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Good Credit Matters: How to Understand and Improve Your Credit Score

A good credit history is a big part of financial independence; a good credit score makes it possible to get credit cards and buy a home, while a poor or missing credit history can make it difficult to rent an apartment, get insurance — or even get a job. Here’s what you need to know about building a great credit history and using it responsibly.

FICO 101: A really simple guide to your credit score.

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.

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?

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:

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?

Basically there are two ways to check your own credit score. You can can sign up for a monthly credit monitoring service, most of which will give you your three credit scores for free when you subscribe. The price ranges from $15 to $30 a month, although most provide a free trial period of 7 or 30 days; cancel within that timeframe and you won’t be charged. (Sometimes credit monitoring is helpful, like if you’re getting ready to apply for a mortgage or you suspect you’re susceptible to someone else trying to use your credit information.)

Alternatively, you can try CreditKarma, a totally free service that provides an estimated credit score. 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. Credit Karma is free because it advertises to users based on their actual credit profile. Read my full review of CreditKarma 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.

Check your credit score for FREE (for real -- no CC required). Learn how here.

About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. David-

    LOVE the napkin! Seriously, I might use that in one of my presentations…

    Like you said, it might be somewhat remedial, BUT just like budgeting skills…to know and to practice are two very different things, and a friendly reminder can be a nice way to kick you in the butt and get you back on the right track.

    Keep up the good work!

  2. Thanks for all the helpful tips. I am going to try the free website :)

  3. I went to creditkarma. I was a little weary because it asked for my social security, but because you recommended it and it was a secure site.. I went for it. Now I know my credit score :)

    • David Weliver says:

      Glad it worked for you Laurie. They’re legit; they need your SSN to get your credit information as does any credit checking site.

  4. I like Credit Karma because it actually allows you to put all these different factors into play and simulate the effects they will have on your score. For example, thinking of skipping a bill payment? That’ll be 10 points or more. Thinking of getting a second credit card? no effect. Etc. It really answered questions I have had about How Much different actions impact your score, regardless of how close to FICO their free score really is.

  5. The Oil Barron In Training says:

    How does paying things off early affect your score. I recently bought a car and put half down. I had planned on buying it out right, but my old car broke down before I had the cash. I took out a 5 year loan, but three months later I hit a big win in the stock market and paid my car off way early. Being that this drastically reduced the interest paid on the loan, will it hurt my credit score?

    • David Weliver says:

      Hey Oil Barron. I too, paid off a car loan early and was surprised to see my credit score go down…but it came back up within a few months. It’s one of many flaws (IMO) of our credit system that penalize smart behavior. The logic is that a person with a mix of OPEN accounts (credit cards, mortgage, auto loans, etc.) is a better credit risk than somebody who only has credit cards. So when you pay off (and CLOSE) one of those accounts, it may impact your score negatively, at least in the short-run.

  6. Great Tips! You make if very easy to understand how credit works!

  7. When I worked at the bank I had quite a few non-resident aliens come in to open a secured credit card. I think it’s a good way to start and put credit on your name.

  8. Thanks for all the info! Quick question: I have a Southwest Visa (I fly a lot) and like to use it to pay my school bills. Unfortunately, every time I use it to pay my school bill, I max it out – although I’m careful to not exceed the credit limit. I pay it back almost immediately… but is the fact I’m periodically using most of my credit negatively affecting my credit score?

  9. This is probably a basic question, but I’m 20 and just opened my first credit card. Is it bad for my credit score if I make payments throughout the month online versus paying at the end of the month when my statement is due?

  10. I created an account with Credit Sesame based on this site’s recommendation, and in this month’s update it reported my credit score lowered by 15 points. The only change in my spending & debt in this period is my using two credit cards for every purchase I make. The reason is reward points, and my (maybe mistaken) understanding that higher usage, with the balance paid in full each month, will help raise my credit score. But my usage is still at only about 4% of my limit. Can the higher usage negatively impact the score — or, since you mention above that Credit Karma is “accurate within 10-20 points of my actual FICO score,” should I not obsess over Credit Sesame’s figure?

    • David,

      After reading this post I created an account with Credit Karma and that site reported my credit score 113 points below the number I was given by Credit Sesame. What are your thoughts on the discrepancy? Thanks!

    • David Weliver says:

      Hi James: Each credit score is a little bit different. Whether you get it from Credit Karma, Credit Sesame, myFico or another paid credit score provider, each could be using a different algorithm and a different credit reporting provider. Hence, your credit score is relative…the best thing to do is to find one source and track your score for a few months. From each source, you can also find out what the max score is…if one is on a scale up to 850 and another 950, you can see how it’s not apples to apples…

  11. David,

    I have heard that checking your credit score brings it down, is that true?

    • David Weliver says:

      Rachel, checking your own credit report or score will NOT bring it down. If you apply for credit and somebody ELSE checks your credit—then your score may decrease a few points.

  12. Thank you so much! I’m a senior about to head off to college and had no idea what a credit score was until I had to write a speech about financial responsibility. This was really easy to follow and I finally realize just how important a credit score is. Thanks again!

  13. Hello David is there a UK equivalent to Credit Karma I have just signed up to Experian for a 30 day trial to see what is on there and remove any indiscrepancies. I have checked google but haven’t had much luck so far.
    Matt.

  14. Hey David,

    How can I entitle a free credit report, can you tell me about it?