There is so much to understand when it comes to credit. What is a good score? What is a bad one? How can I raise my credit and what brings my credit score down? Sometimes these things can be confusing, and even misleading. These days many people end up with bad credit scores simply because they didn’t know what they were doing and how credit works. So for those of us who can’t always understand all that legal mumbo jumbo posted on the backs of credit card applications, here’s a short crash course in the American credit system.
Basics: What is a credit score?
Just like the A or the F you got on your report cards in school, the credit score is a number which is supposed to represent how well you are doing with your credit. When your score is higher it is supposed to indicate to lenders that you have been managing your credit well. This score is used by banks and other financial institutions to determine the likelihood that you will be able to pay back any money that they loan you. The better your score then the more trustworthy, or creditworthy, you are. If you have a good score and banks consider you more creditworthy then they will be willing to lend you more and give you better rates. This is how having good credit works. But if you have a bad credit score, it can be difficult to get a new loan or credit card which can be devastating when you really need a new house or car.
What is a good or bad credit score?
A good or bad score is somewhat subjective because certain companies or people may think of some scores as good scores even if another company may not. Generally the higher your score is then the better it is, but it is nearly impossible to have immaculate credit. As we’ll talk about when we discuss FICO and credit reporting agencies, there are different ranges of credit score depending on where you get the score from. The most popular is the FICO range, which is from 300 to 850. According to FICO, credit scores above 770 are considered excellent and at that point it doesn’t really matter if your score is higher you are already considered extremely creditworthy. Once into the 700-770 range of scores you are still considered to be very creditworthy. Think of this like an A on your report card and a 770 is an A+. Of course, you don’t have to have an A or an A+ to be considered creditworthy. The average credit score for someone with good credit is around 650. 620 is where things start to get murky though. This score is the difference between good and bad credit. Most financial institutions consider 620 to still be good credit, but anything lower is going to start to be not so good. There is still some leeway with a score of around 600, but much less than that and you are likely going to be completely denied further credit. Anything less than around 550 is considered absolutely terrible.
How do they determine my credit score?
Your credit score is a makeup of several different factors which are meant to determine your creditworthiness. The most important factor is your payment history, where companies look to see that you make regular payments for the right amounts and check that you make those payments on time. The second most important factor in your FICO score is the amounts that you still owe to current financial institutions. Banks want to make sure that you can pay them back and if you have a lot of other things to pay back they assume it will be difficult for you to handle paying back yet another account. Your length of credit history also poses a significant factor in your credit report. Newer accounts are actually more beneficial. Older accounts show banks that it takes you a while to pay things off. FICO also looks at your lines of new credit. If you have recently opened a lot of new lines of credit, or submitted a lot of new credit applications this can seem desperate and negatively affect your credit score. For more factors that can negatively affect your credit score see our article 8 Missteps to Bad Credit.
What is FICO? What are credit reporting agencies?
Perhaps the most confusing part of understanding the credit system is understanding exactly what FICO and all the other credit reporting agencies actually are. FICO is the most popular credit scoring agency, and is what most lenders look at when determining your creditworthiness. There are actually three major credit reporting bureaus: Experian, Equifax, and TransUnion. The way these companies work is that when you sign up for new lines of credit those lenders send your credit information to the credit reporting bureaus. The lenders tell the bureaus whether you make your payments on time, how much your credit line is for, how much of your credit line you have used, and many other things about your credit line. Then the credit reporting bureaus compile your credit information into a database of information about all your lines of credit. However, the problem with this is that a lot of lenders only report your credit history to one or two of the reporting bureaus instead of all three. Each reporting agency may have different information on file for you depending on which lenders have sent them your information. Regardless, unless you have managed your credit perfectly in one account and completely ignored other accounts, your credit score should be generally the same across all three reporting agencies. Now that we know what the credit reporting bureaus are, we can understand what FICO is. FICO takes the credit information provided by these three credit reporting bureaus and creates a credit score based on its credit scoring criteria mentioned above. FICO does not compile the information in all three agencies to provide us with one credit score and instead does provide us with three credit scores, one based on the information provided from each of the three reporting agencies.
Can I get a copy of my credit score?
Because of the Fair and Accurate Credit Transactions Act, every U.S. resident is entitled to get a free copy of their credit report from each of the three major credit reporting agencies every year. You are entitled to one from each agency, which means you actually get three credit reports per year. But this can be very misleading to consumers. The credit reports that you are entitled to are only reports from Experian, Equifax, and TransUnion. You are not entitled to a copy of your FICO score, which is what most lenders use to determine your creditworthiness. The Experian, Equifax, and TransUnion reports can be very helpful to consumers in determining whether you need to work to improve your credit score, since they will provide you with information on how creditworthy you may appear to be to lenders. But in some cases it may be more beneficial to you to purchase your FICO scores, or purchase a score from another service. Also if you would like to monitor your credit score more than once a year, FICO and other credit scoring agencies offer services where you can receive monthly or quarterly credit scores. It may be helpful to ask potential lenders which credit scoring services they will be looking at and then go out and purchase those exact scores.
What about services that claim you can receive a free credit report?
We’ve all heard the catchy jingles on TV and the radio advertising free credit reporting websites, but you should be wary of any credit scoring or reporting service which claims to be free. Annualcreditreport.com is the official website for ordering the annual free credit reports that you are entitled to by law. A lot of websites that advertise free credit reports do not give you the scores that lenders will actually be looking at, and often only use scores and reports from just one of the three major credit reporting bureaus. Usually these types of sites will claim that their reports are free, but you are actually required to sign up for a free trial of their membership service to see your score. These sites will make it very difficult for you to cancel your membership during the trial period, and if you don’t cancel soon enough you will be charged for a monthly membership until you do cancel. Even if you do manage to cancel your monthly membership without incurring any fees, these types of websites will often spam your email inbox long after you have cancelled. Be sure to look closely at the fine print for any “free” credit report website before you sign up and look for reviews online before you buy.