A Beginner’s Guide to Credit Scores

A credit score is defined as a “number assigned to a person that indicates to lenders their capacity to repay a loan”. Basically, it’s a magical three-digit number that tells banks whether or not they should lend you money.

This post is motivated by a recent article I read on the difficulties and reservation of our generation getting credit cards. It baffles me that people struggle on simple things like getting a credit card. Credit cards may sound scary, but there’s really nothing to be afraid of, so long as the card is used responsibly. I don’t care how nerdy this makes me sound, but effective use of credit is near and dear to my heart.  I talk more about credit cards here. Back to the one at hand – credit scores.

Why does a credit score matter? If you’re like me, you don’t have any large purchases currently looming on the horizon, like a house or a car. Credit scores most commonly matter when applying for credit cards (hence the earlier paragraph), and also occasionally for apartment applications. Additionally, even if none of those things describe you, it’s important to have a good credit score, at the very least, for your own peace of mind.

First things first. What makes up a credit score? A FICO credit score can range from 300 to 850. There are 5 factors (in approximate order of importance):

  • Payment History
  • Amounts Owed
  • Length of Credit History
  • New Credit
  • Credit Mix

If you don’t know what your credit score is or don’t have a credit score, stop reading right now, open a new tab, and pull your credit report. I’ve made another post detailing how to pull your free report here. You are entitled by federal law to receive a free report every 12 months from the 3 credit bureaus, Experian, Equifax, and TransUnion. A credit report is not your credit score, but as long as your credit report doesn’t show anything delinquent, then that’s a good baseline to start with. Next, you can pull your free credit score with one of sites listed here. If you’ve pulled your report before and you don’t have a credit score, I’ll put up a separate post shortly detailing what to do when you don’t have a credit score.

What does a credit report have to do with any of this? While a credit score is the number that people pay attention to, a credit report tells you why your score is what it is. If you don’t know why your score is low, you can verify it with your credit report, and either work to fix it, or contact the bureaus directly if information on your credit report is incorrect.

If your credit score is above 680, congrats! Most lenders in the country would consider you to be a prime consumer. You can apply to most credit cards. If your score is above 720, you’re considered superprime and are at the top of the heap, keep doin’ you. There are industry differences as to whether the line is drawn at 680 or 660, but you get my point.

If you’re significantly below 680, you’re considered to be a subprime consumer. As long as you’re above 600, I wouldn’t be super concerned – that’s an easy number to bounce back from. However, the lower on the credit spectrum you sit, the harder you will find it is to be approved for credit cards and loans. While there are products available for the subprime mass market, many of these carry extremely high interest rates.

There’s a wealth of information on the internet detailing what you should and shouldn’t do to raise your credit score. The quick and dirty? Here’s the formula:

  1. Get a credit card that you don’t foresee canceling (avoid cards with annual fees)
  2. Keep your credit card utilization under 20% (whatever your credit line is, don’t go over 20% of it)
  3. Pay off that credit card, in full, every month (a good rule of thumb is to set up auto-pay as soon as your get your card so that you never forget to pay your bill)

These things, without fail, will raise your credit score over time. Obviously, there’s no quick fix to improving your score. But if you’re new to the whole thing, I would highly emphasize a credit card with no annual fee. This will then be a card you can essentially keep forever, which will improve your length of credit history (there are no shortcuts to this).

Bonus points: it’s a good habit to regularly monitor your credit score. There are many sites that will do so completely free of charge. My favorite is Credit Karma, which updates on a weekly basis. The caveat is to not freak out over short-term swings in your credit score. A high credit card balance in one month can cause a score to drop by a few points, which is no big deal as long as you’re paying it off in full every payment period. New credit inquiries will also negatively impact your score, but they only last for 2 years on your report and after a few months of using the card the activity typically balances out the effect of the inquiry.

I want to keep this post relatively short because the point I’m trying to make is that there’s nothing daunting about the world of credit. If you’re not satisfied yet, don’t worry – there’s plenty more on this topic to come.

 

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