Inside: Your credit score seems more mysterious than a crystal ball. I’ll show you how it works and why it’s so important. You could literally save thousands!
Up until a couple years ago I had no idea what a credit score was, much less why I should care. That was for people who actually earned money, I thought. Ha! Not me.
Little did I know that the whole time, companies had been chugging away in the background. They had been reporting and collecting data on me, and distilling it down into one single number.
I didn’t need that number now, but future me sure does. Future (current) me is thanking my lucky stars that I somehow did all the things those companies wanted done right. Somehow, even though I’ve made shit hit the fan with my debt situation, I’ve come out with a smokin’ hot credit score of 759.
What’s more, that credit score is literally saving me a ton of cash today. It’ll save me even more in the future!
What is a credit score?
People don’t just hand out money willy-nilly like a grab-as-much-cash-as-you-can machine. In the real world, creditors (people who lend you money) will only give you money if you’re likely to repay it.
How do they know if you’re likely to repay it (besides asking your cat)? A credit score.
The core of your credit score is made up of two things: a credit report, and a credit scoring algorithm.
Your credit report is like a debt report card for grownups. Anytime you do something debt-related—make a debt payment, open a credit card, or even fail to pay your normal non-debt bills—it gets recorded on your credit report. You can check yours for free at annualcreditreport.com (warning; there are a lot of copycat sites that’ll charge you money and /or your firstborn child. This URL is the only legit one).
A credit scoring algorithm is a math formula that pops out a number. It’s like a stats program for a collection of research data—put data in, and it’ll pop out one number to characterize that whole data set. There are many credit scoring algorithms, but FICO and VantageScore are the most popular. You can check your VantageScore (which is usually pretty close to FICO) for free at Credit Karma.
Creditors are likely to check both your credit report and your credit score. For simplicity’s sake, though, as long as you know your credit report is accurate, the credit score is an easier number to focus on.
Your FICO credit score runs from 300 to 850. The higher the number, the better.
Why care about your credit score?
Do you like things?
I like things.
Your credit score affects your ability to get things in two ways:
- Whether you’ll be approved for a loan or not
- How high your interest rate will be (if you are approved)
A lot of people who follow gurus like Dave Ramsey say that you shouldn’t care about your credit score because you should be able to buy things in cash. Sure, that’s a great idea, but do you have $199,200 in cash lying around? That’s the median home price as of May 2017, according to Zillow.
No? Me neither. But, if you have a good credit score, you can get a mortgage for said house. If you have an even better credit score, you’ll pay less money for that mortgage.
Case in point: Let’s look at two mortgages, both for $199,200 with 30-year terms, and not including the taxes and insurance that most mortgage companies roll into your monthly payment. The difference? One person has just-OK credit (620-639), and the other person has excellent credit (760-850). These credit scores currently qualify for interest rates of 5.208% APR and 3.619% APR, respectively.
If you have just-OK credit, you can expect to pay $875.85 per month, versus $726.23 per month with excellent credit. That’s a pretty big difference.
But, when you look at the total interest paid over the life of the loan, the person with just-OK credit pays $155,946 whereas the person with excellent credit pays $102,081.
Lemme state it another way: A difference of just 1.589% APR from having good credit will save you $149.62 per month, and save you $53,865 over the life of the loan.
So yeah. That’s why I care about my goddamn credit score! I can buy a lot of tacos with $54k.
What exactly goes into calculating your credit score?
It’s important to understand how your credit score is calculated so you know how to raise it.
According to FICO, your credit score is composed of the following parts:
- Payment history – 35%
- Amounts owed – 30%
- Credit history length – 15%
- Credit mix – 10%
- New credit – 10%
Let’s break this down Gangnam-style.
The biggest factor in determining your credit score is whether you even make the damn payments on time. Depending on your credit score, one single late payment can drop your score by as much as 100 points. Don’t do that. Naughty-naughty. Set that shit up on autopay instead and never worry about it again.
How much money you owe is the second biggest factor. Specifically, credit card debt has a huge influence. Pay off some or all of your credit card debt and you’ll see an instant boost in your credit score.
Related: The Qoins app: Round up spare change and turbocharge your debt payoff (affiliate link)
How long you’ve been using debt products is another big factor. This is why you should never close your oldest credit cards (unless they’re charging an annual fee and you’re not using them, of course). Creditors don’t want to hand out massive amounts of cash to new frat boys, after all—they want seasoned people who know what the heck they’re doing. Like Gerard Butler from the movie 300 (oooohhhh…..).
Credit mix (how many types of debt accounts you have) and new credit (how many recent credit inquiries you have) are the least important factors. Still, it pays to diversify your account types. If you have a significant other, split up who applies for what if you need to take out a loan or a credit card. And for Pete’s sake, don’t apply for tons of credit cards all at once so it doesn’t look like you’re going for bust on a Vegas gambling spree.
Is your credit score the only thing you should be worried about?
Your credit score is pretty goddamn important. But, it’s only one measure of a tiny slice of your financial picture.
As I myself have proven, you can have a great credit score and still be in trouble in other areas. I look great to a creditor right now, but I don’t have a lot in savings. Zach used to have a good credit score, but it dropped 100 points after we gave up our evil house. In most other areas though, he’s above average.
Related post: A Step-By-Step Guide To Get Out Of Debt
Your net worth, savings rate, debt load, and monthly income are all other important indicators. You can combine them with your credit score to create a more holistic picture of your financial health.
But still, your credit score remains a very important metric that you should be familiar with—especially before you make a large purchase like a home or a car. You could literally save tens of thousands of dollars over time!
Do you pay attention to your credit score? Leave a comment below!
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