For better or for worse, we are all numbers. When you walk into the bank looking for a loan, the bank representative will pull up your number from the computer and tell you how much it will cost you to borrow from them.
What is it?
That very important number is your credit score. It tells the bank how creditworthy you are. If your credit score is higher, it signals to the bank that you are more likely to pay back the loan than someone with a lower credit score.
Credit scores range from 300-850. There are three major credit bureaus that report credit scores: Experian, TransUnion, and Equifax. All three calculate your credit score slightly differently, but in theory these three bureaus should report very similar credit scores. The bank is likely pulling your credit score from one of these three bureaus.
The most common type of credit score is the FICO. Here’s a breakdown of how your credit score is determined:
You have the ability to actively improve your credit score with a credit card. By using your credit card responsibly, you are showing other lenders that you are capable of borrowing and paying back. The algorithms that calculate your score give you a higher score for making payments on time over a long period of time (the longer the better). They also like to see that even though you have access to a large amount of credit, you’re only using a small percentage of it (some say 30% is the sweet spot).
Why does it matter?
1) You will need a loan at some point or another in your life. For most of us, this point is sooner than we think. Think first home or first car.
2) Banks aren’t the only ones who use your credit score. Other institutions such as insurance companies and phone companies often use it as well.
[UPDATE: Some employers and landlords will also check your credit. (Thanks Jenny!)]
Most of all, your creditworthiness determines the interest rate at which the institution lends you money.
Let’s take a look at how your credit score translates to thousands of dollars either lost or saved:
According to Credit Karma, the average credit score of 18 to 24 year-olds is 638. Let’s use that as our hypothetical credit score.
It looks like you’re ready to purchase your first home. You really like this $300,000 house in the suburbs of California, but you don’t have all the money. That’s okay because, like most people, you take out a loan (a.k.a mortgage) from the bank to purchase the home. Here’s what your mortgage payments might look like:
With a credit score of 638, you will be paying $1,605 every month. Over the 30 years, this adds up to $277,789 in interest payments alone. So at the end of the 30 years, you will have paid $300,000 + $277,789 in interest. That’s almost two houses.
If you raised your credit score, here is what you could save:
The same idea applies to auto loans.
If you are purchasing an even more expensive home, the potential savings increase.
Play around with the calculator to see the savings you can achieve with a higher credit score.
It’s really easy to improve your credit score!
Start using a credit card now and use it effectively. In my next post, I’ll talk about using a credit card.
Notes:
You are entitled free access to your credit report from all three of the major credit bureaus once every year. If you want to access your credit reports more than once a year, it will cost you.
I am a fan of Credit Karma, which gives you free access to your credit score all year long. It’s not 100% accurate, but they use their own methods to give you a sort of proxy for your credit score.
In combining the two, you should check your credit report for free once every year, and then use Credit Karma to give you a sense of how your credit score is moving.