We live in a country where a healthy credit score and having the ability to borrow money is seen as one of the biggest accomplishments in personal finance. Even though most of us know the importance of having good credit and reviewing our credit report and score regularly, so many people still have no idea what goes into this mysterious number and how to actually improve it over time.
First thing's first: Make sure you understand the difference between a credit report and credit score. Your credit report is a huge file about you and your credit history. It includes your personal information, a summary of your financial accounts, if you've filed for bankruptcy in the past and any past inquiries made.
Your credit score is your FICO number, which lenders use along with your credit report to determine how risky a borrower you are. Your credit score can range anywhere from 300 to 850, and the higher the score, the better. When you apply for a car loan, student loan, home loan or credit card, your credit score is used by the lender to determine how much they will lend you and what your interest rate will be. The more risky you seem, the lower the limit they'll give you -- and the higher the interest rate they'll charge.
So now that you understand the difference between your credit report and credit score, let's review the five factors that go into calculating your credit score.
- Payment History. For example: Are you paying your bills on time? This accounts for about 35 percent of your score.
- Total Amount Owed. According to Mint.com, you should strive to keep your score healthy by using less than 30 percent of available credit across all your credit cards. This factor accounts for 30 percent of your score.
- Length of Credit History. This factor accounts for 15 pecent of your score. Getting an early start on building credit is essential.
- New Credit. This includes the number of recently opened accounts and credit inquires you've made, for example. It accounts for 10 percent of your score.
- Types of Credit Used. Car loans, mortgage and credit cards fall under this category. This accounts for 10percent of your score.
The goal is for your score to be above 760. This means you have excellent credit. If you have credit below 620, you are considered a subprime borrower, or more risky.
How does this all play out in your financial life? Making sure you have good credit is a given. But the difference between high and low credit scores can mean thousands of dollars saved over the course of your lifetime when it comes to borrowing money. Let's look at an example.
Let's say you are ready to buy your first home. You work with a mortgage broker to pre-qualify for a $500,000, 30-year fixed home loan. Your credit score is 620, so you get a mortgage loan approved at a 5 percent interest rate. This equates to a monthly mortgage principal and interest payment of about $2,685 per month. Over the course of 30 years, your total principal and interest payments equal $966,600. So on your $500,000 mortgage loan you will pay approximately $466,600 in interest over 30 years.
Now let's say your credit score is 760, so you get a mortgage loan approved at a 3.5 percent interest rate. This equates to a monthly mortgage principal and interest payment of about $2,245 per month. Over the course of 30 years, your total principal and interest payments will equal $808,200. So on your $500,000 mortgage loan you will pay approximately $308,200 in interest over 30 years.
Just by having the better credit score, you could potentially save $158,400 in interest over the course of 30 years! That's a lot of money and that's why having a good credit score is very important.
You want to get in the habit of checking your credit score at least once per year. You can go to sites like www.annualcreditreport.com to access your credit report for free once per year, then pay an additional fee to get your credit score. Other sites, such as www.creditkarma.com will allow you to monitor their version of your credit score, which is similar to your FICO score, for free on a regular basis.
Remember, it's up to you to take control of your financial future. Start with baby steps and take time to really understand the importance of having a good credit score.