Why Your Credit Score is Important

What Is It?

A credit score is just one of those essential numbers that is needed to become an adult. This three-digit number, ranging from 300 to 900, is an indicator of how trustworthy you are as a borrower and represents the overall health of your finances. Credit scores are intended to help alleviate financial risk and to help companies “take a risk” on you. This risk might be providing a loan to you (can they make sure you will pay it back on time and in full?), offering to give you a new credit card (will you be able to consistently make the monthly payments?), or even providing you a line of credit (can you afford to pay it back?). Credit scores are designed to help predict the chance that you as an individual will be able to pay back the amount of money borrowed. 

If you have low credit score, meaning below 500, or even no credit score as you haven’t started building it, you are considered high risk and if you decide to buy a house, rent an apartment, take out a line of credit or even try opening a credit card, it will be very difficult for you and more expensive as companies will not know if you have the means and the history to pay them back. This will lead to one of two outcomes: either they will decline you or they will just offer you a high interest rate. This is done so that they can make sure that they get a maximum amount of their money back right from the start rather than worrying that you might default (stop paying or cannot pay anymore) and they are left with nothing.

A credit score is a number that will help dictate your future by allowing you the chance to get a lower interest rate and a larger grace period if you do end up forgetting to pay for a credit card bill once. Knowing where your credit score lies on the range is very important. Depending on where you are, this might be the difference between paying $1000 a month on a mortgage and paying $1200 a month on the exact same mortgage on the same house or apartment.

So What Do These Numbers Mean?

On average, the credit score ranges from 300-900 and it is broken down like this:

Terrible: Less than 500

The individuals who have a credit score of less than 500 tend to be those who do not pay their bills monthly, have high levels of debt and no income to pay down this debt. You also find individuals who are just starting to build their credit score. Those in this range will not get approved for new credit and should seek out ways to improve their credit score.

Very Poor: 500-579

Scores in this range are similar to the 500 or less range, they will rarely get approved for anything but they are able to begin repairing their credit as long as they can show proof that they can slowly chip away from their high levels of debt. People in this range that want to improve their credit score can ask for a pre-paid credit card where you are able to pay the bank before spending money on your credit card so that you can rebuild your credit and the bank does not need to worry about you paying them back as you have already paid them in full.

Poor: 580-619

Those who are found in this category are considered high risk, it may be difficult to obtain a loan. If you are approved for any sort of credit, you will be offered a high interest rate as you are a credit risk to the lending institution.

Average: 620-679

This range is considered to be good, individuals will receive a slightly higher interest rate than those with better scores but should have little to no trouble in getting approve for new credit. If you are just starting to build your credit score, this is the point where you will be able to drastically improve your credit score quickly as long as you pay off all of your debt monthly and do not purchase more than you can afford.

Good: 680-719

Individuals that fall into this range have good credit and will have little to no trouble getting approved for new credit. These are the individuals that tend to receive more exclusive offerings of new credit cards or phone calls from companies wanting to provide them with new credit cards or lines of credit.

Very Good: 720-799

This range is almost perfect. These individuals will benefit from reduce interest rates and are considered to be the gold standard for credit scores. They will enjoy some of the best interest rates available.

Excellent: 800+

Individuals who fall into the ‘excellent’ category will enjoy the lowest interest rate on the market and will typically always be approved for a loan as they are considered trustworthy and not risky at all. 

As you can see, the different ranges are all very subjective. You might have been an individual who was in the average range and forgot to pay a credit card bill on time. By not paying, you are considered to be slightly more risky than you were before and you might be demoted to poor. So now, how does this score actually work? Is it only based on paying my bills completely every month or is there more to it than just that?

Factors that Affect Your Credit Score

Now determining a credit score is a lot tougher than just looking at a person’s ability to pay their bills every month. There are actually 5 main factors that affect how your credit score is calculated. If you want to improve your credit score, these are the areas that you definitely need to focus on.

1.) Payment History (35%) – Determined by payments that you make to your lender or to your creditor. This basically reflects how often you pay your bills or loans on time. If you are trying to improve your credit score, you should always make your payments on time every month or every 2 weeks depending on what you have agreed to. This is probably the easiest factor to improve your credit score, as it is something that can be worked on every month by paying off your bill in full. 

2.) Debt / Credit Utilization Rate (30%) – This shows the amount of outstanding debt you currently have as a consumer compared to the amount of available credit you have. As an example, if you have a total credit limit of $10,000 and every month you use $4,000 of your available credit, than you have a credit utilization rate of 40% ($4,000 / $10,000) and your credit score will be negatively affected. To improve your credit score or to keep a good credit score, make sure you pay down your debt and the rule of thumb is to never have more than a 30% credit utilization rate. Keeping with the example above, if you expect to consistently spend $4,000 a month, find a way to increase your available credit to more than $13,333.33 so that you can remain below the 30% credit utilization rate.

3.) Credit Length (15%) – The longer you have had a credit account (credit card, line of credit, mortgage etc) open, the better it is for your credit score. This is because it is good when a lender can see that you have had a long history of borrowing than paying back fully. This helps them feel like you are not overly risky and allows you to borrow more money in the long-term. Please note that if you are looking to cancel a credit card as an example, make sure you do not cancel an old card as this would negatively affect your credit life as you would go from a longer credit history to a shorter credit history once that old credit card is gone. If you need to cancel a credit card, go with your newest and shiniest credit card.

4.) New Inquiries (10%) – Every time you ask for a new financial tool like a credit card, the potential lender or creditor will pull your credit score which will cause a temporary and small hit to your score. But fear not, this small drop is only temporary and will not drastically affect your score as long as you are not applying to a bunch of lenders within a short time period. This is because other lenders will be able to see if you have applied for other credit recently and they might be worried about your ability to pay them back if they are worried you are opening lines of credit with multiple lenders. As an example, when you begin (in a couple of years) to shop around for a mortgage, the rule of thumb is to only check with 2 banks and/or financial institutions in a one month period as any more than this might send red flags to other institutions and will lower your credit score and raise your base interest rate which is not good for you.

5.) Diversity (10%) – The more diverse your open credit accounts are, the better it is for your credit score. This is because potential creditors can see that you are able to juggle different types of credit accounts and that you can pay them all on time. What we mean by diverse credit accounts is that an individual who has $10,000 in credit through 2 credit cards (each at $5,000) is going to have a lower credit score than someone who has $10,000 in credit through 1 credit card ($5,000) and 1 line of credit ($5,000). Even though they both have the same amount of credit, the diversity gives an extra boost of confidence to the creditor and increases your credit score.

So there we have it, these were the 5 factors that affect your credit score. If you take a moment, you can see that the first 2 factor – Payment History & Debt / Credit Utilization Rate – are worth the most and are also the ones that you can begin fixing immediately just by paying off your debts on time and not going too much into debt. The other 3 factors – Credit Length, New Inquiries & Diversity – are factors that can be improved over the long-run as they take time to improve. To help you get a better grasp of seeing the benefits of a strong credit score, I have included an example below.

Credit Score Example

For those of you like myself who prefer to see the numbers behind all of these words, let me give you an example. So there are 2 people, Person 1 and Person 2. Person 1 has an average credit score of 650 and Person 2 has a very good score of 750. They are the same age, gender and both of the same after-tax income. Other than their credit score, they are the same. They are both looking to purchase the same house, a beautiful 2,000 sq. ft. for $500,000. They both have a down payment of $100,000 (which is a 20% down payment that is the norm usually when you are purchasing a house so that we can avoid mortgage insurance). Now let us break it down:

• Down payment - $100,000
• Mortgage - $400,000
• Amortization Period – 25 years (# of years to pay down the mortgage)
• Payment Frequency – Bi-Weekly (every 2 weeks)
  

	Person 1 (Credit Score - 650)	Person 2 (Credit Score – 750)
5 Year Fixed Mortgage Rate	3.24%	2.39%
Payment Amount	$896.26 / Bi-Weekly	$816.62 / Bi-Weekly
Interest Payment	$182,501.13	$130,800.93

So let us go over what the table above means, assuming both Person 1 and Person 2 purchase identical homes with the same down payment and use the same bank for their mortgages but at different rates respectively. So Person 1 with an average credit score of 650 gets a 3.24% fixed 5 year interest rate and pays 896.26$ every 2 weeks compared to Person 2 with a very good credit score of 750 with a 2.39 fixed 5 year interest rate and pays $816.62 every 2 weeks. 

So Person 1 pays every 2 weeks $79.64 more than Person 2. Now this might not seem like that a big enough deal to try and push to get a better credit score as 80$ every 2 weeks seems negligible for the effort it will take to improve your credit score. But, if you take a look at the interest payment column above, you will notice that these small $79.64 differences every 2 weeks actually grow to be over $51,700.20 ($182,501.13 – $130,800.93 = $51,700.20). Wow! That tiny change in your interest rate purely based on your credit score could save you $51,700.20 on the total cost of your mortgage! So think about it, $51,700.20 you would save divided by the original $400,000 mortgage would be like paying off 12.92% of another $400,000 mortgage without getting the same amount of house. I hope this example shows you the incredible power of a small change in interest rate as only 0.85% led Person 1 to pay an additional $51,700.20 in interest payments.

A Couple of Ways to Improve Your Credit Score Quickly

1.) Increasing your credit limit: One of the easiest ways to increased your credit score quickly is to increase your credit limit as this will decrease your Credit Utilization Rate. As long as you can make sure that you do not overspend, this is a great and quick way to get a credit score boost. Depending on the person and where you are located, increasing your credit limit could boost your credit score anywhere from 25-75 points.

2.) Setting up automatic payments: One of the easiest ways to ruin your credit score is missed payments. By setting up automatic payments, this will take off some of the pressure off remembering when you need to pay bills and help prevent missed payments which could negatively affect your credit score.

Comments

Have any more questions on credit scores? Want to know a rough way of finding your own credit score? Does something not add up or just want to chat? Let me know down in the comments!