What is a Credit Score? The Complete Guide to Understanding “Your Number”

I don’t know about you, but I really, really, really wish we didn’t have to be slaves to our credit scores. Although it’s possible to live without regards for the modern American credit scoring system, it’s not easy. For most of us, we’re going to have to suck up to Lady FICO and King Equifax whether we like it or not.

In a post I’ve been wanting to do for a while, I want to step back to the basics of credit scoring and lay down the facts. This may be remedial for finance blog junkies (sorry), but for everybody else this is THE crucial information to have on credit scores. If you read nothing else on credit scoring, this should be it. In this post, I’ll quickly cover:

• What is a credit score?
• Why does your credit score matter?
• What’s a good credit score?
• How do you get a good credit score?
• How do you fix a bad credit score?
• How do you get your own credit score?

Short on time? You can get the basics from this doodle:

If I had to fit this post on the back of a napkin, this is what it would look like. The keys to a good credit score are paying your bills on time, having a mix of accounts (credit cards and loans), and keeping accounts in good standing for many years. Ta-da! But seriously, the meat and potatoes follow.

WHAT IS A CREDIT SCORE?

A credit score is a number that measures how likely you are is to repay a loan on time.

That’s it. Your credit score is based upon your history repaying loans. Banks use your credit score to decide whether or not to loan money to you and, if they make the loan, what interest rate to charge. For better or worse, your credit score may also be used by landlords, insurance companies, and even employers to decide whether or not to do business with you. (I’m not saying that’s fair—and I don’t think it is—but it’s reality).

WHY DOES IT MATTER?

See above. Your credit score may matter if you apply for a job or insurance, and it definitely matters if you ever need a loan. If you don’t establish a good enough credit score, most banks won’t give you a loan for a car, home, or business. And the higher your credit score is, the less interest bank will charge you for the loan.

Who cares? Well, you should if you care about saving money. For example, the difference in total interest payments on a $250k, 30-year mortgage between a 5% interest rate and 8% interest rate is about $179k. That is the cost of less-than-perfect credit.

WHAT’S A GOOD CREDIT SCORE?

The classic question. Unfortunately, it’s also hard to answer because your credit score is a moving target. There are two primary reasons for this:

• Different companies calculate your credit score differently (and on different scales).
• Your credit score is a ranking, not a rating (it’s like test scores put on a Bell Curve).

Every time you apply for credit, you don’t know which scale(s) your lender will use to pull your credit score. In addition, you don’t know what their criteria are. For example, over the past couple of years the standard for a “good FICO score” has increased somewhat dramatically.

Note: FICO stands for Fair, Issac and Company, the providers of the some of the most commonly-used credit scoring algorithms. Your FICO score is just another way of saying your credit score (like Kleenex vs. tissue).

But with that disclaimer in place, you can be confident that a score of 720 is “good” on most scales, while a score of 800 is “very good” on most scales. Scores in the high 600s aren’t necessarily bad, but they won’t qualify you for all loans or the best rates. Finally, it’s important to note that once your credit score approaches the high 700s to low 800s, any further increases won’t do much for you…banks will already give you the best rates. (It’s like if a prof awards an A+ to numerical grades of of 97-100, once you hit 96 there’s no additional benefit to getting a 98 or 99, etc.)

HOW TO GET A GOOD CREDIT SCORE

There are three big components to a good credit score:

• Establishing credit over time.
• Paying bills on time.
• Staying out of credit card debt.

Establishing Credit

The first step is often the trickiest, because you need to get credit before you have a credit score. There are several ways to establish credit for the first time, but it’s arguably easier to do when you’re young and either in college or still dependent on your parents. For example, you can:

• Ask a parent to make you an authorized user on one of their credit cards.
• Take out a federal student loan.
• Take out a loan with a cosigner.
• Get a secured credit card.

Once you have one open account, it becomes easier to get additional accounts. Over time, you’ll get the best credit score when you have at least one or two credit cards and one or two loans (like student or auto loans). That said, more accounts is not necessarily better. Finally, a key part of credit scoring is time. It typically takes several years to develop a good credit score.

Paying Bills on Time

If I had to sum up advice for maintaining good credit in five words, it would be this: Pay your bills on time.

Nothing builds credit more reliably than paying your credit cards and loans on time every time. Not surprisingly, nothing will wreck your credit score faster than failing to pay these bills on time. The longer you take to pay them (and the more often you’re late), the lower your credit score will fall.

An example: I’ve had fairly good credit all my life, but once many years ago I screwed up and paid two bills late. My credit scores fell by an average of 60 points and it took two years to fully recover.

Staying Out of Credit Card Debt

Carrying credit card debt is bad, mmm-k? It’s bad for your finances in general and it’s bad for your credit score.

Credit card utilization (or how much of a balance you carry in relation to your credit limit) impacts your credit score. The higher your combined balances in relation to your combined credit limits, the more your credit score will suffer. For the best credit score, you want to keep this “utilization ratio” as low as possible.

And, for advanced credit score hackers, there are other things to take into account here, like the fact some credit cards that don’t report credit limits can negatively impact this ratio and, thus, your credit score. That said, the bottom line is having a credit card or two is good for your credit score, but carrying credit card debt is not.

HOW DO YOU FIX A BAD CREDIT SCORE?

The same way you build a good one! By paying your bills on time and staying out (or getting out) of debt.

Unless you’ve been the victim of identity theft or otherwise have errors on your credit report, the only way to “repair” your credit is to pay your bills, pay down debt over time, and avoid applying for new credit. Expect it to take between one to two years of responsible credit management to make an impact on a troubled credit score, and be wary of anybody who tries to sell your shortcuts to a better credit score.

HOW DO YOU GET YOUR OWN CREDIT SCORE?

Undoubtedly you’ve seen the incessant ads for ways to check your free credit score. All of these services make you sign up with a credit card for monthly credit monitoring services and then cancel that service within seven days if you don’t want them…that’s how your score is “free”. It works, I’ve done it, but it can be a pain. (And I typically don’t recommend credit monitoring unless you’re a frequent victim of ID theft or you’re just obsessed with that sort of thing).

That said, if you want your official credit score—either free or for a one-time fee—here are the links to these offers.

Alternatively, you can try CreditKarma, a totally free service that provides unlimited estimated credit scores. You have to create a free account, and then CreditKarma pulls your credit report and gives you an estimated score. I’ve tested it, and it’s accurate within 10-20 points of my actual FICO score. The service also provides some useful charts for comparing your credit score to averages. Read more about how to check your “real” FICO score here.

So there’s you have it—the five minute guide to your credit score. Think I missed anything important? I specifically didn’t get into some of the nuances of perfecting credit (like deciding when to cancel credit cards, for example), but hoped to cover all the biggies. Let me know what you think, or if you have credit scoring questions leave them in the comments and I’ll try to find an answer.