If your credit score is keeping you up at night, you are not alone. Statistics show that nearly 12% of the entire U.S. population has an ultra-low credit score, which falls somewhere below 550, and less than 1% of American adults have a perfect FICO score of 850. The lack of substantial knowledge of credit trivia among young adults is alarming, as nearly 54% of that population have never inquired about their credit scores or reports. If your credit is not keeping you up at night, you might have better sleep hygiene, but the fact remains the same – credit scores, whether we like it or not, are an essential part of our existence. They are the inseparable elements that allow most of us some of the biggest life purchases, such as your dream home with a white picket fence. It’s time to get to work and familiarize yourself with the ins and outs of credit. Here’s credit scoring in a nutshell.
How Do Credit Scores work?
A credit score is your pathway to a more relaxed life, allowing you to afford many essentials or luxuries the world offers. However, it can also be a source of struggle for those who encountered financial mishaps along the way. Credit scoring is a system that provides lenders with fundamental knowledge about your credit history – whether your previous actions represent decent creditworthiness. The entire process of loan approval is essentially based on your individual credit score and credit history report.
How are Credit Scores Calculated?
Your credit score is formulated using sophisticated algorithms derived from your borrowing and repayment history. Ultimately, they are designed to make life easier for lenders, showing them how much they can trust you. Whenever you get approved for a loan, any activity on your account is reported to credit bureaus, which translates into your credit report. Because credit reports tend to be lengthy and filled with detailed information, a computer tool summarizes that report into a simplified credit score.
You might be surprised to find out that you have more than one credit score, and all may slightly differ depending on many factors. Equifax, Experian, and TransUnion are three major credit bureaus – they calculate their scores utilizing different mechanisms and managing diverse information from various lenders. Another credit scoring model is provided by FICO or VantageScore, which are also guided by specific criteria. The loan approval process may place more emphasis on your borrowing history, the mix of all credit scores, or rely on the information provided by one credit scoring agency.
Let’s take a look at credit score components that account for its calculation:
Credit Score Components
Your credit score, despite its diverse origin, has many common elements that are taken into account. And although the impact of each component may vary across the credit reporting companies, similar constituents generate your credit score.
Your repayment history of previous loans and credit lines plays a crucial role in determining whether you are the right candidate for a new lending extension. Based on your prior financial habits, whether any of your former accounts have been in default or you have had a flawless repayment history, your entire record is taken into consideration.
Your payment history includes everything from student loans, retail credit purchases, installment loans, mortgage, auto loans to all other debt repayment activities. Besides all credit accounts, your potential lender might consider every missed payment, foreclosures, filed bankruptcy, or collections. Your credit score’s meticulous calculation includes delinquent accounts, the ratio of all missed payments, and how late they were.
Combined with payment history, your current debt is another very impactful component of your credit score. Together they account for approximately 75% of your credit score calculation. Understanding the credit utilization ratio is extremely important to get out of debt faster and keep your financial affairs in order, which includes raising your credit score.
The credit utilization ratio is your entire revolving credit on all accounts in relation to your current debt. As a rule of thumb, your credit utilization ratio should not exceed 30% of all your dues. If your entire revolving credit is $1000 and your indebtedness is $700, your credit utilization rate equals 70% – a sign it is time to start repaying the debt promptly and reduce the ratio to at least $300 or less.
Tip: An excellent way to affordably pay off your current debt is to apply a micropayment tactic. Instead of paying a minimum payment every month, which also accumulates unnecessary and damaging interest without lowering your overall balance, strive for making smaller yet more frequent payments throughout the month. For instance, if your minimum payment is $25, consider making $10 weekly payments on your account. That way, you can avoid high-interest rates, pay off your financial obligations faster, and reduce your credit utilization ratio. Win-win.
Credit Score Mythbusting
Although the current age of information and technology spreads more awareness and education in various fields, certain misconceptions still exist regarding credit score. Let’s dive in and do some myth-busting:
A bad credit score does not go away.
Indeed, continuous late payments, delinquent accounts, and other financial irresponsibilities will hurt your credit. However, believing the myth that a bad credit score is there to stay may be as damaging, prohibiting you from taking appropriate action, such as repairing your credit and changing your financial habits. Your credit score can and will improve if the proper approach is applied, and you are committed to fixing what has been broken, leaving the past in the past.
Checking your credit score lowers it.
Finally, let’s answer the most frequently asked question – does checking your credit hurts your score? Later in the article, we will present safe ways you can check your credit score, but for now, let’s bust the omnipresent myth: checking and monitoring your credit score does not lower it. You can and should inspect your credit report and your score on a regular basis, provided that you use the appropriate tools and avoid any hard inquiries. Examining your credit report allows you to catch any mistakes and inaccuracies early, preventing you from further damage and giving you insights into what is happening.
It takes a while for a credit score to drop.
Unfortunately, that isn’t the case. Your credit score can significantly drop over the course of a few weeks or months, depending on how much harm you are inflicting upon your credit. Although each financial institution has its own protocol of action, abandoned or severely delinquent accounts will eventually be subjected to charge-off or collections – the worst possible scenario for your credit score.
An excellent credit score requires substantial income.
False! Everyone, despite their financial situation, has the ability to produce a perfect or adequate credit score. Income does not impact your credit score unless you find yourself unable to pay off your current debt. If your earnings prevent you from enjoying certain luxuries, it might be worth reconsidering your spending habits, including utilizing credit for unnecessary purchases. Repaying that liability can cost you more than money, so it is essential to calculate your spendings accordingly.
Closing an account will get rid of the problem.
Closing your credit line will not help you in terms of raising your score, even if the balance has been paid off in full. In fact, it will lower your credit utilization ratio by reducing the total revolving credit. You are better off keeping the account open even if you do not intend to use it. It goes without saying that closed accounts with current balances might severely hurt your credit score.
If I pay off my collections, I will help my credit score.
Another myth worth busting. While you might be tempted to pay your collections in order to re-establish a good credit score, think again. Once your account becomes delinquent, and the collection agency takes over, your credit score is probably already damaged, and paying it off will not bring immediate results.
I have to wait at least seven years to rebuild my credit score.
This misconception is as damaging as the bad credit score itself. It prevents you from regaining confidence in your finances and pursuing your ultimate goals. Although negative credit entries remain on your credit report for up to seven years, waiting that long to get a hold of your affairs can jeopardize your life. You can rebuild your credit score in the meantime, and it is highly advisable. Regular credit report monitoring will allow you to catch errors or out-dated entries on time, which will, upon dispute, raise your credit score.
How to Check Your Credit Score?
While you are entitled to a free annual credit report from all three credit bureaus, and we encourage you to take advantage of it, your credit score will not be displayed on your credit report. So, how can we check our credit score without hard inquiries that may lower it?
Your financial institution
Many banks started offering credit score checks for their customers. You may find it on your monthly statement or by utilizing their online tools by logging into your bank’s platform.
Checking Your Credit Score Online
You can obtain a copy of your credit score by purchasing them directly from one of the credit bureaus online. Another option for checking your credit score is by utilizing online tools either for free or by a monthly subscription fee. Credit Karma is an application or internet-based platform where you can effortlessly find your credit score.
Checking Your Credit Report Online
As we mentioned, you can and should keep an eye on your credit report at least once every 12 months. Your credit report is essentially your reflection of past spending habits, a recollection of all positive and negative financial behaviors. Unfortunately, your credit report most likely contains a few inaccuracies that should be tended to as soon as possible.
Equifax, TransUnion, and Experian all offer annual free credit reports to all users. Even if your credit is in good standing, it is essential to use the free service and inspect your credit report regularly for any errors or inaccuracies that may potentially impact your credit score.
Understanding Your Credit Report
Your credit report contains all the essential information that generates your credit score and provides insights into your creditworthiness to lenders. Your credit report includes your personal information, such as your date of birth, the types of credit under your name, the time your accounts have been active, and your payment history. Any filed bankruptcies, arrests, and suings are also listed on your credit report.
Lenders use all of that information to assess whether they can extend their loans to you. Your credit report is updated with each activity, positive or negative, which also includes all inquiries for new credit lines.
Frequently Asked Questions
We have covered extensively the behind-the-scenes of credit scoring. Let’s answer some of the questions that are most likely bothering you, as thousands of Americans inquire about them daily.
Why does your credit score go down when you check it?
If you check your own credit score through a reliable source, that is considered a soft inquiry and will not affect your credit score. However, hard inquiries made on your behalf may slightly lower your credit score. Whenever a lender checks your credit score for loan purposes, it impacts your rating.
How many points does your credit score go down for an inquiry?
Hard inquiries might affect your credit score by up to five points. If your credit is in excellent standing and your credit history is intact, your credit score may be even less impacted. The drop due to hard inquiries is rather temporary, and you should be back on your feet in no time.
Does your credit score go down when you check it on Credit Karma?
According to Credit Karma, the portal requests credit scores from TransUnion and Equifax, and those are considered soft inquiries. As mentioned before, soft inquiries do not directly affect your credit score.
Is checking my credit score free?
There are various ways to obtain your credit score, even for free. Nerdwallet, for instance, offers free of charge credit score checks for everyone using the soft inquiry approach. There are many ways to check your credit score for free. The abovementioned Credit Karma also offers free credit scores for its users.