When it comes to personal finance, there’s no figure more important — or more misunderstood — than your credit score. Most consumers know their score is what determines how much credit they qualify for. But beyond that, their knowledge of that “magic number” is often murky or downright false, right down to what a “good” score really is.
In general, anything below a 640 will make you a higher risk to banks and lenders, while a score of 800 makes you the cream of the crop. (The average credit score is just under 700.) Put simply, higher scores represent better credit decisions, and they make creditors feel more confident that you can repay your debts.
Let’s say you’re given a credit limit of $10,000. There’s no harm in using it, right? Actually, that’s a common misconception. From a credit score standpoint, try to minimize how much of that you’re actually spending. If you are using the majority of your credit line all the time, it can eventually cause your credit score to plummet.
Another common credit score misconception is that when it comes to the number of credit cards you have, the more the merrier. In reality, though, once you get past two credit cards, it can actually detract from your credit score. With all that open credit, what’s to say you won’t use it all and spend more than you can afford? From a creditor’s perspective, that makes you high-risk.
How Your Credit Score Affects Your Financial Health
So why is a credit score so important anyway? The short answer is that it can affect your life milestones in so many ways. If you’re looking to get a mortgage, car loan, or personal loan, your score helps determine your loan eligibility, how much you can borrow, and your interest rate. And it’s not just banks that look at your score — companies you do business with (such as phone providers, landlords, insurers, and even utility companies) might look at your score and adjust your rates accordingly.
Your credit score might even impact your ability to find a job. In most states, employers have the right to run credit reports on prospective employees. These aren’t always the same reports that are given to a lender, but they can have an impact on whether you’re hired.
Of course, having a poor credit score doesn’t necessarily disqualify you from obtaining a loan, buying insurance, or finding a job — but a good score can make all of those things easier. To stay informed about where you stand score-wise, you can request a free copy of your credit report once a year from Experian, Equifax, and TransUnion. Visit AnnualCreditReport.com or call 1-877-322-8228 for more information. Fifty-two percent of American adults haven’t checked their credit score in the past year, so by keeping up with your credit report, you’ll be ahead of the game.
How to Achieve a High Credit Score
If your credit score isn’t stellar, it doesn’t mean all hope is lost — there are still several things you can do to boost your score over time. Although these aren’t overnight fixes, if you take several small steps at a time, you’ll be well on your way to earning a top-notch score.
- Pay your bills on time.
The most important thing you can do to improve your score is to pay your bills on time. That doesn’t just mean credit card bills, either — it also includes your rent or mortgage, utilities, loans, car payments, etc. Your payment history makes up 35 percent of your credit score, so even one or two late payments can cause your score to take a hit.
To make it easier to pay everything on time, try setting up automatic payments. That way, you never need to remember to pay your bills, and you can rest easy knowing your payments will be made on time every time.
- Reduce your balance in relation to your credit limit.
This is known as your credit utilization ratio. This number is calculated by dividing your total credit card balances by your total available credit. This makes up 30 percent of your credit score, so next to paying your bills on time, it has one of the biggest impacts on your credit health. Lenders like to see ratios of 20 percent or less to know that you’re not getting close to maxing out your available credit, and people with the strongest credit tend to have very low ratios.
Sometimes, people think that the best way to lower the ratio is to simply open more credit card accounts — after all, if you have more credit available yet you’re still spending the same amount, your ratio will automatically be lower, right? The downside is that too many credit card applications can also hurt your score. Every time you apply for a new card, it creates what’s called a hard inquiry on your credit report. While hard inquiries aren’t permanent (they stay on your report for two years), each one does cause your score to drop by a few points.
- Be proactive about the accounts you open.
Besides your payment history and your credit utilization ratio, the other three factors that influence your credit score are the mix of accounts you have open (which makes up 10 percent of your score), how often you open new accounts (10 percent of your score), and how long you’ve had credit history (15 percent of your score).
If you have a variety of accounts (for example, credit card accounts, a mortgage, a car loan, and student loans), it will be more beneficial for your score than just one type of account. This is because you’re proving to creditors that you can handle different types of debt. However, keep in mind that opening too many new accounts in a short period of time can hurt your score. So while it is good to have a variety of accounts, if you get a mortgage and then immediately try to open three new credit cards, expect your score to drop by more than a few points.
Also, the number of years you’ve had a credit history will impact your score; the longer your history is, the more trustworthy you become in the eyes of lenders.
- Be careful when co-signing.
While this isn’t a factor when determining your credit score, co-signing for someone else can affect your credit. Even if the person you’re co-signing for is trustworthy, his or her decisions will affect your credit in what’s known as contingent liability. Even though you aren’t using the money, the debt counts against you when you apply for your own loan. This is because your name and credit history are tied to their accounts. So if your friend or family member makes a late payment, your credit score will take a hit.
In addition, if the borrower is over 21 years old, the creditor can suddenly increase the available credit without notifying you. That means the cardholder can start spending more without you knowing, and if that person is not able to pay the bills, it’s your credit score on the line.
In short, a good credit score is way more than just a number; it’s a valuable tool that helps you qualify for the best interest rates, buy a shiny new phone, or a sign a lease on that dream apartment. In other words, getting a handle on your credit score can be the first step toward your path to financial freedom.