A good credit score is important if you plan to borrow for a big-ticket item like a car or a house, or sign up for a credit card. Your credit score will determine your down payment, interest rate and ultimately your monthly obligation.
Fourteen years later, good credit and the access it brings to your working and financial life has never been as important to success as it is today. The first edition of that book was published in 2006 (and the fifth edition will be out this fall), which means I have been answering the basic question of why a credit score is important for a while now.
Here’s what I can tell you today – a Keeping Score “cliff notes” version if you will about the importance of credit scoring in today’s society.
See related: How does credit work?
What is the importance of a good credit score?
A good credit score is important if you plan to borrow for a big-ticket item like a car or a house or sign up for a credit card. Your credit score (a three-digit number that typically ranges from 300-850) will determine your down payment, interest rate and ultimately your monthly obligation.
But credit has also become a nonfinancial indicator of things like character, integrity and responsibility. So, even if you think credit is evil and you have no intention of going into debt to buy anything or even getting a credit card, credit will still have a major influence on your life.
What’s your definition of a good life? A good job, a safe place to live, a car, financial security, maybe a good education for your kids or even for yourself? Well, the reality of life in the U.S. is that having good credit as expressed by a good credit score is important in accomplishing goals like these and more. Let me explain:
Finding a job
If it is indeed a “good” job you are applying for, chances are that more than one person will be in the running for it. Employers routinely check your credit history to see whether you are reliable or to see if you may have distracting financial issues at home.
A credit report is a fairly reliable snapshot of your financial life, which can be seen as a reflection on the type of employee you will be. Do you keep your promises (pay as agreed)? How sound is your judgment (maxed out cards)? Are you a responsible person (accounts in collection)?
If your competition has a resume equal to yours and has good credit but you do not, chances are the employer will pick the safer of the two candidates, all other things being equal. Before you say that’s not fair – that the employer should just rely on the resumes presented – understand that people lie on their resumes. Some do it a little, and some a lot. It is estimated that about 50% of applicants lie on their resumes. But no one can lie on their credit report!
Renting an apartment or buying insurance
Other examples include when you try to rent a place to live or buy insurance. Many landlords routinely pull credit reports and scores when looking at prospective tenants.
In the case of insurance companies, they use what is known as a soft inquiry to help set rates; these are not the kind of inquiries that will affect the new credit portion of your score. Instead, your credit report is used in calculating their credit-based insurance score, which uses some of the information in your file to predict how likely you are to file a claim and what you will be charged for your policy.
For these two uses in particular, your payment history will be very important in their decision making, but certainly not the only thing that they will look at. In all of these non-lending situations, the person making the decision may check your credit history as routinely as they may check your references.
Qualifying for a loan
Of course, credit plays a large role in lending, determining if you get a loan and at what price and terms. For a great many Americans, securing a home mortgage, buying a car (or any other expensive item), even going to college requires that some or all of the price of those things be bought on credit.
Unlike a layaway plan – where you pay for an item over time before taking possession of it – credit purchases are going to come with an additional price tag in terms of the interest rate you will have to pay. You don’t want to wait years to save up enough to buy your home or car with cash.
The kicker is figuring out how much that credit is going to cost you in the long run, and that’s where your credit score comes into play. The better your credit report, the better your score, the better your access to inexpensive loans. It really is that simple.
See related: What credit scores do mortgage lenders use?
How to maintain a good credit score
While I agree that figuring out all the rules of good credit can be daunting at first, following some basic rules will go a long way toward your establishment of a good credit score. The first rule – the golden rule in my book – is to pay all of your financial obligations on time, as agreed, each and every time they come due.
This includes paying your rent and utilities on time – all financial obligations means “all.” If you can do that, you will be well on your way. That’s because payment history is the number one factor in credit scoring. FICO counts this as 35% of your total score.
After payment history, credit utilization comes in second at 30% of your FICO score. Utilization refers to how much credit you are using in relation to your credit limit. Having a credit card with a $5,000 limit does not mean that you should go out and charge $5,000 right away, even if you plan to pay it back as soon as the bill comes due.
Maxing out a card is one of the quickest ways to tank your credit score. Keeping your utilization below 25% is important to your score; below 15% would be better and keeping it in the single digits would be better still. This is why FICO high achievers, those persons with excellent credit scores, regularly have utilization rates in the single digits.
See related: What is a good credit utilization ratio?
Length of credit history
Next up in the FICO credit scoring pie (coming in at 15%) is your length of credit history, or how old your accounts are. This piece is often the bane of the young-to-credit consumer because there is just no way to tweak this part. Your accounts are only as old as they are and only time will help here.
Credit mix and new credit
Finally, coming in at 10% each are credit mix and new credit. Credit mix looks at what types of accounts you have. It’s best to have something more than credit cards, like a car payment or other installment-type loan with a fixed payment.
New credit looks at how many new accounts have been applied for in the recent past. Note that I said “applied for” not “approved” – the hard inquiries are what counts in this part.
The difference between FICO and VantageScore
FICO is not the only credit scoring entity out there, although it is probably the most well-known. A relative newcomer to this arena is the VantageScore. Its scoring matrix is a little different, but it looks at basically at the same components.
There are a few differences in what is most important; for instance, where payment history is the most important to FICO, it is considered “moderately influential” to VantageScore. More important pieces are total credit usage, balances and available credit (all “extremely influential”). Credit mix and experience is also more important (“highly influential”) than payment history in the VantageScore model.
In the end, how you handle your financial obligations matters most to your credit report, much of the rest of your life and ultimately, your score, be it FICO or VantageScore.
Remember to keep track of your score!