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How Your Credit Score Works (and How to Improve It)

You may think that your credit score only matters if you’re applying for a credit card or a mortgage.

And while it’s true that having good credit is helpful in both of those cases, your credit score matters in many other areas of your financial life. Therefore, you should understand how credit works — even if you never plan to get a credit card or buy a house.

Below, we give a full explanation of credit scores. We’ll start with an overview of what your credit score is, as well as why it matters.

Then, we’ll examine some ways to increase your credit score (including some that don’t require you to get a credit card). All of this should give you the confidence to boost your credit and use credit responsibly.

How Your Credit Score Works

When you apply for a loan, the lender wants to be reasonably sure you’ll be able to repay it. To determine this, they’ll check your credit report and credit score.

Your credit report is a document that contains the following information:

  • Identifying info – Your name, address, Social Security number, date of birth, and employment information. This information is included so lenders can verify your identity
  • Credit accounts – A list of all the credit accounts you have, including the type of account, the date you opened the account, your credit limit/loan amount, the account balance, and your payment history
  • Credit inquiries – A list of all the requests lenders have made for your credit report over the past two years
  • Bankruptcies and collections – If you’ve declared bankruptcy, have a debt that’s entered collections or are delinquent on a loan payment, that information will appear on your credit report

There are three main consumer reporting agencies (also called credit bureaus) that supply credit reports to lenders: Equifax, Experian, and TransUnion. Each agency formats and reports the info in your credit report differently, but the underlying information is the same.

As you can imagine, reading through every single item of a credit report and then making a lending decision is a time-consuming, subjective process. To make things faster and more objective, a lender can check your credit score in addition to your credit report.

A credit score is a number calculated using the information in your credit reports. The higher the score, the less risky you are for lenders.

There are different types of credit scoring systems, but the most common is the FICO score. FICO scores generally range from 300-850.

Typically, lenders care less about your precise score than the range of scores it falls into. According to FICO, here are what the general ranges of credit scores signal to lenders:

  • Lower than 580 – Poor
  • 580 – 669 – Fair
  • 670 – 739 – Good
  • 740 – 799 – Very Good
  • 800 or higher – Exceptional

So what goes into your credit score? In general, FICO uses five factors from your credit report to calculate your score. In descending order of importance, they are:

Payment History

For this portion of your score, FICO sees if you’ve ever missed a payment on a loan (credit card, mortgage, student loan, etc.). The theory goes that if you’ve missed a payment in the past, you’re more likely to miss one in the future.

Payment history is one of the most important factors in calculating your FICO score, making up around 35% of the total.

Amounts You Owe

Up next, FICO looks at your total debts across all accounts (car loan, mortgage, student loan, credit cards, etc.). They also consider your “credit utilization,” the percentage of your available credit that you’re using.

Having some debt and credit utilization isn’t a problem, but having large debt payments or credit utilization higher than 30% can lower this part of your credit score. This makes sense, as someone who’s already in a lot of debt is a poor candidate for further loans.

The amounts you owe figure significantly into your FICO credit score, making up around 30% of it.

Length of Credit History

All other things being equal, a lender would prefer a borrower with a longer credit history than not. This is because the longer someone has (responsibly) used credit, the less of a risk they’re likely to be for future loans.

This part of your score is less important than payment history or total debts, accounting for only around 15% of your FICO score. And because the only thing that can increase it is the passage of time, it’s not a factor you should worry about too much if you want to raise your overall score.

New Credit

This part of your score looks at how many new lines of credit you’ve recently applied for. It’s not a huge component, accounting for only around 10% of your FICO score. But it’s still something lenders consider when assessing how much of a risk you are as a borrower.

You typically don’t have to worry about this part of your score as long as you’re not doing something irresponsible like opening a bunch of credit cards at once.

Credit Mix

The final factor to determining your credit score is your credit mix. As the name implies, credit mix refers to how many different types of credit you have available to you. This includes credit cards, student loans, auto loans, mortgages, etc.

In general, the more varied your credit mix, the better. But since credit mix only accounts for about 10% of your FICO score, it’s not something you should worry much about. Your payment history and the amounts you owe are far more impactful.

Note: While your credit score is a major factor in lending decisions, it’s not the only thing that lenders consider. Your income and employment status can also play a role, though they aren’t included in your credit score.

Reasons Your Credit Score Matters (Besides Getting a Credit Card)

You now understand what your credit score is and how credit bureaus calculate it. But…so what? Why does your credit score matter? While it’s impossible to cover every case, here are the main situations and life events where your credit score could be relevant:

Applying for a Mortgage

Mortgage brokers consider many factors when assessing a potential borrower, but your credit score is a significant part of their decision.

If your credit score is very low, you could be denied a mortgage altogether. And even if your score is high enough for you to qualify, a lower score will typically mean a higher interest rate.

An interest rate difference of a few percentage points may not seem like a big deal, but it can massively impact the amount you pay for your house over the long term. To see how much of a difference your interest rate can make, have a look at this mortgage calculator.

Overall, if you’re planning to get a mortgage, a higher credit score is better.

Getting an Auto Loan

Even if you never plan to buy a house, you’ll probably have to buy a car at some point. And unless you’re paying for your car in cash, you’ll need an auto loan.

Similar to mortgages, a higher credit score will mean a lower interest rate on your auto loan. And a lower interest rate means lower monthly payments and a less expensive vehicle overall.

Rental Applications

Not every landlord or property manager will check your credit, but they are legally allowed to do so.

You might think that a credit check for a rental application is strange since you aren’t applying for a loan. But just as the info in your credit report can help lenders determine how at risk you are of defaulting on a loan, so can it help your potential landlord determine how at risk you are of not paying your rent.

The specific laws around how and to what extent landlords can check your credit/background info vary by state. But given how common it is, you’re better off having a higher credit score. The last thing you want is for bad credit to hold you back from living where you want.

Signing Up for Utilities

A final area where your credit score could matter relates to signing up for utility service. While the utility company isn’t giving you a loan, they are taking the risk that you might not pay your bills. This is certainly an extreme case, but it’s still a possibility when a company deals with thousands or even millions of customers.

Typically, bad credit won’t prevent you from setting up utilities. But having a high credit score could mean that the utility company waives the required deposit. And that deposit is money that you could put to better use, such as investing in index funds or learning new skills.

How to Raise Your Credit Score

You now know the factors that go into your credit score, as well as why it matters. But what can you do to boost your score?

The typical answer you’ll get to this question is something like, “Get a credit card, put one or two recurring purchases on it, and pay the full balance off each month.”

And yes, that is a solid approach to improving your credit. Getting a credit card increases your total available credit, which can raise your score. And paying the card off each month establishes a responsible payment history, which can also raise your score.

However, let’s say that you don’t want to get a credit card (or can’t). In that case, what are some other ways to boost your score? Let’s take a look:

Pay Down Debt

As we discussed earlier, the total amount that you owe lenders accounts for around 30% of your credit score. Therefore, reducing the amount that you owe can help your credit score increase.

Here are some of the types of debt you can consider paying down:

  • Credit card debt – If you aren’t paying off the full balance of your credit card each month, the debt can quickly compound to an unmanageable amount. But if you can reduce the amount you owe to less than 30% of your total available credit, your credit score will likely improve. Learn more about how to get out of credit card debt.
  • Student loans – Student loan debt isn’t necessarily a bad thing, particularly if you have federal loans with low interest rates. But student loans are still debt, so paying them off can help boost your credit score. Learn how to pay off your student loans fast.
  • Auto loan – If you have a car loan, see if you can put a little bit extra towards your payments each month.

Get a Secured Credit Card

Okay, so I know I said I would discuss ways to raise your credit score without a credit card. But I do want to mention a “safe” way to get all the credit-building benefits of a credit card without the risks.

It’s called a secured credit card. Essentially, it works just like any other credit card. The difference is that to qualify for it, you must “secure” it with a cash deposit equal to your line of credit (the amount you can spend on the card). The card issuer holds this deposit in case you can’t repay the card’s balance.

While they don’t offer the same perks and rewards as regular credit cards, secured credit cards are an amazing tool for building (or rebuilding) your credit. Each monthly payment you make gets reported to credit bureaus, which can improve your score with time.

Note: To get your deposit back from the card issuer, you’ll either need to upgrade to an unsecured credit card or cancel the secured card (in good standing).

Apply for a Credit Builder Loan

Consider a credit builder loan from a bank or credit union if a secured credit card is still too much of an overspending temptation.

Here’s how they work:

  1. You borrow a small amount, typically less than $1,000.
  2. You then repay this loan, plus interest, over a period of 6 to 24 months.
  3. Each time you make a payment, the bank deposits it into a savings account or certificate of deposit (CD). And they also report each payment to the three major credit bureaus.
  4. Once you’ve paid off the loan (and any interest), the money in the savings account/CD is returned to you.

Credit builder loans are a great option if you don’t have the cash to deposit for a secured credit card. And with terms of 6 to 24 months, they offer a (relatively) quick way to improve your credit.

The main downsides are any interest and setup fees the bank may charge. But these could be worth it in the long run to boost your credit score.

How to Check Your Credit Score for Free

You can’t improve your credit score if you don’t know what it is. So here’s how to check your score for free.

To start, be aware that you are entitled by law to a free copy of your credit report every 12 months from each of the three major credit bureaus. Learn how to get your free report.

While accessing your credit report helps you find any errors, it won’t give you your credit score. To find that, you’ll need to turn to other means.

First, check with your bank or credit card issuer. Many let you view your FICO credit score for free as part of being a customer.

If you can’t get your score from your bank, then consider Credit Karma. They let you check your VantageScore for free.

VantageScore is an alternative credit scoring algorithm developed through the collaboration of the three major credit bureaus.

While the numbers will differ from FICO, your VantageScore is based on the same credit report information that FICO uses. So the score will still give you a useful idea of your current creditworthiness. (And many lenders and financial institutions use VantageScore instead of or in addition to FICO).

Note: While Credit Karma is “free” in the sense that you don’t have to pay anything for the service, they will use your credit data to make product recommendations from partner banks or lenders.

If you choose one of their recommendations, then Credit Karma gets paid by the bank or lender. The company is transparent about this business model, but it’s something to be aware of.

Let Your Credit Score Work for You

I hope you now have a better understanding of how your credit score works, as well as how to increase it.

Whatever you do, don’t get overwhelmed by all of the information in this article. The main things to keep in mind when improving your credit are:

  1. Always pay your bills on time
  2. Pay down debt
  3. Consider a secured credit card or credit builder loan to establish a history of on-time payments

Finally, be sure to use credit responsibly! To learn more about that topic, check out our guide to getting a credit card.

Image Credits: woman holding credit card