Credit Score Defined: What is a Credit Score and Why Should You Care?

Credit Score Defined: What is a Credit Score and Why Should You Care?

Have you ever wondered what your credit score is or why it matters? If so, you’re in the right place.

In this post, we’ll introduce you to a handful of credit score basics. By the time you’re done reading, you should have a general idea of how your credit score is determined, why it’s so important, and how to improve yours over time.

First things first – let’s define the term credit score.

Generally speaking, your credit score is a numeric representation of how good you are at borrowing money and paying it back. The most popular type of credit score – the FICO score – is determined using a low score of 300 and a high score of 850. While a high credit score tells banks and credit card companies you’re the type of person who will pay back the money you borrow, a low score tells them you may not be creditworthy.

But, how do they know this? The three credit reporting agencies – Experian, Equifax, and TransUnion – know this because they track the following factors:

  • how often you pay your bills on time
  • how long you’ve been paying your bills on time
  • how much money you owe to others
  • if there are loans or bills that you’re having problems paying back
  • how much money you can borrow, but have decided not to (i.e. your available credit)

Checking Your Credit History & Your Credit Score

If you’re interested in finding out your credit score, you’ll be happy to know there are an ever-increasing number of options when it comes to checking your credit score for free. For example, Discover lets you monitor your credit score for free whether you carry one of their credit cards or not. You can also monitor your credit score for free at Credit Karma.

Yes, you read that right – this service is absolutely free. No matter what anyone says or what you might assume, you don’t have to pay ongoing fees to the credit reporting agencies to view your credit score. And you don’t have to pay a third party to “monitor” your credit, either. There are plenty of free and simple ways to monitor your credit movements without forking over your hard-earned cash.

Protect Your Credit

It seems like we’re hearing about a new data breach every day of our lives. So, how can you protect yourself from would-be identity thieves? Believe it or not, consumer advocate Clark Howard suggests you freeze your credit. When you freeze your credit, no one is able to open a credit account in your name.

Freezing your credit is immeasurably more effective than a credit monitoring service such as LifeLock. Why? Because it stops people from performing a crime, whereas other services offer a reactionary response.

Clark Howard likes to use the analogy of putting a lock on your door to being a credit freeze versus installing an alarm system for credit monitoring. By putting a lock on your door (i.e. freezing your credit), no one can get into your home and steal your stuff. With credit monitoring, the alarm only goes off after someone has already broken into your house.

You’ll need to unfreeze your credit when applying for a new line of credit. Depending upon the credit line you are applying for (credit card vs. home mortgage), you will need to unfreeze one (credit card) or more (home mortgage) credit reports with the three credit reporting agencies. However, if you’ve already applied for a new line of credit recently (i.e. a credit card), they have very likely already pulled your credit report. This is because this process can sometimes be instantaneous.

Don’t Lose Your PIN

When you freeze your credit, you will either be issued or choose your own Personal Identification Number (PIN). You will use this PIN to unfreeze and re-freeze your credit in the future. Keep this PIN in a safe place. Do not lose it! Your PIN is the key to your credit freeze.

Having a Good Credit Score Doesn’t Mean Paying Interest

No matter whether you’re young or old, you should always work to build your credit – and your credit score. However, many people falsely assume that paying interest on a debt balance can help their credit score.

Keep in mind that this credit rumor is absolutely false. Why? Because around a third (30 percent) of your score is based on how much money you owe in relation to your credit limits, carrying debt can hurt your score – especially if you have high credit utilization. To boost your score, pay off debt and keep your credit utilization as low as it can go.

How to Improve Your Credit Score

But, how low should you go?

Ideally, you want to use less than 30 percent of your available balance. If you have a single credit card with a $10,000 limit, for example, you’ll want to make sure you owe less than $3,000 at any given time. Just by following this rule, you can give your credit score a lot more potential to surge.

If possible, you should also try to avoid closing credit cards. This is because closing a credit card is the same as decreasing the amount of your available credit.

Consider this example: You have two credit cards, and they each have a $1,000 limit. You carry a $500 balance on one card, which is fine because you’re still under the 30 percent credit utilization rule.

But, if you close one of the cards, you’re now over the 30 percent rule. That’s because you now owe $500 on a credit card with a $1,000 limit – or 50 percent of your credit limit. Using this much of your available credit will absolutely hurt your credit. This is why it makes sense to keep credit cards open forever.

Still, there are a few more things to keep in mind as you try to keep credit cards open for the long haul – annual fees and keeping old accounts active.

Avoid Annual Fees

Just as with investing, you want to avoid fees. When it comes to your credit cards, make sure you’re not paying an annual fee. It doesn’t make sense to keep a credit card open just for the credit score factor if you’re paying money every year for the privilege. There are countless credit cards available without an annual fee that will give you the same benefit.

If your favorite long-term credit card charges an annual fee, call your bank to see if you can downgrade it to a no-fee version. This way, you can keep that card’s account history without paying the fee.

Keep Your Account Active

In addition to making sure you’re keeping credit cards without annual fees, you should make sure you actually use all your credit cards a couple times a year. Even making a small purchase every few months will keep your accounts active. Clark Howard even suggests purchasing a gallon of milk a few times per year on each card just to keep them in good standing.

Don’t Get Carried Away

I notice that many clients take pride in their credit score. However, sometimes clients can overdo it or even become obsessive over it. The thing is, it doesn’t really matter whether you work up to a perfect credit score since any score of 800 or higher will get you the greatest rates. Also keep in mind that myFICO ranks any score between 740 and 799 as “very good.”

“This score range is also above the national average and borrowers in this range are at a great advantage in both the likelihood of getting credit approval and being offered lower interest rates,” writes myFICO on their website.

While you should try to grow your score as high as it can go, a score over 740 won’t get you much more than bragging rights.

When it comes to your credit score, you don’t have to be perfect. You just have to be good. If you treat your credit with care and respect, pay back all the money you borrow, and keep your credit utilization low, your credit score will eventually show it.