For many people, credit scores can be intimidating and confusing, involving complex numbers and difficult calculations. The thing is, they're also important: credit scores can have a major impact on your finances—especially down the road, when you're applying for a credit card, car loan, or mortgage.
With that in mind, here are the basics of your credit score: what it is, how it's calculated, and—most important—a few tips for improving it!
What is a credit score?
Simply put, a credit score is a measure of your credit worthiness, or reliability as a borrower. Lenders look at your score to see how likely you are to repay money that you borrow. They also use your score to better understand the state of your finances, including your payment history, the length of your credit history, how much credit you are using, your total debt and other factors.
Who determines your credit score?
VantageScore and Fair Isaac Corporation (FICO) are the two major scoring systems that financial institutions use to measure your credit worthiness. FICO uses five categories to calculate its scores, while VantageScore uses six. Using these various categories, explains money expert Farnoosh Torabi, credit scoring systems can help your financial institution get a better picture of your overall credit situation. "They can capture all the different ways that people are using credit and are still being credit worthy and credit responsible," Torabi says.
For VantageScore, the result of these six categories is a three-digit number that represents your credit worthiness. Anything above a score of 720 is considered "good" or "exceptional." Scores below 720 fall into "fair" or "bad" range.
Your credit score is really valuable because it captures your credit worthiness, which can go a very long way in achieving your life goals.
What makes up your credit score?
The first—and most important—factor in your credit score is payment history. Aim to pay all bills on or before their due date and pay down your debts consistently over time. A late or missed payment on your loans or credit card bills can stay on your credit report for up to seven years.
"An easy way to set yourself up for success is to consider setting up auto-reminders or auto-payments with your financial institution," notes Pam Codispoti, Head of Chase Consumer Branch Banking. "They're especially helpful for balancing life's many demands."
Age and type of credit
Not all credit is created equal: having different types of accounts—like auto or student loans, credit cards, and home mortgages—can work in your favor. Having accounts that have been open for a long time can also help. In fact, VantageScore ranks the age and diversity of your credit as the second-most-important factor in calculating your score.
With that in mind, it may be worthwhile to keep your old accounts open, even if you aren't using them. Their age could improve your score.
Percentage of credit used
The amount of credit you use—also known as your credit utilization—is another very important factor in calculating your credit. Remember: just because your credit card has a $10,000 limit doesn't mean you should use all of it. VantageScore recommends keeping your balances under 30 percent of your total credit limit.
Total balances and debt
Paying off your debt can be a long, expensive process—especially if you booked that once-in-a-lifetime vacation on your card—but the sooner you do it, the better your credit score.
According to financial website Credit Karma, lenders and financial institutions prefer to see lower balances on your credit accounts because it suggests you'll pay off your loan quickly. Your total balances may not be as crucial as your payment history, but putting some extra money toward your debt each month will improve your profile.
Recent credit applications
It may seem easy and harmless to apply for a new travel credit card, auto loan, and home mortgage in one fell swoop, but it can actually hinder your overall credit score. Before approving a new card, loan, or other account, lenders look at past and current behavior to predict future financial performance. This is called a hard inquiry, and can lower your credit score by a few points. Opening up several accounts at once can trigger several hard inquiries, leading to a more significant drop in your credit score. It also can signal to a lender that you may be taking on too much credit debt, which could be difficult for you to service in a timely manner.
While VantageScore celebrates having different types of credit, spreading out your applications for new accounts could help your score.
While available credit may not be the most important factor on the list, using only the credit you need will be in your overall score's favor. In fact, a recent report by VantageScore found that prime consumers keep an average of $20,000- $22,000 worth of available credit that they do not use.