If you ever want to borrow money– to buy a car, a house, or even just get a credit card for the rewards—the lender will check your credit before deciding if they can lend you money. But when they say they are checking your credit, what are they actually checking?
When a lender “pulls your credit” or does a “credit check” they will receive a credit report, which includes your credit score, from a credit reporting agency. A credit score is a number, usually between 300-850, that tells the lender how likely you are to pay back the money you want to borrow. This is also known as “creditworthiness.” If you have a really good credit score, you might qualify for low interest rates and good credit card rewards. If you have a poor credit score, you will have fewer, higher interest borrowing options.
Higher credit scores are better credit scores
The higher the credit score, the better. Each lender will have their own standards for what exactly is an acceptable score, but everyone uses the same general guidelines:
Excellent Credit: 720 – 850
Good credit: 690-719
Fair Credit: 630-689
Poor Credit: 629 or below
Having a low credit score doesn’t necessarily mean you will not be able to borrow any money, but you will probably have to pay more in interest. The general rule is the lower the credit score, the higher the interest. If you have a really good credit score, you might also qualify for credit cards with good rewards programs, or with interest free promotional periods.
How a credit score is calculated
Your credit score is a single number, which is calculated by plugging 5 different factors into a credit score model. The most commonly used models for calculating credit scores are VantageScore 3.0 and FICO 8. The model used doesn’t usually make a big difference in the score, and they both use the same 5 factors:
Payment history: This is largest part of your credit score, accounting for 35% of the final score. Lenders are very interested to know if you have always paid your credit accounts on time. One late payment won’t tank your credit score, but the best way to keep this part of your score high is to always pay your bills on time.
Credit utilization: If you are using all the credit available to you, for example—you are close to maxing out your credit cards—that might mean you are already financially over extended. The best way to keep your credit score high is to use about 30% or less of your credit limit each month on credit cards, and pay it off completely each month. For loans, the more of the loan you have paid off, the better. For example, if you have taken out a $1,000 loan to buy a refrigerator, and have paid $200 towards the loan, you still owe 80%. The more of the loan you pay off, the better your credit utilization will be.
Average age of credit amounts: The longer you have had credit accounts that you have used and paid off consistently, the higher your credit score. That doesn’t mean you can’t have a high score with only newer credit, but a long-term history shows that you are consistently financially responsible.
Account Types: A mix of different account types— credit cards, retail accounts, installment loans, finance company accounts and mortgage loans—shows lenders that you can manage all different kinds of debt. Don’t worry, you don’t need to have one each, although it does help to have more than one kind.
New Credit Inquires: Research shows that if a borrower is opening several new accounts in a short period of time, this is riskier for the lender. This means that each time a lender pulls your credit report, even if you are not approved, it can affect your credit score a little bit in the short term. Only apply for loans or cards you are sure you want and qualify for.
Where all this information comes from
That is a lot of information about you to make up your credit score! Where does it all come from? And who keeps track of it? The information is stored by credit reporting agencies, also called credit bureaus. The largest three credit agencies are Equifax, Experian and TransUnion. Each month, creditors can report to them on your credit activity and utilization. Reporting credit is voluntary, but most creditors choose to report it because it is helpful to them to have records of consumer’s past credit habits. If a creditor chooses to report to the credit bureaus, there are strict guidelines for how to do so.
How to check your own credit score
It’s a good idea to keep track of your own credit score. You are legally entitled to an annual copy of your credit score from each of the credit bureaus—Equifax, Experian and TransUnion. You could request one every four months to keep tabs on your score—this also lets your catch any instances of fraud in a timely manner. Another way to keep track of your credit score is through a personal finance websites or app, or a financial institution. Many credit cards offer free credit score monitoring as one of the customer perks. If you are looking at your score monthly, you might find that it fluctuates a bit up and down. Don’t worry about small fluctuations, the important thing is to keep your credit score in the good or excellent range.
How to build your credit score
The funny thing about a credit score if that you have borrow money to get a credit score! If you’ve never borrowed money before, it might be a good idea to open a secured credit card and start building your credit. Secured cards are designed for people with no or bad credit. You put down a deposit to open the card, which limits the risk to the lender. You can change a very small amount to the card each month—think $25—and pay it in full, on time, each month. This is an easy and effective way to build credit, and it’s a good idea even if you don’t think you’ll need to borrow money in the future.