What Is Your Credit Score, How Does It Work, and Why Is It Important?

Excellent Credit Score

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If you haven’t paid much attention to your credit, it may be time to do so. A higher credit score could literally save you thousands of dollars (or more) in interest and payments over time.

Applying for any type of loan or credit will typically involve a check of your credit information. This is because any entity that lends you money or provides you with credit wants to know that the borrower will make good on their repayment. In most cases, a lender will review your credit report and credit score before approving your new line of credit.

Although they may sound similar in name, your credit report and your credit score are not the same thing.

For instance, a credit report is a detailed report of your overall credit history. This report can provide lenders and other potential creditors a snapshot of how you’ve handled your debts and payments that were due over time.

There is a myriad of information that may be included in your credit report, such as:

  • Personal information – Like your Social Security number and your employment history
  • Credit history – Including the type and number of accounts you carry, as well as whether or not you’re making your payments on time
  • Detailed account data – Including the beginning and current balances on your loans and/or debts, as well as the monthly payment due on them
  • Credit inquiries – From potential lenders and creditors, as well as other entities such as employers and landlords
  • Other information – Other pertinent info to your credit, such as any judgments, tax liens, and/or bankruptcies you’ve filed

There is also information about you that is not included in your credit report, such as your:

  • Marital status
  • Race
  • Religious beliefs
  • Arrest record
  • Political affiliation
  • Savings and checking account information

Your credit score basically measures various aspects of your financial life. While some of these criteria are similar to those stated on your credit report, your credit score is a different component. This number (typically between 300 and 850) is statistically determined based upon various weightings given with regard to a person’s credit history. Higher credit scores reflect a more creditworthy borrower.

It’s important to keep in mind that your credit score is not included in your credit report. Therefore, if a lender or a creditor wishes to view your credit score, this information will need to be obtained separately.

What Exactly Is a Credit Score?

In its most basic sense, your credit score is a number that has been assigned to you based on multiple criteria, which indicates to lenders and creditors your overall capacity to repay a loan and/or handle future credit.

Your credit score can have a big impact on many key aspects of your life. In fact, it’s estimated that the FICO credit score is used in more than 90% of lending decisions by top lenders in the U.S. (1)

FICO stands for the Fair Isaac Corporation, which is the company that developed the credit scoring system. In the case of credit scores, FICO will take your credit information and use it to help lenders and creditors determine whether you would be a good credit risk. While FICO itself is not a credit reporting agency, it uses the information provided by the big credit bureaus.

Because lenders and creditors place a high weight on your credit score, this information can essentially either help you or hurt you when you’re applying for a mortgage or other loan, as well as in other types of transactions like obtaining a credit card.

That’s because your credit score is considered to be a “report card” of sorts — and based on this information, it is a key determinant about whether you’ll get a high or low interest rate from the lender or creditor…or even if you qualify for credit at all.

This, in turn, can impact your financial life as a whole. A higher interest rate on a loan or credit card can essentially cause you to make higher payments.

Many people aren’t aware of just how big a difference a couple of percentage points can make on an interest rate! In addition to having a higher payment, even just a seemingly small difference can really add up in terms of what you’ll ultimately pay out on the debt over time.

The Difference Between a 3% and a 5% Interest Rate

3% Interest Rate5% Interest Rate
$200,000 borrowed$200,000 borrowed
30-year term30-year term
$843 monthly payment$1,073 monthly payment
$303,544 total amount paid$386,513 total amount paid

Bottom Line: Today, it isn’t just lenders and credit card companies that review your credit score. There is a long list of other organizations and entities that may wish to view your credit history before moving forward with transactions that involve you.

Other entities that may want to check out your credit history include landlords before you rent an apartment, cell phone companies before they issue you a voice and data plan, and potential employers before they’ll offer you a job.

Why Is Your Credit Score Important?

Your credit score is important for several reasons. First, depending on what your score is, it can be a primary factor in determining whether or not you are approved for a loan. Lending money or providing someone with credit can be a risky endeavor for lenders and creditors.

Before these entities move forward with an approval, they’ll want to know just how much risk they may be taking on — or whether they should even move forward with the transaction at all.

Your credit score is also important because it can factor into a lender or a creditor’s decision about the terms that you are likely to get.

Bottom Line: A higher credit score will not only improve your chances of getting approved for a loan or credit, but it will also determine how favorable your interest rate will be.

How Your Credit Score Is Used

In the past, credit was primarily used by banks and other lenders in the process of making lending decisions. Today, however, there are many ways in which your credit score may be used:

Borrowing Money – The most common use of your credit score is still for borrowing money. Here, a potential lender will want to know whether or not you are likely to repay the debt on time. Because lenders and creditors do not know you personally, your credit score can provide them a glimpse of how you go about making good on your debts.

Employment – While not all companies do, there are some that will check an applicant’s credit score before offering them a job. In this case, companies claim they’re trying to judge how responsible you are with money. This can be particularly helpful for the employer if they’re considering you for a financial-related job, such as an accountant or a position where you’ll be working with a budget.

Utility Companies – To obtain services for your home such as electric, gas, water, and even cable TV, companies will often review your credit information. For those with a low credit score, a larger security deposit could be required. This way, if you miss a payment for your monthly services, the utility company can still be reimbursed.

Landlords/Property Management Companies – If you’re in the process of renting a home or an apartment, it’s possible the landlord or property manager will run a credit check. In doing so, they can better ensure that you’ll make good on your monthly rent payments.

Insurance Coverage – There are also some insurance carriers that will check your credit score prior to offering you coverage, and as a tool to help determine an appropriate premium rate. Those who have higher credit scores are presumably less likely to be a risk to the insurer.

Here, while an insurance company may take a look at your FICO score, they also use a figure that is known as your insurance score. These scores can come from a variety of different sources. (2)

How Your Credit Score Is Calculated

Your credit score is calculated from the data that’s included on your credit report(s) from the various credit bureaus. Because there is more than just 1 credit bureau, you can actually have more than 1 FICO score.

The 3 major credit bureaus that provide credit scores are Equifax, Experian, and TransUnion. Also, not all creditors and lenders will report information to all 3 of the major credit bureaus, which means your score can change from one credit bureau to another.

There are 5 categories that are taken into consideration when determining your credit score. Although each category is important, some will weigh more heavily than others when coming up with your score.

Payment History

The first and most heavily weighted category is your payment history. This category accounts for 35%, so it represents more than one-third of what your final credit score will be based on.

Key data reviewed here include your percentage of on-time payments for your loans or other credit obligations. Thus, making all your payments on time can be one of the best ways to raise your credit score. On the other hand, continuously making your payments late (or not making payments at all) can be the primary driver of a lower credit score.

Types of accounts that are considered here can include the payments on a mortgage, auto loan(s), retail accounts (such as store credit cards), credit cards (such as MasterCard and VISA), and finance company accounts.

Other items that can make a difference in this category include the following:

  • How late was a payment? (i.e., 30 days, 60 days, 90 days, etc.)
  • How many late payments have you had?
  • How much money was owed?
  • How recently did these late payments occur?

Amount of Money You Owe

Another key factor in determining your credit score is the amount of money you owe compared to the amount of total credit you have. This is known as your open credit utilization rate.

For example: if you have a credit card that has a $20,000 credit limit, it’s better if you only have a balance of $2,000 instead of carrying a balance of $15,000. In this case, the lower balance would be given a higher credit score because you’re utilizing less of the total credit available to you.

The amount you owe on different kinds of accounts can also make a difference. For example, it is better to owe $50,000 on a mortgage than $50,000 on a credit card account.

Paying down these loans, too, can make a big difference in the eyes of your creditors — and ultimately, on your credit score. For instance, if you borrowed $20,000 to purchase a car and you’ve paid off $10,000 of it, then you’re viewed as being able to manage and repay your debt.

Length of Your Credit History

The length of your credit history also plays into the overall weighting of your credit score. In this case, a longer credit history will typically yield a higher credit score. If you have a long history of credit (and in turn, a longer history of paying your bills), then lenders and creditors will have more information with which to assess your overall creditworthiness.

Here, your various loans and other sources of credit are all averaged together. A long history of credit can be an indicator that you’ve been able to successfully obtain and manage your credit over the years.

Because of this, it makes sense to keep more of your credit cards open longer, even if you haven’t used them in a long time — canceling them could actually lower your overall credit score.

Amount of New Credit and Credit Inquiries

Potential lenders and creditors will also take a look at the amount of new credit inquiries, if any, that you have on your record. In this case, it will typically count against you if you have too many — particularly if they all occurred within a relatively short period of time.

It’s important to note here that there is a difference between a “hard credit inquiry” and a “soft credit inquiry.” For example, a hard credit inquiry occurs when you apply for certain types of loans or credit, such as a mortgage, auto loan, student loan, or credit card.

A soft credit inquiry occurs in such instances as a background check for employment or a background check by a landlord for leasing an apartment. While hard credit inquiries will usually count against your score, soft credit inquiries will not.

Overall Mix of Credit

Your credit score will also be partially based on your total number of accounts, as well as the different types of credit that you have. For example, those who have a higher number of accounts can typically have a higher credit score (provided that the payments have been made on time).

Also, the different types of credit you have will be considered. Here, it’s good to have a variety of accounts as opposed to holding just one form of credit. For instance, it’s better to have a mortgage, a car loan, and a credit card vs. having only credit cards.

Your Credit Score Results

Once all the key factors have been reviewed, the result will be your credit score from each of the credit bureaus. Although each of these credit bureaus has a slightly different scoring method, your scores will generally range from between 300 to 850. Anything over 800 is considered excellent, while anything under 580 is considered poor.

Keep in mind, though, that your credit score is not a one-time, static figure. Instead, this score can change regularly. In some cases, your score can go up or down substantially as the information on your credit report is updated. Therefore, be sure to check your credit report and score regularly. If you happen to find any information in your credit report that isn’t correct, be sure that you file a dispute to get that data changed or removed.

It’s also important to note that different types of lenders will use different types of FICO scores. For example, an automobile lender may use FICO Auto Scores, while many issuers of credit cards will use FICO Bankcard Scores. (3)

Who Can View Your Credit Information?

There are a number of different individuals and entities that can view your credit information. These include banks and other lenders, credit card companies, and retail stores, as well as cell phone companies, utility companies, potential employers, and potential future landlords.

Bottom Line: Reviewing your credit report can save lenders and other creditors a lot of time, instead of reviewing your entire credit report to determine your past payment history and likelihood of repaying your debt responsibly.

Raising (and Lowering) Your Credit Score

Your credit score plays a huge role in your overall financial life, and it’s important to keep it as high as possible — especially if you’re planning to apply for a home loan or other type of credit in the future.

If your credit score has taken a hit due to late payments or a prior bankruptcy, there are some things you can do to help increase your score.

These can include the following:

  • Reduce Your Debt – Reducing the amount of debt you owe can be a big factor in helping to increase your credit score. This is particularly true if you’re holding onto large credit card balances. Paying these balances down can not only reduce your debt-to-credit-limit ratio, but it can also keep high interest from continuing to snowball.
  • Set Up Payment Reminders – Setting up payment reminders can help you to pay your bills on time, which is key to increasing your credit score. In fact, payment history is the top weighted criteria in determining your overall score, so make sure all your bills are paid before the due date!
  • Don’t Cancel Older Credit Cards – Believe it or not, keeping older credit cards (even if you’re not using them) can actually help your credit score. This is because your score is determined in part by your credit history. Therefore, the longer you’ve owned a credit card, the better it will be for your credit score. Keep in mind, though, that going out and opening a lot of new credit cards can negatively affect your credit score.
  • Regularly Check Your Credit Report – By regularly checking your credit report for errors and reporting any incorrect information you may find, you’ll ensure mistakes aren’t keeping your credit score down unnecessarily. Errors on credit reports are actually much more common than people think, so checking your credit report at least once per year is important.

You can obtain a copy of your reports from all 3 credit bureaus for free each year by visiting www.annualcreditreport.com. You can also check your credit score for free by going to Credit Karma, Credit Sesame, and Quizzle. These sites provide other information like credit monitoring, a credit report card, and suggestions for keeping your credit and personal information safe.

Remember that if you make late payments (or skip payments altogether), your credit score is likely to decrease. The same is true if you rack up too much debt, or if you have too many hard credit inquiries on your credit report within a short period of time.

What If You Don’t Have a Credit History?

If you don’t yet have a credit history built up, that doesn’t necessarily mean you’ll be turned down for credit or a loan. There are other criteria a lender may look at to determine whether you could be a good credit risk. These include:

  • Employment – Your employment history can be a big factor, especially if you have a stable track record — this shows consistency and responsibility.
  • Residence History – Lenders and creditors may also look at how long you generally reside in one place. A history of moving around often can sometimes be a negative sign, while a solid residence history shows up as a positive factor.
  • Banking Information – Creditors will also take a look at your banking information. Those who have a checking and savings account will typically be seen in a more favorable light.

Even with minimal credit history, you can begin building up your credit going forward. You can do this in a number of different ways, such as applying for a secured credit card and/or getting a card with a cosigner. You could also take out a small personal loan and then quickly repay it or obtain an auto loan.

The 5 Benefits of Maintaining Good Credit

Attaining and maintaining good credit can be a process, but it’s definitely one that’s well worth your time. There are many benefits that can come with having a positive credit report and a high credit score.

Some of the primary benefits of maintaining good credit are:

  1. A better chance of getting approved for loans and other forms of credit (such as obtaining credit cards)
  2. Qualifying for lower interest rates on loans and credit cards (and in turn, lower payments on those obligations)
  3. An easier time obtaining items and services, such as cell phones and utilities (often with a lower or nonexistent security deposit)
  4. Qualifying for lower premium rates on insurance coverage
  5. Being able to obtain higher limits on credit cards

Final Thoughts

Having a good credit score can open up a world of possibilities to you! It’s beneficial to make sure your score remains high, and that all the information on your credit report is true and up-to-date.

At Upgraded Points, we offer information on building credit, as well as other financial tips and guides. We also provide in-depth credit card reviews, so you know what you can expect if you apply for one or more of these cards with your current credit situation.

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