Home Money & Finance How Credit Works: 6 Key Things to Know About Credit Scores

How Credit Works: 6 Key Things to Know About Credit Scores

by Olufisayo
How Credit Works

As of November 2020, the country’s total consumer debt came in at a staggering $14.2 trillion, with the average American being about $92,727 in personal debt. Debt can either be good or bad, depending on how you manage it.

A sure indicator of sound debt management is a high credit score. Everyone knows a good credit score equals a better life, but what exactly is a credit score, and how does it work? Credit is a sensitive and complex subject for most Americans because not a lot of people understand how credit works.

If you belong in this large group, you don’t have much to worry about. That’s because, in this post, we’ll be looking at everything you need to know about credit and credit scores. That way, you’ll be better placed to make prudent financial decisions and increase your credit score.

What Is a Credit Score?

A credit score is a three-digit number determined by your credit activity and reflects your “debt repayment credibility.” The number ranges from 300 to 850 and is also linked to your social security number. Lenders refer to your credit score before approving your loan.

Your credit score affects nearly every facet of your financial life. With that out of the way, let’s look at essential things you need to know about credit scores.

1. Your Credit Score Depends on Five Key factors

Lots of factors come into play to determine your credit score. However, these are the five primary considerations:

Age of credit accounts: The longer your history of credit accounts, the better your credit score is likely to be. That’s because a long history of debt management proves your long-term financial responsibility.  The age of your credit accounts contributes about 15% of your credit score

Repayment history: Repayment history is how well you’ve been able to keep up with your loan repayments. This is the single most important factor determining your credit score, contributing to a whopping 35% of your credit score.

Credit utilization: Credit utilization means how you use your credit and how much credit you use. Aim for a credit utilization ratio of less than 30%. That means that your credit balance should be less than 30% of what you borrowed.

Inquiries: Lenders are usually cautious with who they lend out money to. As such, you should expect a few inquiries about your credit report before you get your loan approval. The more inquires you have, the lower your credit score.

Account types:  If you have a couple of revolving accounts, it’s proof of proper financial management. For instance, if you have credit cards and installment accounts, you’re more likely to have a higher credit card score.

2. Credit Reports Aren’t Credit Scores

While credit reports and credit scores are related, they aren’t the same thing. Credit reports are a comprehensive record of your credit activity. They contain information like:

  • Debt collection accounts
  • Credit borrowing frequency
  • Credit history

Your credit report may also contain certain public records, including bankruptcies and liens. Credit bureaus or credit reporting agencies are responsible for compiling these credit reports.

You can think of a credit score as a numerical representation of the above information. It’s difficult for lenders and financial institutions to go through all your relevant credit information. Your credit score is a uniform way for lenders to understand your financial and credit situation.

3. There Are Different Types of Credit Scores

That’s right; there are different types of credit scores and various credit score ranges. These credit scores depend on the three credit bureaus. The types of credit scores are:

  • Equifax- 280-840
  • Transunion- 300-850
  • Experian – 360-850

Your credit score will change, depending on the credit bureau you refer to. Make sure you refer to all three credit scores to have a firm idea of your credit situation.

4. You Don’t Have to Pay to Check Your Credit Report and Score

The law requires the three major credit bureaus to furnish you with your credit report every year for free. That means you can check your credit report up to three times every year if you cycle through credit bureaus.  It’s important to do so as much as you can so you can address any inconsistencies or hiccups.

There are plenty of ways to check your credit score. For instance, a lot of the major credit card companies allow you to check your credit score for free. You can also check your credit score on various online platforms.

5. It’s Okay to Check Your Credit Score From Time to Time

Checking your credit score frequently won’t affect your credit score in any way. However, hard inquiries from lenders can negatively impact your credit score. Even so, the effect of hard inquiries on your credit score is minimal and, in some cases, negligible.

However, personal inquiries on your credit score have zero effect on your score. As such, don’t be scared to check your credit scores whenever the need arises. It’s also worth noting that credit score inquiries don’t show up on your credit report.

6. A Low Credit Score Is Costly

There are many perks to having a high credit score. Some of them include low rates on auto on homeowner’s insurance and lower interest rates. A low credit score equals the opposite; high interest and high insurance premiums.

Your low credit score can cost you thousands of dollars compared to if you had a high score. However, don’t despair if you have a low credit score; you can learn how to increase your credit score and get all the perks.

Learn How Credit Works for Improved Financial Management

Now that you know how credit works, you should be wise with your financial management. Remember, a low credit score is actually costly. As such, make sure you make sound financial decisions for a higher credit score and improved life quality.

Tor read more interesting topics, check out our other posts.

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