affected by your credit score.

1. Loans

Your credit score determines whether or not you qualify for a loan, whether that loan is for a mortgage, car or credit card. It also determines the interest rate you’ll pay on the loan. Generally, the higher your credit score, the lower the interest rates you’ll be offered.

For example, according to research gathered by Informa Research Services:

  • Someone with FICO scores in the 620 range would pay $65,000 more on a $200,000 mortgage than someone with FICOs over 760.
  • On a five-year, $30,000 auto loan, the borrower with lower scores would pay $5,100 more.
  • A 15-year home equity loan of $50,000 would cost a low scorer $22,500 more than someone with high scores.

2. Credit cards

Credit card issuers generally disclose a range of potential interest rates with each card offer, such as 11.99 to 34.99. They normally don’t advertise what credit score will give you a particular interest rate. But if you have a good credit score, you can expect to receive a lower APR.

3. Auto insurance rates

Your credit score plays a key role in the car insurance rates you pay. According to Finder.com, people with poor credit often pay over 40% more on car insurance than those with higher scores. In fact, you could potentially save up to $1,000 a year on insurance by raising your credit score by 100 points.

4. Utility companies

Utility companies want to see your credit history to determine whether or you’ll have to put down an initial deposit. If your credit score is poor, you can expect to pay a high security deposit, and much more for water, gas and electricity.

5. Cell phone plans

Your credit score determines whether you’re approved for a new cell phone contract and get the best plans. If you’re looking to get a new phone, cell phone networks will do a credit check to assess how likely it is you’ll be able to keep up with payments each month. If your credit score is poor, this could lower your chances of being approved for a phone contract or an installment plan for a new phone.

6. Landlords

Getting approved as a tenant will be much easier. Most landlords prefer tenants who have good credit scores, and they will check your credit score and credit history before approving your application.

7. Employers

Even the dream job you want may require a good credit score. Today, it’s becoming more and more common for prospective employers to use credit scoring as part of the hiring process.

What is Considered a Good FICO Credit Score?

According to Experian, a FICO score above 670 is generally considered good, while a score of 800 or above is considered to be exceptional. The average credit score in the United States is 695.

How is Credit Score Calculated?

The FICO credit score model ranges from 300-850 with 850 being an excellent score and 300 being the worst. The higher the credit score, the lower the interest rate you will receive for a loan or line of credit.

Your credit score changes due to updates to your credit file which changes based on account activity such as balance changes or additions to your credit file (i.e. new accounts or deletion of older negative accounts more than 7 or 10 years old). As a result, you may see a difference in your score from one month to the next.

According to my FICO, your credit score or credit rating is determined by using the following five main criteria, which you should be familiar with.

Here’s a breakdown of how your FICO score is calculated:

Payment History

Your payment history is the most important component of credit score, and accounts for 35% of your score. FICO looks at both revolving loans – such as credit cards, and installment loans, such as mortgages or student loans.

The more you pay your bills on time, the better your score will be. The activity within the most recent two years carries the most weight. According to FICO: “A few late payments are not an automatic ‘score-killer.’ An overall good credit picture can outweigh one or two instances of late credit card payments.

Credit Card Balances

Your credit balance counts for 30 percent of your credit score. It is not just what you owe already that affects your FICO score. Also taken into account is the amount of credit available to you. For example, if you have a credit line of $5000, but have so far only used $1000, that will be taken into account.

Your total amount of credit will be totalled, and compared to your annual income. So, loans such as car loans, mortgages, credit cards, store cards, will all be added together. The key here is to pay your credit cards in full each month to ensure your balance doesn’t continue to grow. Those who use most or all of their available credit will get a lower rating for this part of the FICO score calculation.

Length of Credit History

The length of your credit history accounts for 15 percent of your FICO score. The longer your credit history, the better for your FICO scores. Additionally, though, a long history with any particular lender will be good for your credit score. FICO also takes into account how long you’ve been actively using those accounts.

Types of Credit

The types of credit you have available accounts for 10 percent of your credit score. For example, do you have only high risk unsecured type credit, or do you also have some solid secured loans such as a home mortgags? Those consumers who have a mix of credit tend to have a higher FICO score. The amount of accounts you have open are also looked at. MyFICO adds that closing an account doesn’t make it go away; it will still show up on your report.

Here are the three major types of credit:

  1. Revolving accounts. These are typically credit cards, home equity lines of credit and retail cards. Unlike a personal loan, a revolving account is one that you don’t have to pay in full every month.
  2. Installment accounts. This are accounts with fixed payments over a fixed period. It includes car loans, mortgages and personal loans. With this type of credit, your monthly payment remains the same for a fixed period of time.
  3. Open accounts. These include utility accounts where the amount due must be paid in full each month.

New Credit

Whenever you fill out an application form for new credit or get a credit check, it is a hard inquiry. The number of hard credit inquiries you have, as well as when the last hard credit inquiry occurred accounts for 10 percent of your credit score. Typically the activity within the last two years is noted, with the hard inquiries of the past year having the most impact. A lot of inquiries into new lines of credit can lower your score because it puts lenders “on alert” that something may be wrong.

FICO Score Ranges

Here is a breakdown of the FICO score ranges. Your credit score will vary from one bureau to the next because each agency collects their own data from various sources and may collect different data for the same account.

These are not set in stone because each lender will have their own definition of what is a good, excellent or bad credit score, and your score can vary anywhere from 5-40 points between the three credit bureaus.

  • 781- 850: This is considered excellent or exceptional. This will get you the very best interest rates across the board.
  • 661-780: Good – you’ll need at least a 680 FICO score in order to get a good interest rate on your car loan. Just a few points below and you’ll be considered a higher credit risk consumer, which translates into much higher rates.
  • 601 – 660: Fair – although you’ll still get credit with some lenders, you’ll be paying very high interest rates.
  • 501 – 600: Poor – you’ll find it difficult to get credit, and even when you do, the rates will be astronomical for everything you don’t pay for in cash.
  • 500 or less: Bad – this means your credit score is well below the average score of U.S. consumers. Lenders will consider you to be a precarious borrower, and you will find it very hard to obtain credit..

By law, the following criteria are not factored in when calculating your credit score in the United States.

  1. Your age, race, gender, marital status, religion or national origin.
  2. Whether or not you rent or own your own home.
  3. Your salary, occupation, title or employer.
  4. How long you’ve been at your current job.
  5. The interest rates you pay on your accounts.
  6. Child or family support obligations.
  7. Where you live.
  8. How long you’ve been living at your current address.
  9. Whether or not you’ve been denied credit or taking part in credit counseling.
  10. Any information that is not found in your credit report.

Note however, that the above may be considered in addition to using your credit score by lenders when considering your application for credit or a loan.

How to Check Your Credit Score

It is important to check your credit score on a regular basis to check for errors that could lower your score, and to make sure that you haven’t been a victim of identity theft.

By law, you are entitled to receive one free copy of your credit report every 12 months from each of the three credit reporting agencies (Equifax, Experian and TransUnion). One thing you can do is to request a report from each of these agencies at different times of the year, rather than requesting for all of the reports at once.

You are also entitled to a free copy of your credit report in any of the following circumstances:

  1. You’re denied credit, insurance or employment based on the contents of your credit report. Note that you must apply for a copy of your report within 60 days of being notified.
  2. You’ve been a victim of identity fraud.
  3. You’re on welfare.

You can get your free reports by ordering online from annualcreditreport.com.

Discover 12 powerful strategies you can use to maximize your credit scores.

Information Sources

Credit.com

Money Advice Service

Equifax

MyFICO

Creditcards.com

Credit Karma

Freddie Mac

Quicken Loans

Wise Bread

Fool