When you apply for a loan in order to buy the house or car of your dreams lenders will look at your credit score and they will use it to decide if they should give you the loan or not.
There are lots of Americans who don’t know what a credit score is or how it is calculated. If you belong to this group of people, then don’t worry because in this article you will learn all these basic concepts that are necessary to start improving yours and to buy the house or car of your dreams once and for all!
What Exactly is a Credit Score?
A credit score is a number of 3 digits that lenders use as an indicator of your capacity to meet financial obligations such as mortgage payments, car payments, credit card bills, loan repayment, etc. It basically tells lenders how likely you are to pay your debts.
It is usually a number between 300 and 850. The higher the credit score, the less risky you are to lenders. And the less risky you are to lenders, the better interest rates you will get. Also, the higher your credit score is, the more chances you have in getting a loan. Sounds simple right?
A score of 750 or more will give you the best interest rates and the best chance of being approved for a loan. On the other hand, with a of 600 or less you will have a hard time finding a lender who is willing to give you a loan. And if you find it, you will have to pay a lot of money in interest just because of that low score.
That’s why you have to improve your credit score as soon as possible (if you have a low one or not):
- To avoid high interest rates.
- To save thousands of dollars in interest in the long run.
- And to get the house or car of your dreams at the lowest cost possible.
Where Does It Come From?
Now you are probably wondering “Where does my credit score come from?” This is a very common question and the answer is simple: Your credit score comes from your credit report.
This credit report is created by the three major credit bureaus in the states and it contains the history of your payments, the amount of loans that you have, how much you owe, and a few other things.
The bureaus use the information contained in your credit report to calculate your score. The three major credit bureaus use the FICO scoring system, which ranges from 300 to 850.
What Exactly is Your Credit Score Made Of?
Your credit score is made of five different parts:
Payment History (35%)
Payment history refers to the ability to pay your bills on time. It represents 35% of your credit score. Your history is considered the best indicator of your future financial behavior. Late payments, missed payments, loan defaults, unpaid taxes, and the worst of all, bankruptcy, will all hurt your score.
It’s also important the amount of negative events and when these events happened. Newer events affects your score more than older ones. More severe events (like bankruptcy) are worse than less severe events. And many events hurt your score more than only a few of them.
Utilization Rate (Amounts Owed) (30%)
Amounts owed represent 30% of your credit score. It refers to the amount of debt you have in comparison to your credit limits. This is also called the “debt to credit ratio” and it works like this:
Let’s say you have $10,000 available and you only owe $3000, then your ratio is 30%. So the formula for the “debt to credit ratio” is: your debt divided by your available. The lower the ratio, the better for your score
Important: If you have a high ratio, don’t apply for more available credit to lower it. It will only hurt your score even more so please don’t do that.
Credit Length (15%)
Credit length represents 15% of your score. The longer your history is the better for your score. This is based on the assumption that your past financial habits are likely to be the same in the future. And if you have a long history, the bureaus can see exactly what your financial behavior is.
New Credit (10%)
The application for new credit represents 10% of your credit score. Every time you apply for new credit, an inquiry is added to your credit report. This inquiry hurts your score, because it tells the bureaus that you are in the need for more money.
Also, taking new credit will bring down the average length of your credit accounts. This is because now the new credit account is taken into consideration to calculate the average length.
Credit Types (10%)
The types of credit that you have represent 10% of your score. It’s good to have different types of credits because it shows the lenders that you have experience managing different credit accounts.
Important: Having different types of credits can help your score but don’t go out and get loans if you don’t need them. This isn’t a significant part in the credit score formula (it only represents 10% of your credit score) so don’t get yourself into more debt just to have a better mix of credit.
How Can I Improve My Credit Score?
Now that you know what a credit score is and where it comes from, the next thing you have to do is to start improving it as soon as possible. The truth is that it won’t be an easy task (especially if you have a low one): it will take some time, money and patience but it will be worth it. A few more points could be the difference between buying the home or car that you and your family deserve or not!