The Importance of Credit to Your Personal Finances

 

Your credit score is more than just a three-digit number to check every now and again. It is a crucial component of your financial life, as it quickly and easily allows new potential creditors and lenders to gauge your financial health. A credit score is a methodically calculated number that is derived from all the information found in your credit report – the good, the bad, and the ugly. When you have a strong track record of responsibility from a financial perspective, you’re likely to have a strong credit score. However, if you haven’t been a good steward of your money in the past, your credit score reflects this fact to new creditors.

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How is Your Credit Score Calculated?

A general credit score is calculated based on certain factors found in your credit reports, which are made available through three main credit reporting agencies: Equifax, Experian, and Transunion. Creditors provide detailed information about your “reportable” accounts, including credit cards, auto loans, personal loans, student loans, and mortgages, to the credit reporting agencies. Your score is calculated based on the specifics of each account, such as your payment timelines, your use of available credit lines, and the presence of negative marks like a bankruptcy or collections account. (Some lenders use credit scores that are more tailored. For example, auto lenders typically use a score that weighs your history with auto loans more heavily than other debts).

This three-digit number ranges from 300 to 850, and the higher it is, the better off you will be in terms of personal financial health. Credit scores ranging from 300 to 649 are considered poor; those from 650 to 699 fall into the fair category; 700 to 750 constitutes good credit, while anything above 750 is an excellent score. Your specific score fluctuates over time, based on the factors mentioned above, making it necessary to check in on where you stand periodically.

Why Does Your Credit Score Matter?

The reason credit has such a strong influence on your day-to-day financial life is because nearly all lenders and new creditors check credit scores before approving someone for a new account. Here are a few examples of how good and bad credit impact your ability to get the things you want in life.

A Good Credit Score Will Help You Get an Apartment or an Auto Loan

When you are in need of a new apartment or a new set of wheels, your credit score becomes incredibly important. On the apartment front, property owners check your credit report and score as part of the application process. They want to know that, in addition to steady income, you have a track record of on-time payments with other debts you owe. While rent payments are not typically included in your credit report, property owners and property managers lean heavily on credit checks to approve or deny a new tenant. If your credit isn’t in good shape, you may not be able to get the apartment you want or need.

The same holds true for auto loans used to pay for a new or used vehicle. Many dealerships offer auto loan financing, as do banks and credit unions. Each has its own set of guidelines to follow in order to approve an applicant for a new loan. A credit check is a vital part of the application process for an auto loan from any source. When credit has been an issue in the past, and that is reflected in a low credit score, you may not get approved for a new auto loan. (To see what auto loan rates you qualify for, you can apply on Outside Financial without affecting your credit).

In some cases, a finance company or bank may approve you even if you have bad credit, but it comes at a cost. The interest rate charged on an auto loan for someone with bad credit can reach the double digits, making the monthly payment hard to manage, in addition to a high total cost of borrowing. While there is no industry standard for minimum credit score requirements for purchasing a car, poor credit often means you pay more to get the financing you need.

Your Credit Will Also Impact Your Home-Buying Decisions

Many people dream of becoming homeowners, as property can represent a gateway to accumulating wealth over time. However, your credit has a significant impact on your ability to purchase a home in an affordable way. Mortgage lenders take a close look at your credit score and credit report to determine if you are a suitable risk for taking on what is often a large financial commitment. The majority of home loans extend repayment over 30 years, meaning lenders need to feel confident you can and will keep up with payments for the long haul.

If your credit does not fall between fair and excellent, you may find it difficult to get an affordable home loan. Some lenders have minimum credit score requirements to qualify for a mortgage, and being on the low end of that minimum may mean the interest rate you receive is higher than someone who has a stronger credit profile. An interest rate difference of a half a percent can have a significant impact on the total cost of your home loan. Similarly, homeowners who are considering home equity options, such as a home equity loan or a home equity line of credit, may not qualify if their credit score is low. These home-buying and home-financing credit requirements can impact your ability to get the financing you want or need when it comes to real estate.

Credit History Can Make the Difference When Applying for a Personal Loan

Credit has an impact on your ability to get a personal loan as well. Lenders offer personal loans in two forms: secured and unsecured. With a secured loan, you are required to provide some type of collateral, such as a savings or checking account balance, to back the loan. This lowers the risk to the lender as they can recoup any non-payment from this collateral if you don’t abide by the repayment agreement. In some cases, a credit check is required as part of the application process, but it may be evaluated less closely because collateral is pledged.

However, with an unsecured personal loan, which requires no collateral, lenders want to know that you can repay the loan as agreed without issue. This means that a thorough credit check is necessary. When credit is in the bad to fair range, you may not qualify for a personal loan at all. If you do, the interest rate could be incredibly high, making it costly to borrow in this manner. A low credit score may also mean the lender requires you to provide collateral to help offset the risk of the loan. Those who have strong credit may easily qualify for a personal loan without the need for collateral.

How Can You Improve or Maintain Your Credit Score?

While it is clear that your credit score plays a major role in your ability to get financing, whether for a new apartment, an auto loan, a mortgage for a home purchase, or a personal loan, the good news is that bad credit can be rectified over time. Credit score calculations put the most emphasis on payment history and credit utilization, so let’s take a closer look at how you can work on improving your score through these two methods.

Having a strong track record of on-time payments is crucial to your credit score. Missing payments or being late on payment due dates can be a serious detriment to your financial health. Not only do payment mishaps ding your credit score, but they may also increase your cost of using credit through penalty APRs or late payment fees. If you’ve struggled with keeping up on payments in the past, you can boost your credit score by creating a system of payment management. This may involve setting up automatic payments to your current outstanding debts, such as credit cards or student loans. Setting calendar reminders for due dates may also help if automatic payments don’t work for you. In either case, developing a history of on-time payments will help bring your credit score up over time.

In addition to payment history, your credit score is influenced heavily by your credit utilization. Take, for example, a credit card that has a $5,000 credit limit. If you are consistently carrying a balance that bumps up against that limit, your credit utilization ratio will be high. Most credit scoring calculations require you to have a credit utilization of 30% or below. So, for our example, you would want a balance of no more than $1,500 on a $5,000 limit card. Plan ahead for your purchases on credit to ensure you are keeping to the 30% utilization threshold, and have a strategy in place for paying off high-balance cards each month when possible.

Credit score calculations also take into account your credit history length, the type of credit accounts you have, and new credit inquiries reported to the credit bureaus. Of course it takes time to build up credit history, especially if you’re just starting out, but having a credit card or loan that you pay on-time each month helps. It is also important to maintain older credit accounts, even if they aren’t actively used, to sustain a lengthy credit history.

You may also want to consider your credit mix when trying to improve your credit score. Taking out a small loan when you do not have any loans on your credit report, or the same strategy for a credit card, can help boost your credit score. However, always have a plan for repaying these debts before committing to a new loan or card.

Finally, new credit inquiries play a small role in your credit score calculation. If you have multiple hits on your credit report from lenders checking your credit history, your credit score will be negatively impacted. Try to space out credit inquiries over time so you do not inadvertently lower your score.

Taking these steps will help boost your credit score, but they all take time. There is no quick fix for bringing a credit score up, so be sure you have plenty of patience on hand and an end-goal in mind. Working toward improving your credit means you will have access to the financing you need in the future, with the most affordable and manageable terms that meet your financial needs.

About the Author

Mike Brown is a writer for LendEDU. He uses data to identify emerging personal finance trends and help consumers make informed financial decisions. Mike’s work has been featured in major outlets like The Wall Street Journal and The Washington Post.


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