Your credit score is one of the most important aspects of personal finance and can be financially defining. It will be one of the most important numbers in your life as you grow and can open the doors to financial independence and security.
Before I scare you too much, let's define what a “credit score” is. In technical terms, your credit score rates your credit risk. In other words, your credit score defines how good of a “borrower” you are. I discussed how credit revolved around borrowing and lending money in a previous article, which you can find here.
How does a credit score determine how good of a borrower you are? First, let's quickly discuss the many uses of credit. Credit is present in almost every part of your life. When you choose to finance a car (which most people do), you are using credit. When you take out a mortgage to buy a house, you are using credit. When you take out student loans to help pay for college, you guessed it, you are using credit. This goes on and on. Think of any situation in which you don’t buy an item for its full value upfront. Whatever you thought of most likely utilizes credit.
Since credit is used in so many essential parts of life, every time you use a form of credit, it is reported to one of three credit bureaus (TransUnion, Equifax, and Experian). Every single use of credit is reported, whether it's a $2 pack of gum bought using a credit card, or a $400,000 mortgage payment.
Every time you use credit or make pay off a bill, it gets reported to one of the credit bureaus, who factor it into your score. These companies use an equation called a scoring model to determine your credit score.
This score is based on how you use credit. Pay your bills on time, and you're considered a "good borrower", meaning your credit score will increase. On the other hand, if you are late making a payment, or miss it entirely, your credit score will decrease. Other factors like closing an old account, opening a new line of credit, and paying off a loan can result in changes to your credit score.
Credit scores range between 300-850, with anything below 580-600 being considered “bad”. Having a credit score below 600 makes it extremely hard to get loans. The average score in the US is 704, and anything above 680 is considered “good”.
I briefly talked about what your credit score is used for, but one of the key factors it influences is your ability to get loans/take on debt. Remember, anytime you don't pay for something entirely upfront, you use credit to get some kind of loan. This can be an auto loan, to buy a car, or a home loan, to buy a house. Before you get a loan, the institution (bank, credit union, etc) who is giving out the loan will take a look at your credit score, among other things, to determine if you are a credit risk.
If you have a low credit score, it means you have a history of being late on payments, or missing them entirely, meaning you are a credit risk. To the bank, it seems as if you won’t pay back your loan. They'll hesitate to give you a loan, and reject you outright if your score is too low.
Conversely, when you have a higher credit score, it shows the bank or credit union that you have a history of paying back your loans on time, meaning they won’t have a problem getting their money back. This means you are a decreased credit risk and makes them more willing to give you a loan.
Banks aren’t the only institutions looking at your credit report. Landlords, student loan lenders, utility companies, insurance companies, and even potential employers will look at your credit score to get a basis for your financial habits.
Essentially, having a higher credit score means it's easier for you to take out loans, making it easier for you to get more expensive items like cars or a home.
When you have a higher credit score, you tend to pay less interest on loans. Interest is a small percentage of the total loan amount that you have to pay on top of your monthly/yearly payments. Interest is the way banks make money on loans. After all, they can’t lend money for free. If you have a lower credit score, an institution is taking a risk by giving you a loan, so they'll make you pay more interest to counter-balance the risk.
Saturday’s article will be dedicated to credit and interest rates, and I’ll also be discussing how to build and maintain good credit as a teenager in a coming article, so stay tuned for both for more information on credit.
In short, your credit score shows how well you borrow money. A number of factors play into calculating a credit score, and everything from your credit card usage to car payments is accounted for. Having a high score can be extremely beneficial, and make life just a little bit easier.