Having good credit and a good credit score is important to your financial well-being and your life. Having credit allows you to purchase things you need, such as homes and automobiles and can even help you get an apartment or a cell phone contract. Your credit history and your score affect your ability to borrow money, and it affects the interest rate you’ll pay, which can make it easier or harder for you to pay off your loans.
In this article, we look at why having a good credit score is important, and how your score affects your interest rate.
What Is Your Credit Score?
Your credit score is a number that’s derived from your credit history. This number tells lenders how much of a risk you are when deciding to lend you money or extend lines of credit to you.
Since this number is one of the main factors taken into consideration, you need to work hard to maintain a good credit score, because having bad credit lessens the chance you’ll be able to borrow money, and increases the chance of borrowing money with unfavorable terms.
How Companies Determine Credit Scores
The information in your credit report is what’s used to determine your credit score, and it’s vital you understand what information credit reporting agencies consider so you can take steps to improve your score if needed.
There are 5 pieces of information that determine a credit score: Payment History, Amount Owed, Credit History, Types of Credit, and New Credit.
Your payment history comprises the largest percentage (40%) of your credit score. The information a credit reporting agency uses to factor in payment history is the number of accounts you have versus how many payments you’ve made on time.
The number of accounts that are 30 days or more delinquent factors into this.
Reporting agencies take into account whether you’ve filed for bankruptcy or had an account go into collections. Making every payment on time is the most important thing you can do to maintain your good credit and to build it up if it’s not where you want it to be.
The next factor that goes into your credit score (30%) is the amount you owe on your accounts. The credit reporting agency looks at your spending habits and the amount of money you owe to determine if making payments is sustainable should you encounter financial hardship. Factors that determine the amount owed are the number of accounts in which you have a balance, how much credit you’ve used, and how much you owe on all of your cards and loans.
As with making on-time payments, paying down debt goes a long way to improving your credit score and is easy to do if you pay more than the minimum payment every month.
How long you’ve had credit cards and other forms of credit is another factor that goes into your credit score. For example, if you have, say, five years of on-time payments with a credit card, it looks better than if you only had an account for a few months. The longer your credit history, the better the risk you’re seen as for lenders.
Therefore, it’s important you keep your old credit cards instead of cutting them up. Use them for small purchases to keep them active and pay off the balance at the end of the month to maintain a long credit history.
Types of Credit
Lenders like to see a variety of credit accounts, which is why you should have loans, retail cards, and bank cards instead of only credit cards. Having more variety in your types of credit shows you’re a well-rounded borrower.
The last bit of information that credit reporting agencies consider when determining your score is the new lines of credit you opened up recently. Factors in this include how long it’s been since you’ve opened a new account, the number of ‘hard pulls’ to your credit you had in the last year, and how long it’s been since you last had an inquiry into your credit report.
Credit & Interest Rates
Now that you know about what makes up your credit score, let’s look at how that score affects your interest rate.
Lenders & Numbers
So, when you apply for credit, your lender looks at the credit score given to them by one of the major credit reporting agencies. Credit scores usually range from 300 to 850 and the number that comes back to the lender affects the interest rate they’ll offer.
A high score tells the lender you’re low risk and that you’ll most likely make payments on time and won’t default on the loan. This means you’ll usually get a lower interest rate, and some lenders may reduce the amount you have to put down for a mortgage or an auto loan.
However, lower scores (usually below 620) means you’ll probably get a high-interest rate or may not get a loan at all. Many lenders look at scores above 670 to be good, so if you’re below that, you’re better off improving your score before you apply for a loan.
Building Your Score
Let’s say your score is less than perfect, and you want to get a mortgage or car loan. As mentioned, you’re better off improving your credit score before applying for a loan to get better terms and here’s how to do that.
- Make your payments on time. Even if you’ve missed in the past, start making them on time every month from here on out.
- Reduce the credit to debt ratio to be 30% or lower.
- Pay off your high balances as quickly as possible; make more than the minimum payment to do this.
- Get a copy of your credit report and make sure there are no errors that can drive your score down.
- Get help from a credit counselor to help rebuild your credit.
Many people get into trouble with credit because they don’t understand how it works. If you can avoid it, don’t carry over balances from month to month. Be smart about using your credit, make your payments on time and you should have no trouble when it comes time to get a mortgage or loan.