What is a credit score? And why it is important to have a good one

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A credit score is a three-digit number that represents your creditworthiness as a borrower. It typically ranges from 300 to 850 and is calculated using complex mathematical formulas called scoring models. Scoring models derive your credit score based on the information from your credit report provided by a credit bureau. The score reflects how likely you will repay the debt on time to the lender.

Generally, high credit score customers have lower credit default rates than those with lower credit scores. When evaluating your application for a new loan or credit card account, banks and lenders use your credit score to make decision on whether to approve your application.

As a rule of thumb, the higher your credit score is, the better interest rates and borrowing terms you will get. A very low credit score may even result in a loan or credit card application being denied by a bank or lender.

There are different types of credit scores. It’s a common mistake to think there is only one universal credit score. People may have several different scores calculated from the same credit report. Usually, scores vary because of the differences between their scoring models and the exact information which went into the calculations.

The most famous and widely used credit scores are FICO® Score and VantageScore®. They are calculated by Fair Isaac Corporation, or simply FICO, and the VantageScore consumer credit-scoring system. The latter is a joint venture of three major national credit bureaus. FICO and VantageScore scoring models compete with each other, and their scores cannot be translated from one to another.

FICO and VantageScore weigh information in your credit report differently. The two scores also have more than one version leading to more differences between the scores. For example, there are VantageScore 3.0 and 4.0, FICO Score 8, and FICO Score 9. Those are all different versions of FICO and VantageScore.

What is considered a good credit score?

The definition of credit score brackets may vary, and the meaning depends on the kind of credit score and its version. The commonly used guidelines for what a credit score typically means are as follows,

• 800-850: Excellent
• 740-799: Very good
• 670-739: Good
• 580-669: Fair
• 300-579: Poor

Despite the widespread adoption of the above guidelines, each bank or lender independently decides what minimum score is required to qualify for a particular loan or credit card.

Financial institutions establish particular guidelines and procedures known as credit policies to extend credit to customers. Credit policy standards may vary substantially between lenders. They depend on many factors, including a particular approach to risk, the current economic climate, and others.

If you are denied a loan with one lender, it does not mean you cannot qualify for a loan with another lender with the same credit score.

Nevertheless, it is worth remembering that a good credit score just reflects good credit history, and the bad one indicates otherwise. Building and maintaining a good credit history is the key to getting a good credit score.

What is my credit report?

Your credit report is a primary source of information for the lender about your payment history, current debt, length of credit history, and other financial information. It also includes bankruptcies, tax liens, and civil judgments. A credit report contains information on various types of credit accounts, such as credit cards, personal loans, mortgages, car loans, and others.

Your credit report is compiled and maintained by the three major credit reporting companies, also called credit bureaus - Experian, Equifax, and TransUnion. The credit bureaus collect credit information on individual consumers, analyze it, and produce consumer credit reports. The credit reports are generally updated every month, and credit scores are recomputed on a monthly basis as well.

In the United States, some 89% of adults have established credit histories, and nearly 70% have scores that are generally considered good. Good credit score is the result of responsible debt management, which means making timely payments, keeping your unpaid debt balances low, and maintaining a healthy mix of various credit types.

The remaining 11% are credit invisible, which do not have a credit score from any major credit bureau. Without a credit history, consumers usually struggle to obtain loans and open credit cards. Banks and lenders are mostly unable to assess the creditworthiness of such borrowers accurately. Large uncertainty about customer creditworthiness often leads to challenges with credit card or loan application approval, higher interest rates, and lower credit limits.

What factors affect my credit score?

Knowing the fundamental factors that drive your credit score calculations is essential. FICO and VantageScore scoring models use somewhat different mathematical formulas to calculate a credit score, yet five major factors are common to both models. These five factors make up most of your credit score, whether it is FICO or VantageScore,

• Payment history. Your payment history is a track record of payments made on time, late payments and delinquencies, bills in collection, and bankruptcy filings. It contains information on any credit accounts that you have open. This is the most significant factor in your credit score.

  Making payments on time can gradually improve your credit score over time. Late payment or delinquency, on the contrary, can severely damage your credit score. Always make at least the minimum payment by the due date to keep your account in good standing.

• Amount of debt. The unpaid debt across all your accounts relative to a total available credit limit is often referred to as the credit utilization rate. The higher your amount of unpaid debt, or the utilization, the lower your credit score will usually be. Credit utilization is the second highly influential factor, and a healthy utilization rate is deemed to be less than 30%.

  You should strive to reduce the amount of debt you owe and keep your credit utilization rate as low as possible.

• Length of credit history. The average age of all your credit accounts and the age of your newest and oldest accounts refer to the length of credit history. Generally, the longer your credit history, the higher your credit score. When you close an older credit card account, you reduce the average length of credit history.

  Keeping your oldest credit card open can benefit your credit score, but remember that some lenders may close your account if it has been inactive for a long time. Small purchases made occasionally on an old credit card will help your credit account stay active and, therefore, positively impact your credit score.

• Recent activity. Your recent activity indicates how many new accounts you have opened recently, along with the number of recent hard inquiries you have on your credit report. Opening a credit account or applying for a loan is usually considered a negative event and tends to lower your credit score. The more new accounts you have opened in a short time, the more negative effect will be on your credit score. Too many hard inquiries in a short time can also lower your credit score, as it suggests to lenders that you might be financially overstretched, and your likelihood to pay back the loan might be lower.

• Credit mix. The number of loans and their types are known as credit mix. It’s usually a good idea to keep a combination of both revolving accounts and installment loans.

  The most common type of revolving account is the credit card. Other examples could be a personal line of credit or home equity line of credit. Installment loans are usually auto loans, mortgages, and personal loans.

While all five factors are important to your credit score, your payment history and the amount of debt have the most significant impact. Regardless of the scoring model, your credit score will be largely made up of your payment history and credit utilization.

Once you know what factors influence scoring models the most, you should be able to improve them to achieve the desired credit score.

What factors have no impact on my credit score?

The credit score is calculated based on the records from your credit report, and information not included in the credit report has no impact on either FICO Score or VantageScore.

The following factors have no impact on your credit scores,

• Your age, sex, gender, race, nationality, color, and marital status
• Your income, job title, and job location
• Whether you are employed or receiving public assistance
• Your place of living and your medical information
• Political or religious affiliations
• Soft inquiries to your credit history

Credit reports also do not include non-credit banking information such as checking and saving accounts, prepaid debit cards, private party loans, etc.

Why is it important to have a good credit score?

Having a good credit score is a precious life asset. Borrowers with higher credit scores can access more financial products and receive better interest rates. They are offered favorable lending terms, higher credit limits, and higher loan amounts.

Over a lifetime, higher credit scores will help you save a large amount of money on interest and fees.

For example, if you decide to buy a property, your credit score will directly impact the mortgage interest rates you would be offered. The difference between the rates for a 30-year fixed-rate $300,000 mortgage with FICO® score equal to 670 vs. 770 will be 6.649% - 6.036% = 0.613%, or $1,926 - $1,806 = $120 per month (as of March 28, 2023; data is from myFICO.com). It may not seem as much in the beginning, but over the lifetime of the mortgage the higher score will save a whopping $43,385 on interest. It literally pays to have a high credit score!

Good credit scores may also affect your non-lending decisions,

• Landlords are more likely to rent you an apartment if you have a good credit score
• Some employers may review your credit report as part of the hiring process
• Good credit history can make it easier for you to get utility services
• A higher credit score usually decreases your auto insurance premium

Building credit history, however, takes time and effort. Remember to check your credit score regularly - it will help you ensure your credit position is in a healthy state and the information in your credit report is accurate. Checking your own credit history does not hurt your credit scores; in most cases, you do not need to pay to check your credit score. Many card issuers, including Big 4 US banks, provide tools to their customers to check credit scores for free. If you spot an error in your credit report, you must contact the major credit bureaus to get it corrected. Your goal is to build and maintain high credit scores using responsible debt management strategies and good credit habits.

How to establish a credit history using just a credit card?

One of the easiest ways to start building a credit history might be to get a credit card. It is a revolving type of credit that remains available over time and allows you to borrow as needed against the assigned credit limit. If you are only interested in building a credit history and not so much in credit itself, you can pay off your balance in full at the end of the billing cycle to avoid any interest and fees.

If you have no credit history, you can apply for a secured credit card. A secured credit card requires a cash security deposit when you open the account. The deposit usually would be equal to your starting credit limit and act as collateral on the account. Otherwise, a secured credit card functions similarly to a traditional credit card. By using a secured credit card wisely, you can prove yourself as a responsible borrower to the lender and credit bureaus. A responsibly managed secured credit card would allow you to establish strong credit history and get a good credit score.

Another great way to start building credit via a credit card is to become an authorized user on a friend’s or family member’s credit card account. The card issuer would usually start reporting account activity in your name beside the original account owner. New records will appear on your credit reports, and your credit history will grow. As long as the account is managed responsibly, this would help you build a credit history or obtain a good credit score. But remember that negative records, such as missed or late payments, would instead harm your credit history and lower your credit score.

If you are a college student, you can apply for a credit card designed specifically for students. Usually, students do not have an established credit history, or are new to credit, i.e., have less than three years of credit history. To help build a credit history, some credit card issuers have developed cards focusing on young adults attending college.

You can browse our list of top credit cards for students or find secured credit cards in offerings from Bank of America and Citi.