If you don’t understand your credit score and how it’s calculated then you’re in the dark regarding one of the most important aspects of your financial life. Here’s a look at how credit scores work, how they’re calculated, and ten steps you can take to start improving your score today.
Not convinced your credit score can have a serious impact? Look at the chart below, which shows your expected interest rate on a 30-year fixed rate mortgage, depending on your current credit score:
Credit score/ Interest rate:
760-850 /3.9%,
700-759 /4.1%,
680-699 /4.3%,
660-679 /4.5%,
640-659 /4.9%,
620-639 /5.5%.
So with a credit score of 620, your interest rate could be as much as 1.6 percent points higher than if you had a score of 760. Now, you might think it doesn’t matter because, really, there’s not much difference between 3.9% and 5.5 %.
Wrong. For big purchases, like houses and cars, such a seemingly small difference can result in almost unimaginable extra costs over the life of the loan. Let’s take the 30-year fixed rate mortgage loan above as an example, on a home-loan of $200,000. Here is what you can expect to pay, based on your interest rate:
Interest Rate /Monthly payment/ Total interest paid in over 30 years
3.9% /$944 /$139,684
4.1% /$969 /$148,906
4.3% /$990 /$156,350
4.5% /$1,015 /$165,455
4.9% /$1,067 /$184,095
5.5% /$1,134 /$208,356
I’ll let that sink in for a moment…
Yes, you read that right. A lower credit score can cost you an extra $68,000 on a 30-year home loan. And you’ll see similar (though not as drastic) effects on auto loans and other large purchases.
Now that we’re all in agreement about the importance of understanding your credit score, we can dive into the details…
Credit scores are compiled by the Fair Isaac Corporation (FICO), and for
that reason they’re often called FICO scores. Lenders rely on these scores and the accompanying credit reports to determine your likelihood of defaulting on a loan. When you apply for a loan, the bank or lender will pay one of the three main credit bureaus (Transunion, Experian, and Equifax) to obtain your report.
The question is, how can you easily improve your credit score to save yourself money in the long run?
According to FICO, there are 5 factors that make up your credit score. They’re each weighted somewhat differently in terms of their effect on your total score. Let’s go through these one by one and describe specific actions to help you improve your score in each area.
Payment History (35% of Total Score)
This is pretty obvious at first glance: your history of making payments (or not, as the case may be) on loans and credit cards plays a big role in determining your credit score. Duh!
But digging a little deeper we start to see more nuance. The size of the late payment and the length of time it has been overdue matters. A $55 credit card payment that is 90 days late will usually have a smaller impact on your score than a $500 auto loan payment that’s six months late.
And remember, almost any type of late payment can affect your score. Cell phone bills, child support payments, medical bills… if you pay any of these late your score could pay the price. There have even been instances where overdue library fees were handed over to a collections agency and hurt people’s credit scores!
Furthermore, you need to have concrete evidence of on-time payments (not just the lack of late payments).
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