The Definitive Guide To Understanding Your Credit Score

Historically, your reputation was always your most important asset. People in your village, town, or neighborhood would learn how trustworthy you are, and those who didn't know you could find out just by asking around.

In a way, your credit score is the modern version of that system. Businesses report their experiences with you to consumer credit bureaus, and those who want to do business with you pay them for this information in the form of a credit report or credit score.

Understand Your Credit Score

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The difference between a credit report and a credit score

The information that businesses report the consumer credit bureaus is put together to create your credit report. This data includes your identifying information, credit accounts, credit inquiries, and any public records of debts or collection items. Negative information can appear for as long as seven years, while some positive information, such as accounts paid on-time, remain for up to 10 years.

For many adults, their credit report can run ten pages or longer, and it can take a fair amount of time and skill to interpret the report and make a decision about the person's credit worthiness. That is why credit scores were created. You can think of your credit score as the simplification of your credit report into a single number that anyone can use to decide whether or not to grant you a line of credit.

Credit scores are created by running your credit history through a formula, and the most popular one is called FICO, which stands for the company that created it, the Fair Isaac Corporation. Typically, the three major consumer credit bureaus, Equifax, TransUnion, and Experian, apply the FICO scoring formula , to the information that they have collected on you (there are various version of this formula as well as others from competing companies). Since each bureau might have different information, your FICO score will vary depending on which bureau is reporting it.

What goes into a FICO score

The exact formula that FICO uses to create a credit score is a secret, but they do disclose its general outlines.

  • 35% is from your payment history. This is the record of whether you have paid your credit accounts on time.
  • 30% is based on your amounts owed. This is how much debt you have, but it takes into consideration the total amount of credit you have been extended.
  • 15% is determined from your length of credit history. This part includes how long you have had various accounts in your name, both current and past accounts.
  • 10% is from the types of credit you have in use. This factor includes credit cards, retail charge accounts, car loans, student loans, and mortgages.
  • 10% is from recent credit. This area considers how many new credit accounts you have opened recently.

What do the scores mean:

The FICO formula produces a score from 300 to above 800. Below is a rough guide to what different credit say about your ability to qualify for a new loan:

  • 350 - 550: Bad credit. Don't expect to qualify for any new loans or lines of credit.
  • 580-620: Poor credit. There may be some sub-prime loans available to you, but the terms will not be favorable.
  • 620-680: Fair credit. This is the lower end where you can qualify for standard loans, but with less competitive terms.
  • 680-740.: Good credit. You should qualify for most new loans, however you will not receive the lowest rates possible.
  • 740+: Excellent credit. You will qualify for the lowest possible rates when applying for any loan.

How to improve your credit score

Dozens of books have been written about how to improve your credit score, but most focus on trying to "trick" the formula or on how to make minor improvements to the least important factors. But just as any doctor will tell you that the keys to any legitimate weight loss program are diet and exercise, there are just two essential ways to improve your credit score: Pay your bills on time, and have very little debt. These two factors alone represent 65% of your credit score, and you can't have a good score without doing both reliably. Likewise, it is hard not to have excellent credit if you always pay your bills on time and have very little debt.

Once you have those two things under control, here are a few common sense suggestions to consider:

  • Keep several credit card accounts open. Many believe that closing accounts will help their credit score, but it doesn't. Having several accounts open and in good standing increases your credit history and lowers your debt to credit ratio, relative to a given amount of debt.
  • Pay your account balances before the statement closing date. The amount of your statement balance is reported to the credit bureaus as debt, even if you ultimately avoid interest by paying your balance in full. If you earn rewards by using your credit cards heavily, doing this will ensure that you do not have a lot of your spending reported as debt.
  • Don't try too hard. Interestingly, there is no benefit to having an extremely high credit score, such as one above 800. Once you are in the "Excellent credit" range, all scores are essentially equal. If you have excellent credit, feel free to leverage it for a really good credit card sign-up bonus.

You don't want to have a bad credit score any more than you want people in your neighborhood saying bad things about you. By understanding the basics of how credit scores work, you can work this system to your advantage.

Not sure what your credit score is? FreeCreditScore.com offers a 7-day free trial that includes your credit score. Don't forget to cancel the trial right away to avoid a monthly charge.

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