What Is a Credit Score

July 28th, 2020
July 28, 2020
Joseph Vecchio

Having a good credit score is imperative for your financial health. It allows you access to many savings and benefits along with loans and credit cards that can come with valuable perks.

We’ll cover the three fundamentals of credit scores:

  1. What a credit score is and how is it calculated
  2. How to improve and maintain your credit score
  3. What to avoid when managing your credit

What is a credit score and how is it calculated?

Your credit score is simply the measure of how good you are at paying back the money you owe. The better you get at paying back loans, the more banks and other entities are willing to loan you.

The first thing you need to understand is the difference between your credit score and your credit report. While your credit score is an overall measure of your ability to pay back loans, your credit report is a detailed list of payments you either made or failed to make to your lenders.

Chart comparing credit scores

From there, the next thing you need to understand is the danger of credit. According to the National Foundation for Credit Counseling, about 37% of all Americans are stuck dealing with credit card dept.

To avoid this pitfall, you must take preemptive action to avoid credit card debt before it strikes. If you fail to do this, growing interest and a damaged financial reputation can make things significantly harder. The good news? That same preemptive action to avoid debt is also the best way to boost your credit score.

How to improve and maintain your credit score

In order to secure good credit scores and high financial standings you need to do two things:

  1. Consistently check your credit score and credit report (for free)
  2. Maintain a beneficial credit utilization ratio

How to check your credit score and credit report:

Credit score is derived from three credit reporting agencies:

  • Equifax
  • Experian
  • TransUnion

These agencies track factors relating to your current bills and loans, prior bills and loans, and credit history.

Every year, you are entitled to three FREE credit reports, one from each reporting agency.

Two helpful resources for getting these free credit reports are:

You can use either of these to check your credit scores for free, so forget about paying a third party to keep track of your credit history.

How To Calculate Your Credit Utilization Ratio

Let’s say you have a credit card that grands you a maximum spending limit of $10,000 per month. This month you go and spend $8,000 of that money on anything from food to vacations. Your credit utilization ratio for this month would be 80% because you spent 80% (8,000 / 10,000) of the total amount that you could have.

Credit utilization ratio calculation with words and numbers
The Credit Utilization Ratio

 

Here’s the trick: according to Shore Financial Planning, you want to try to keep your credit utilization ratio below 30%.

Credit utilization ratio calculation with words and numbers
The Credit Utilization Ratio

Having a high credit utilization ratio brings concern to lender when you are in large amounts of debt. Keeping your credit utilization ratio below 30% is a safety net for your reputation when debt occurs.

What to avoid when managing your credit

Lastly, there are three things to avoid when raising and maintaining your credit score:

  • Closing accounts you no longer use
  • Annual fees
  • Credit repair services

Your credit utilization ratio is calculated as a net product from all of your credit accounts.

Let’s say you have two credit accounts open, named account A and account B, which both have a $10,000 limit. Your total spending limit would be $20,000. You spend $4,000 per month on account A and $0 per month on account B. In total, you would be spending $4,000 out of $20,000. Your credit utilization ratio would be 4,000 / 20,000 = .2 or 20%, keeping you under that 30% benchmark. Now let’s say you go and close account B because you never use the card. Your total spending limit is now $10,000 instead of $20,000 and your credit utilization ratio goes from 20% to 4,000 / 10,000 = 40%, which is above that 30% line.

Accounts A and B are both open:

Credit utilization ratio calculation with words and numbers

Total Credit Utilization Ratio Calculation With Multiple AccountsAccount A is open, account B is closed:

Credit utilization ratio calculation with words and numbers

There is one issue that can arise through this. Some credit card companies charge annual fees, so don’t pay to keep a card open just for your credit score. Either call your bank and downgrade to a fee-free version of your card or replace that card with one of the countless fee-free cards available out there.

Lastly, the only thing you need to repair your credit score is discipline. Do not waste money on credit card repair companies which commonly use tricks to temporarily boost your credit score without putting you in better financial standing.

Follow these tips and tricks to improve your credit score, clamp down on your credit and reap loans and other benefits.

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