Consumer credit may seem confusing, but it’s not as complicated as you think. Credit systems have been in place for thousands of years. The modern credit system in the United States started taking shape during the 20th century and has continually evolved.
In this guide, I have put together the ultimate beginner’s consumer credit score guide so you can learn what a credit score is and why it’s essential to have a good credit score. This article is part one of a two-part series.
Contents:
- What is a credit score?
- How is it calculated?
- Credit score ranges
- How do I establish a credit score?
- Why you need a good credit score
- Weight of credit score categories
- How often do credit scores update?
- How to check credit scores
- FICO Score vs. VantageScore
- Raising your credit score
- Credit scores myths and facts
What is a Credit Score?
Let’s begin by defining what a credit score is. Credit scores are a scoring model that predicts how probable you are to pay back loans and debts.
When financial institutions lend money, they are taking a risk due to the possibility of a borrower defaulting. To mitigate this risk, institutions will look at your credit score to determine how probable you are to repay a debt.
A higher score means the probability a loan or debt is repaid is greater.
How is it Calculated?
Credit scores are calculated by three major credit bureaus: Equifax, Experian, and TransUnion. Each of these bureaus has a separate credit file for each consumer that produces individual scores.
The credit bureaus determine scores through a variety of categories:
- Payment history
- Number of credit accounts
- Type of credit accounts
- Balance to limits
- Length of credit history
- Hard inquiries
- New credit established
Some of these categories weigh heavier than others in determining scores, but all still impact your score.
The general rule of thumb is to make payments on time and minimize the number of balances and inquiries: the more available credit you have, the better.
Each month, creditors will report your liabilities to the credit bureaus that will update your scores.
Credit Score Ranges
Now that you know what a credit score is and how it’s calculated let’s dive into the range of credit scores.
According to Equifax, here are the credit score ranges.
300-579: Poor
580-669: Fair
670-739: Good
740-799: Very good
800-850: Excellent
The higher your score, the better your chances are of being approved for a loan, mortgage, credit card, etc. Financial institutions associate a higher score with a lower risk.
How do you establish a credit score? Let’s jump right in.
How do I establish a credit score?
Establishing a credit score is simple. There are a couple of ways to do so.
Option 1 – Secured Credit Card
The first option is to apply for a secured credit card (aka credit builder card). A secured credit card uses a security deposit as collateral. The minimum amount that is required for the security deposit varies between companies.
Once your secured card has been opened and the security deposit made, you can use the card as you would with a regular credit card.
Even though your secured card is ready to use, paying the entire balance owed each month on time is critical. Otherwise, you will hurt your score immediately.
There are a few ways to get the security deposit back. Most of the time, the security deposit will be refunded when the account closes or if payments are made on time for a specific period.
Option 2 – Co-Signer
When I purchased my first vehicle, I had my father co-sign for me. That was because I did not have the credit history of being approved for the auto loan.
Since my father did have excellent credit, the dealership approved the loan. The dealership saw my father as a low-risk customer.
You can always look to a family member or close relative as a co-signer.
Why You Need a Good Credit Score
If you ever plan to purchase a home or vehicle or borrow the money, you will need good credit to do so. Having a low credit score could lead to financial institutions declining your application.
Also, a lower credit score could lead to higher rates and costs if approved.
Outside of lower interest rates and reducing the chances of being denied, here are some additional reasons you need a good credit score.
- Higher credit card or line of credit limits
- Higher loan amounts
- Better insurance rates
- Avoid security deposits for phones & utilities
- Higher paying jobs
- Less hassle with creditors
- Renting an apartment
- Purchasing investment properties
Weight of Credit Score Categories
As listed in the second section of this article, credit scores are calculated using the categories below.
- Payment history
- Number of credit accounts
- Type of credit accounts
- Balance to limits
- Length of credit history
- Hard inquiries
- New credit
I want to look deeper at these categories and rank them based on each type’s weight on your credit score.
- 35% – Payment History
- 30% – Balance to limits
- 15% – Types of credit
- 10-12% – New Credit/Inquiries
- 5-7% Length of Credit History
A third, you read that correctly; a third of your credit score weight is based on payment history. You must make payments on time. Late payments impact your credit score most and should be taken seriously.
Also, the balance limits of your credit have an identical impact on your payment history. I mentioned above that the more available credit you have, the better.
It’s not entirely about how many credit cards you have, but about how many of those cards hold balances. If you have five credit cards and only one of them has a balance, your credit score will be great. Your credit score will drop significantly if all five cards are maxed or carry balances.
The remaining categories are all important but don’t quite hold the same weight. That doesn’t mean that these categories should be ignored.
A significant amount of inquiries and newly established credit can drop your score quickly.
How Often Do Credit Scores Update?
Credit scores update at least once per month. Each time a creditor reports to any credit bureaus, your score may change.
Your score may change multiple times if you have many items on your credit report.
When your scores do change, the categories weighted above go into effect. If you make a payment late, it won’t report as delinquent on your credit report until 30 days after. The longer you go without making a payment or increasing balances, the more it hurts your score.
How to Check Credit Scores
There are several ways to check your credit scores. The score you receive will be either a FICO score or VantageScore. Over 90% of lending decisions are made using the FICO score.
If you own a credit card, you most likely have free access to check your FICO score online. However, you can always check with your financial institution, as most offer it free through their online banking.
Checking your credit score at least once a month is recommended.
You might be asking, what are FICO scores and VantageScores? The following section will give you a breakdown of them and the difference between them.
FICO Score vs. VantageScore
Before diving into the differences between FICO Scores and VantageScores, I want to clarify one thing. Your online score will most likely be different from what a creditor sees.
This will happen if you are looking at a different credit bureau’s report than the creditor or due to your score dropping from the new credit inquiry not reflected online yet.
While FICO and VantageScores provide a credit score, they are vastly different. Forbes provides an excellent article regarding each company’s background.
The first difference between these scores is the required minimum scoring criteria. FICO scores require an open tradeline (credit card) at least half a year old. It must have activity during that period. VantageScores only need the open tradeline.
The second difference between them is the scoring values. While the minimum and maximum possible scores are the same, the tiers considered excellent down to poor differ.
| FICO/VantageScore | FICO Score | VantageScore |
| Exceptional/Excellent | 800-850 | 781-850 |
| Very Good/Good | 740-799 | 661-780 |
| Good/Fair | 670-739 | 601-660 |
| Fair/Poor | 580-669 | 500-600 |
| Poor/Very Poor | 300-579 | 300-499 |
Raising Your Credit Score
As this article covers, having a good credit score is essential. But how do you raise your credit score if your current credit score is low?
Here are some ways you can improve your credit score:
- Make payments on time
- Increase credit limits but don’t use it
- Pay down credit card balances quickly
- Pay any collections
- Have rent or utilities reported each month
- Don’t close credit cards
- Limit the number of inquiries
- Maintain credit card balances below 30% of the limit
If you follow the recommended steps above, your credit will improve quickly.
Credit Scores Myths and Facts
The final section of the first part of this two-part series focuses on credit score myths and facts. The table below will assist you in steering away from false information.
| Myths | Facts |
| Closing accounts help credit scores. | Maxing credit limits hurt credit scores. |
| Increasing credit limits hurts credit scores. | You can dispute credit items. |
| Impossible to have a perfect credit score. | Child support reports on the credit report. |
| Checking credit scores hurt your score. | Student loans can hurt scores. |
| Income impacts credit scores. | |
| Employers can see your credit score. |
