Finances

Credit Score: How Does It Work and Why Is It Important?

Explore the details of credit scores – from understanding the calculation to the impact on your financial life. Learn about the factors influencing your credit and much more!

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Your credit, your life – 3 digits, endless consequences!

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Credit Score: How Does It Work and Why Is It Important? Source: AdobeStock

Getting straight to the point, your credit score is a number that represents your credibility as a consumer. Want to understand how does credit scores work? It changes everything in this game.

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With that in mind, we’ve put together a guide that explains it all. Learn how credit scores really work. It’s just three digits that make all the difference in your financial life.

How do credit scores work?

The major question here is how does credit score calculation work? Credit agencies use a formula to compute your credit score. Now, let’s delve into this formula.

Imagine an equation with several variables. Take into account your payment history combined with your credit history. Subtract from this total your overall debts.

Lastly, the “y” in the equation represents your new credit applications. In other words, be careful not to open too many new credit applications in a short period. This can adversely affect your score.

Why is it important to have a good credit score?

Many aspects of your life can be influenced by your credit score. Did you know that a good credit score can even help you secure a good job? An example of how the score influences.

And, of course, it means obtaining lower interest rates on loans and credit cards. Better payment terms are always waiting for individuals with good credit scores.

Even when it comes to renting an apartment or buying a house, this score will make all the difference. Therefore, understanding how it works can alter every aspect of a functional adult life.

What factors influence your credit score?

As already mentioned in this article, your credit score is influenced by various factors. However, to simplify everything, let’s group them into five categories so that you truly understand and answer the question of how does credit score works.

We’ll assign a percentage of importance to each element. It’s important to note that this calculation may vary from one agency and financial institution to another, but it serves as an excellent foundation!

Payment history (35% weight)

This is the most crucial factor. Consistently making on-time payments for all your bills, loans, and credit cards significantly boosts your score. Conversely, late payments can severely damage it.

Amounts owed (30% weight)

This refers to your total debt compared to your available credit. Ideally, you should aim to keep your credit utilization ratio (the percentage of your credit limit you’re using) below 30%.

Lowering this ratio can significantly improve your score.

Length of credit history (15% weight)

Smiling caucasian man, using his credit card and laptop, at home.
Your credit, your life – 3 digits, endless consequences! Source: AdobeStock

The longer your credit history, the more data lenders have to assess your creditworthiness. Ideally, you want to maintain a mix of older and newer accounts.

New credit (10% weight)

Applying for too many new lines of credit in a short period can negatively impact your score. This is because it raises concerns about your ability to manage additional debt.

Credit mix (10% weight)

Having a diverse mix of credit accounts, such as mortgages, car loans, and credit cards, can demonstrate your ability to handle different types of credit, potentially boosting your score.

What are the different credit score ranges?

The FICO Credit Score Scale is the primary measure used by financial institutions. Therefore, there will be few changes in relation to other existing scales.

The score ranges from 300 to 850. Now, let’s analyze what it means for you to be in each of these score ranges. This way, you’ll know what to access and how to improve.

Poor (300-579)

This level indicates a high risk of default, making it challenging to obtain credit and usually resulting in higher interest rates and less favorable payment terms.

Check out this article to learn how to get out of this situation.

Fair (580-669)

With a moderate risk of default, you will have an easier time obtaining credit with lower interest rates and more favorable payment terms.

Good (670-739)

Considered a good level, this indicates a low risk of default. You will have easy access to credit with competitive interest rates and advantageous payment terms.

TransUnion vs. Equifax

TransUnion vs. Equifax

Learn the key differences between TransUnion and Equifax, two of the three major credit bureau! Keep reading and find out more!

Very good (740-799)

With a very low risk of default, you will have access to credit with the best conditions, including the lowest market interest rates and the possibility of obtaining exclusive offers.

Excellent (800-850)

This is the highest level on the FICO scale, indicating an exceptionally low risk of default. You will have access to all types of credit with the best interest rates and payment terms.

Financial institutions will consider you a high-value customer.

How often is your credit score updated?

There is no set rule; each profile will have its evaluation frequency, often based on its own financial activity. However, generally, your credit score is usually updated monthly.

Nevertheless, you can request a free credit report every 12 months and even gain a practical understanding of how the credit score works.

The three main credit agencies in the U.S. are Equifax, Experian, and TransUnion.

These agencies gather credit information from various sources, such as banks, financial institutions, retail stores, and utility companies.

Can you check your credit score for free?

As mentioned earlier, there is indeed a way. In fact, for free, you can check your credit score once every 12 months from each of the three major credit agencies.

How long does it take to build a good credit score?

Good construction takes time. The credit score works the same way. And it all depends on how we will start this project.

If you have a poor credit history, it may take a few years to improve your score. However, there are some things you can do to enhance your credit score more quickly. See below!

What steps can you take to improve your credit score?

cropped view of man holding pen near paper with credit report letters
Credit Score: How Does It Work and Why Is It Important? Source: AdobeStock

Understanding how credit score works is not a matter of magic. And to make your score increasingly “green,” there are basic steps. Apply consistently.

Pay your bills on time

This is the most important step you can take to improve your credit score. There’s no secret: Fulfill your responsibilities and be content with your score.

Reduce your debt

Try to pay off as much debt as possible, especially debts with high-interest rates. It’s even possible to contact the original institutions of your debts and inquire about payment conditions.

Do not open new credit applications

Be responsible with your credit applications. Engaging in requests “for the sake of it” will only harm you. Only apply for credit if you genuinely need it.

Check your credit report regularly

This is important to identify and challenge potential errors. Often, your score is lower than the actual level due to errors from financial institutions. Look for mistakes and dispute them if you find any.

An alternative to improving credit: Credit Strong

On this journey, there are some useful tools. Credit Strong is one amazing example of a credit repairing tool! Uncover every detail of this card in our comprehensive guide.

Credit Strong logo

Apply for Credit Strong

Read on and learn how to apply for Credit Strong. This platform will help you build credit and teach you how to save money!

About the author  /  Beatriz Vieira

Beatriz Vieira is a producer and copywriter who is part of the finance writer team in this portal. She has a degree in Journalism and aims to improve her bilingual writing skills. Her subjects of most significant interest are culture, finances, and self-development.

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