Your credit score is a key indicator of your credit history’s health and an important component of your overall financial well-being. But if you don’t know how the credit system works and what goes into calculating your score, it can be challenging to improve and maintain a good credit history.
What Is a Credit Score?
A credit score is a three-digit number that provides a snapshot of your credit history. The most popular credit score is the FICO score, ranging from 300 to 850. Generally speaking, scores fall into the following ranges:
- Poor credit: 300 to 579
- Fair credit: 580 to 669
- Good credit: 670 to 739
- Very good credit: 740 to 799
- Excellent credit: 800 to 850
This score is calculated based on the information your creditors report to the three national credit bureaus: Experian, Equifax, and TransUnion. Each of these agencies maintains a credit report for all consumers in the U.S. credit system. As your creditors report information, such as payments, balances, delinquencies, bankruptcies, and more, other lenders can use that information to determine whether or not to extend credit to you when you apply and how much to charge you in the form of interest.
In addition to the FICO Score, another common score you might see (especially from free credit reporting services) is the VantageScore. These two credit scoring models consider many of the same factors when calculating a score, but they’re different enough that most financial experts recommend focusing on your FICO score because it’s what lenders typically see when you apply for a loan or credit card.
A high credit score signals to lenders that you’re a responsible borrower and less likely to default on new debt. These are the folks that typically qualify for low interest rates. In contrast, if you have a low credit score, it could be an indicator that you’re new to credit or you’ve made some missteps in the past. In this scenario, you may end up with a high interest rate or even get denied outright.
What Is Factored Into a Credit Score?
FICO considers five different factors when calculating your credit score. It also assigns a weighting for each, so you have an idea of which are more important than others:
- Payment history (35%): Making your payments on time is the most important thing you can do to build and maintain a good credit history. Even one payment that’s late by 30 days or more could drop your score significantly.
- Amounts owed (30%): FICO considers the total amount of debt you owe but specifically focuses on your credit card debit and other revolving accounts. The model considers your credit utilization rate, which is the percentage of your available credit you’re using at a given time. The higher the rate, the more it could hurt your score.
- Length of history (15%): The credit scoring model considers the average age of your credit accounts, as well as your oldest account. The longer you’ve been dealing with credit, the better it is for your score.
- Credit mix (10%): Having a good mix of different types of credit accounts can show lenders that you’re a more responsible credit user. For example, having a credit card, a mortgage, and an auto loan can be better for your score than just having credit cards. That said, it’s generally not a good idea to apply for credit solely to improve your mix of accounts.
- New credit (10%): Virtually every time you apply for credit, the lender runs a hard inquiry on some or all three of your credit reports. If you have multiple inquiries in a short period, it could be a sign that you’re struggling to get by without credit and can hurt your score.
One thing to keep in mind is that while FICO assigns a percentage to each factor, there is no hard-and-fast rule in practice. For example, if you’re just getting started building your credit, a missed payment could have a much bigger impact on your score than if you’ve been using credit responsibly for years.
Are All My Credit Scores the Same?
You have several different credit scores, even with FICO. This is because FICO has updated its scoring model over the years, with each new version making minor tweaks that change how your score is calculated.
So if a lender uses one of the older FICO scoring models, which is common among mortgage lenders, for instance, they’ll get a different score than if they use one of the newer ones. Also, the credit scores are based on information found in your credit reports, and that information can vary by credit bureau.
For example, when you apply for a loan, many lenders don’t run a hard credit inquiry on all three reports. As a result, you may have more recent inquiries on one report than on another. In this case, the FICO score calculated based on the report with the inquiry may be slightly different than on the report without it.
That said, all FICO scoring models are similar enough that you likely won’t see significant differences between them. So if you check one, it’s likely in the same ballpark as the one a prospective lender uses when you apply for credit.
How Do I Establish Credit?
You now know how credit scores work, but how do you actually begin the process of building credit from scratch? Here are three common strategies you can use.
Credit Cards
One of the simplest ways to establish credit is through credit cards. However, keep in mind these rules of thumb:
- Before making large purchases, develop a plan for how you will repay what you owe in a timely manner.
- Try to keep your balance below 35% of your monthly credit limit.
- Using your card sparingly and for smaller purchases, such as groceries, and paying off your monthly balance will raise your credit score.
- Never miss a payment. Failing to make a payment on time could negatively impact your credit score.
In addition to traditional credit cards, there are also a few alternatives you can use to boost your credit. For example, a retail or store card is a credit card that can only be used at a certain store. They typically are easier to obtain than a standard credit card, but they often come with higher interest rates. You can also get a gas card (similar to a store card but used at certain gas stations), which is a great way to make sure you do not overspend while still boosting credit.
Loans
A slow but significant way to establish credit is by taking out a loan — whether it be an educational loan, a home loan, or some other type of financed purchase. Many young adults have to borrow money at some point to pay for college or purchase a home, and having a moderate amount of loans in good standing can be a great way to build credit. However, because payment history is the most influential factor in calculating a credit score, you should prioritize paying your loans on time each month.
A good way to ensure punctuality is to set up automatic payments (whenever possible), set reminders, or make your monthly payments as affordable as possible. Figure out what amount is feasible for you to pay based on your income, and talk to your lender about the possibility of lowering your monthly rate if you’re worried about falling behind.
Rent Payments
A third, often overlooked option for establishing credit is making timely rent payments. Two of the three credit bureaus, Experian and TransUnion, now allow you to factor monthly rent payments into your credit score. If you don’t have a credit card or loan to your name and are a renter, this is a solid way to build credit history in college, after college, and as a young professional.
Learn More – Can You Build Credit With a Debit Card?
How Can I Check My Credit Score?
For a long time, it was almost impossible to get access to your credit score without paying for it or applying for credit. Since FICO launched the FICO Open Access program in 2015, though, it’s gotten a lot easier.
Many financial institutions offer free FICO score access to their customers, so check with your bank and credit card issuers to see if it’s a benefit in your online account. Alternatively, you can get free access through Discover Credit Scorecard — you don’t need to be a Discover customer — or Experian, one of the three credit bureaus.
Other companies that provide credit monitoring services, including Credit Karma, Credit Sesame, and NerdWallet, use the VantageScore. That option isn’t widely used by lenders, but it can still give you a good idea of how healthy your credit is and whether you need to address any potential issues.
The Bottom Line
Establishing a good credit history is a daunting process, but credit is something that nearly every American uses at some point to borrow money and make certain purchases. Just remember, everyone has to start somewhere, and you can nearly always recover from a credit misstep and work to improve your score.
Flex your financial literacy by checking your credit score, reviewing your credit reports for inaccuracies, and seeking out advice for areas where you can improve. Building or rebuilding credit can take time, but the benefits are well worth the effort.
Ben Luthi | Originally published December 16, 2020
Ben Luthi has been a freelance writer since 2013, covering all things money and travel. His work has appeared in many major publications and financial websites, including U.S. News & World Report, The New York Times, Fox Business, Experian, FICO and more. Ben lives in Utah with his two kids, and loves spending his free time traveling, hiking and talking about credit cards.
Information contained or linked in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as legal or tax advice. An financial, legal, or tax advisor should be consulted for advice on specific issues.
