The Ultimate Guide to Credit Scores

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Updated: January 24, 2021

You may hear a lot of people talk about their credit score, and maybe even about wanting to improve them. Someone has probably advised you to “start building credit” at some point in your life. But why is it important, and what determines a credit score?

Why Credit Scores Are Important

Credit scores are basically your financial rating. It’s like your grade report for finances (and just when you thought you were done with school forever). Lenders, landlords, credit card companies, and insurance companies may pull your credit score. They do this to evaluate your financial “worthiness,” to put it bluntly.

Mortgage lenders (and similarly, auto lenders) use your credit score to determine if they will give you a loan, and how high your interest rate will be. That’s incredibly important, because it makes a big difference in how much you’ll pay over the life of the loan. For example, an increase from 3% to 4% in your interest rate on a $200,000 home increases your monthly payment by about $100, and equates to paying an extra $30,000 over the 30-year loan period!

Credit scores typically range from 300 – 850. Anything over 700 is considered good, but you should try to keep it as high as possible to get the most favorable lending terms.

How to Find Your Credit Score

Lenders will tell you what your credit score is when they pull your credit. Any time you apply for a new loan, you will learn your credit score.

Many sites will provide free estimates of your credit score (and free credit monitoring), but they may not be extremely accurate because your lender may use a different credit model & bureau when they pull your score. When I applied for a car loan, there was around a 20-point difference between the credit score the lender pulled and my free credit score estimate provided by my bank account. I try to pay more attention to the trend than the absolute score (I always want my score to be going up or at least staying the same).

The following are a few companies that provide these free credit score estimates. I highly recommend all of them, not only for their credit score reporting, but also for their rewards:

The three major credit bureaus are Experian, Equifax, and TransUnion. You can get one free credit report from each credit bureau (for a total of three per year) at Annualcreditreport.com. Don’t confuse a credit report with your credit score. Your credit report does not include your credit score, but it does include your entire credit history which is what determines your credit score. You should use these three checks per year to make sure there are no errors in this information since it will influence your credit score.

Factors That Affect Your Credit Score

In order of importance, the factors that affect credit score are:

  • Payment history
  • Credit utilization
  • Length of credit history
  • Mix of accounts
  • New credit inquiries

Let’s break it down one by one:

Payment History

Making loan payments on time (credit card, mortgage, car loans, student loans, etc.) will have the greatest effect on your credit score. Missing payments (even 1) will lower your credit score.

Credit Utilization

The lower your credit utilization, the better your credit score will be. Your credit utilization is basically the percentage of your available credit you regularly use. For example, picture two scenarios: A) you have only one credit card with a $500 credit limit and you put $50 on it, or B) you have one credit card with a $10,000 credit limit and you put $50 on it. Your credit utilization is lower in scenario B, so scenario B would be better for your credit score.

Length of Credit History

Length of credit history is simply the age of your oldest credit line. For example, if you are 30 and you obtained your first credit card at age 20, that would have a more positive effect on your credit score than if you waited until age 25 to open your first credit card. This is why I recommend that everyone have a credit card by age 18, even if you hardly use it (assuming you can handle paying it off in full each month).

Mix of Accounts

This is how many different credit accounts you have (mortgage, car loan, student loan, credit cards, etc.). You’ll generally have a better credit score if you have a mix of accounts with regular payments (mortgages, car loans, student loans) and revolving accounts (credit cards or other credit lines).

New Credit Inquiries

Lenders make “inquiries” when checking your credit score to decide whether to loan to you, or to determine what interest rate to give you. Credit inquiries decrease your credit score, because it’s an indication you’ve applied for credit. These inquiries generally affect your score for 2 years.

I really hate this factor, because I do not feel that credit inquiries reflect whether or not someone is a good user of credit. This is my weakest area of my credit score, because I tend to regularly apply for loans or credit line increases.

Last year, I applied for a car loan and mortgage loan, and those inquiries still influence my credit score. I regularly request credit line increases to lower my credit utilization. I also try to stay preapproved for mortgage loans in case a good deal pops up. To me, these things don’t indicate I’m irresponsible (I would think it shows the opposite).

In good news, at least this factor has the lowest impact on credit score.

How to Improve Your Credit Score

If you have a lower credit score, the best thing you can do to improve your score is to start making consistent payments. This is the single most important factor. Plan to never miss a payment again.

To improve your credit utilization, regularly request credit line increases, and have a few credit lines open (but don’t do this all at once, as opening new lines of credit will also temporarily decrease your score). However, do not inflate your spending when you get credit line increases! This defeats the purpose of requesting credit line increases, because you’re not decreasing your credit utilization if you just increase the amount you owe on the credit cards.

To improve your length of credit history, don’t close your older credit cards. I still have my first credit card (with an impressive $500 credit limit, I might add), and while I don’t use it, I keep it open so I don’t negatively affect my length of credit history.

To improve your mix of credit accounts, I recommend having a few different credit cards. It may benefit your score to have either a mortgage, car loan, or student loan in addition to credit cards, but I wouldn’t recommend obtaining additional loans just for the sake of improving your credit score a few points. It’s a better overall financial decision to have less debt. However, because of my interest in real estate investing, I expect to always at least have credit cards and mortgages, and this will likely benefit my score.

An important note: many of the things that will improve your credit score could lead to bad behavior. While I recommend having higher credit limits or multiple credit cards, be careful not to increase your spending because of this. Increasing your spending means you’re saving less money, or worse, you can’t afford to make your monthly payments and thus lower your credit score when you miss payments.

Also, don’t get credit cards if you can’t handle them. If credit cards cause you to spend more than you earn, it’s better not to have one at all. However, if possible, I would recommend learning how to manage your credit card spending by budgeting. Credit cards are generally beneficial because you can use them to improve your credit score, and take advantage of credit card rewards for purchases you would have to make anyway (food, gas, etc).

Lastly, keep in mind how many recent credit inquiries you’ve had. Try to avoid getting a car loan right before you apply for a mortgage. Don’t request credit line increases right before you apply for a car loan.

Those are the basics on credit score! If you struggle to manage your credit card payments, be sure to read about tracking your spending.

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