What is a Credit Score?
by Daniel Ruedi, CFP®
A credit score is used by banks and other lenders as a metric for how responsible borrowers are with their debt. This score was first conceptualized by the Fair Isaac Corporation, or “FICO” for short, and is by far the most commonly used credit scoring system.
Your credit score is calculated based on a number of factors. The first is payment history, or how timely you are when paying your bills, which accounts for 35% of the score. Naturally, borrowers who pay their bills on time are rewarded with higher credit scores.
The second factor is your credit utilization ratio, the amount of debt you have relative to the credit that is available to you, which accounts for 30% of your credit score. If you are able to borrow up to $10,000 and have $4,000 of debt, your credit utilization ratio would be 40%. A general rule of thumb is not to let your credit utilization ratio go above 30%. Those striving for an excellent score may want to keep it under 10%.
Length of credit history accounts for 15%, with longer credit histories being considered less risky. For this reason, it is important to establish a credit history early. It can be a good idea to open a credit card (even if you don’t need one) for the sole purpose of spending a small amount and paying it off completely each month.
The type of debt you have, whether it be credit cards, mortgages, student loans, etc., accounts for 10% of your credit score. Recently opened lines of credit account for the final 10%.
Credit scores are numbered from 300, the lowest possible score, up to 850, the highest possible score. Scores above 800 are considered excellent. Scores in the 740 – 799 range are considered very good, and scores in the 670 – 739 range are considered good. The 580 – 669 range is considered fair, and anything below 580 is considered poor.
Your credit score is important because it is used by lenders to determine how much you can borrow and at what interest rates. You can receive a free credit report from each of the three credit bureaus (Equifax, Experian, and TransUnion) to confirm that there are no mistakes in your credit.
If there are mistakes and you don’t correct them, it may cause you to pay higher interest rates or even prevent you from getting a loan. Though it may seem complicated, it is important for everyone to be aware of what their credit score is, and take steps to increase it as much as possible.
Daniel Ruedi is a Certified Financial Planner™ professional with Ruedi Wealth Management in Champaign, Illinois.