The concept of a credit score is one that seems to be laden with myths and misconceptions. In this article, we’re going to run through these myths and give you a thorough understanding as to what makes a good credit score, how to raise your credit score, and what to avoid when establishing a good credit rating. We will define what a good credit score actually is and how you can raise yours in the most direct manner possible.
Table of Contents
- What are Credit Scores Anyway?
- How Are Credit Scores Calculated?
- Factors Affecting Credit Score
- What Is a FICO Score?
- What Is a VantageScore?
- Major Differences Between Vantage Score and FICO
- Understanding Credit Reports
- Proven Techniques to Raise Your Credit Score
- Understanding Credit Utilization Ratio
- Debunking Myths About Credit Scores
- 6 Things That Lower Your Credit Score (Regardless of Scoring Methodology)
- FICO complexities
- What to Do Without a ‘Good’ Credit Score?
What are Credit Scores Anyway?
The credit scoring system underpins business and finance in the USA. It is an essential means of determining how reliable a person or business is. Without this system, it would be nearly impossible to determine who to lend capital to. Lenders need a way of rating applicants.
Credit scores are used to apply for loans of all kinds, as well as mortgages. Not only will the credit score determine whether or not you get a loan – it will determine the all-important rate of interest, and how much you pay for the loan in total. The better your credit rating, the lower the rates you will get. You may also benefit from an expedited loan process with a better credit score.
American citizens need to get loans for a variety of reasons – going to university, buying a car, starting a business, etc. And without a good credit score, they might not be able to access these fundamental functions. Some employers will even check your credit history to see if you are fit for the role, and insurance companies will nearly always check them when evaluating your application. The bottom line is that everybody needs a credit score, and it is better to have a good one.
How Are Credit Scores Calculated?
There are two major credit scoring systems in the USA – FICO and VantageScore. You only need to be familiar with these two in most instances. However, bear in mind that there are many subcategories of these scoring systems, and they are regularly updated.
Each of these major credit institutions has their own individual criteria for the purposes of evaluating a credit score. It can get a little complex, but once you understand the fundamentals you can raise your credit score, as long as you are patient and persistent.
There are also three credit reporting agencies, which are distinct from the credit scoring systems. The 3 major credit reporting agencies are:
- Experian – Check your credit score with Experian
More detail on these credit agencies is given below. But they have data on hundreds of millions of Americans and use this data to calculate credit scores. Each of these credit bureaus will have different information on each individual or business. Your credit score can change over time, depending on the data that the credit bureaus have on you, as reported by commercial and Federal entities.
Factors Affecting Credit Score
There are a number of factors affecting a given credit score. These include:
- Your payment history (missed v on-time payments)
- The total amount of outstanding debt
- Your credit utilization ratio
- The number of credit accounts you own
- The different types of credit you own
- The total age of your accounts
These are the basic and most important criteria. But what you need to remember is that payment history is the most important. Lenders want to know if you make all of your payments on time. This shows that even if you have a large number of accounts and huge outstanding debt, you still have the capability to make your payments. And this is what financial institutions love – you are in debt, but still, make payments. Both FICO and VantageScore have stated that payment history is the most important criterion for assigning a credit score.
Of course, the other factors are also taken into account. You might have a 100% payment history from a 12-month loan of $5,000. There is not enough data here and your payment score cannot be very high with such a short record. The credit utilization ratio is also quite important, accounting for over 30% of a rating. It is the sum of what you own on your total credit available. So if you have a credit limit of $1,000 and a debt of $500 on that line, then your credit utilization ratio is 50%. This is one reason why you may not wish to blindly close your credit cards.
Moreover, just because you have a history of making payments on time does not mean that you will remain solvent forever. Lending institutions are always looking to manage risk and avoid black swan events.
What Is a FICO Score?
FICO (“The Fair Isaac Corporation”) is the most widely used of all credit scoring systems, by a large margin. According to the FICO website, this scoring system is used in 90% of all lending decisions by the top lenders. It has been in operation since the 1950s and has something of a monopoly on the market.
FICO takes the data from the 3 credit bureaus and then assigns credit scores. It runs computations on past data to generate the appropriate levels of risk for each individual entity, and how likely each person is to repay a loan on time. Remember, lending institutions are looking for one thing only – to assess how likely you are to repay the loan. It is a game of statistics and probability. As per the FICO credit scoring system, a good credit score is 670 and above.
|FICO Score||Classification||% of People||Description|
|< 580||Poor||16%||Risky borrower. Well below average. Usually avoided by lenders unless there are significant safeguards in place.|
|580 – 669||Fair||17%||Below average defined as ‘subprime borrower’. Will often qualify for loans with high-interest rates, penalties, and collateral.|
|670 – 739||Good||21%||Average or slightly above average. Most lenders consider this a good score.|
|740 – 799||Very Good||25%||Very dependable and reliable borrower.|
|800 +||Exceptional||21%||An incredibly low risk borrow with a fantastic credit rating. Will get the lowest rates.|
Keep in mind that there are a large number of people with no credit score at all. So if the sum total of the US population was calculated, then the percentages above would all go down, and the ‘Very Good’ and ‘Exceptional’ categories would shrink substantially. 21% of US citizens certainly do not have an 800+ credit score. But 21% of those with a registered FICO credit score does.
What Is a VantageScore?
VantageScore was actually developed by the 3 major credit bureaus. The credit scoring system with VantageScore is a lot different than FICO, ranging from 300 – 850. However, there are still 5 major categories to assess an application – ‘Very Poor’, ‘Poor’, ‘Fair’, ‘Good’, ‘Excellent’. About 60% of US citizens with a credit score have a ‘Fair’ or better VantageScore rating.
Below is a table with the VantageScore credit rating system ranging from 300 – 850 (similar to FICO). This is distinct from older versions that ranged from 501 to 990. Like FICO, VantageScore is constantly updating its system.
|VantageScore||Classification||% of People||Description|
|300 – 499||Very Poor||5%||Risky applicants that are unlikely to be approved for credit|
|500 – 600||Poor||21%||Subprime borrowers that will get loans with steep terms and conditions|
|601 – 660||Fair||13%||Average or slightly above average applicants that will be approved for most loans with reasonable rates|
|661 – 780||Good||38%||Will qualify for practically all loans with very good rates|
|781 – 850||Excellent||23%||The most reliable applicants that are highly unlikely to miss a single payment or go into default.|
While FICO is definitely the most dominant scoring system, VantageScore is increasing in popularity. It was designed specifically to challenge FICO and its monopoly on the market. The factors determining the rating system for VantageScore 3.0 are outlined below.
Major Differences Between Vantage Score and FICO
There are too many differences between the VantageScore and FICO scoring methodologies to go into in great detail, but we will run over some of the major differences to see how each one individually calculates credit scores.
While FICO calculates on a total of 5 categories, VantageScore calculates 6. No longer are there differences in the total range model, with VantageScore migrating to FICOs’ model ranging from 300 – 850. Earlier versions of VantageScore used a 501 to 990 range. VantageScore also abandoned the letter grades with its third version.
VantageScore is now a lot different than FICO, due to its latest upgrade to VantageScore 4.0. It no longer gives percentages with regard to how heavily weighted each category is. The following are the breakdowns for the most popular (not the latest) credit versions:
FICO 8 Score
- Payment history (35%)
- Total Debt (30%)
- Credit History Length (15%)
- Type of Credit Allocation (10%)
- New Credit & inquiries (10%)
- Payment History (40%)
- Credit Age and Credit Type (21%)
- Credit Usage (20%)
- Total Credit Usage (11%)
- Recent Behavior and Inquiries (5%)
- Available Credit (3%)
However, bear in mind that VantageScore now has a fourth version (4.0). They have abandoned allocating percentages to each category and reduced the total categories to 5. The following are the weightings for VantageScore 4.0:
- Extremely Influential: Total Credit Usage, Balance, And Available Credit.
- Highly Influential: Credit Mix And Experience.
- Moderately Influential: Payment History.
- Less Influential: Age Of Credit History.
- Less Influential: New Accounts.
This makes it more complicated for people to understand what the VantageScore 4.0 ratings really are. It also mixes a lot of categories together. For example, ‘Available Credit’ (formerly weighted as 3%) is mixed with ‘Total Credit Usage’ (formerly weighted as 11%) and ‘Balance’ (no percentage is given). Like FICO 9, most lenders are not actually using VantageScore 4.0 yet.
Understanding Credit Reports
If you are looking to raise your credit score, then you will definitely want to request a credit report from each of the 3 credit reporting agencies. You can do this for free and without having an effect on your credit rating score. But you are only entitled to one free report every year.
This is known as a ‘soft’ inquiry. For information on how to get your free report. The credit bureau will list the 5 most obvious reasons that your credit report is not higher, which is very useful for those trying to understand their credit scores.
A ‘hard’ inquiry occurs when you request a credit report more frequently or when your lender pulls your credit report after you make an application for a loan. Unfortunately, you have to be careful here. It can have a negative impact on your credit score, though the effects are not huge. Employers and insurance companies may also pull hard inquiries.
If you apply for a mortgage loan or a credit card, the lender will check your credit score with a hard inquiry, though this can only be done with your permission. The reason a hard inquiry can affect your credit score is that they typically mean that you are looking at new kinds of credit. So if you have a lot of hard inquiries it means you are opening a lot of new accounts, which can impact your score.
Proven Techniques to Raise Your Credit Score
Raising your credit score is not rocket science. All you have to do, literally, is make payments on time and pay down your total outstanding debt. However, it does take time. A good strategy could be to take out a single loan and make payments on time each month.
After a year or so, your credit score should rise. But realistically, you will want to have at least 2 to 3 years of making every payment. This will look very, very good to the reporting agencies. There is not much more to it than this – for example, you must pay back your utility bills on time, as they can be factored in.
Remember, it is best to have one or two credit accounts at the most and to focus on paying these back. Having too many different types of credit does not look good from the lenders’ perspective. They are really looking for a focused person with one or two types of credit and a long history of making payments on time, every time.
You might also want to consider disputing your credit score, once you have you received them from the credit bureaus. According to a 2012 report by the Federal Trade Commission, over 25% of US citizens found errors in their reports, which could affect their scores. To dispute a credit error, you can contact the credit bureau by mail or online. It can take up to 45 days for a response. The bureau must furnish you with the results of their investigation along with a free copy of the updated credit report if it there was an error.
Understanding Credit Utilization Ratio
The credit utilization ratio is one of the least understood (but very relevant) factors in the credit ratings. It is how much of your total allowed credit that you happen to be using. For instance, let’s say that you have a total credit limit of $20,000 across various accounts. If you use none of it, then that is a bad sign.
If you use $20,000, that is an even worse sign. It shows that you are overly dependent on your card, which comes with high rates. The golden figure is often cited at 30%, so if you use around $6,000 and pay it back each month, your credit score will rise rapidly.
Each credit account you have will have its own unique credit utilization ratio. The credit utilization rate is based solely on your revolving credit. Revolving credit is simply credit cards and lines of credit. This is why car and mortgage lenders pay less attention to the credit utilization ratio. They take your debt to income ratio into account, which calculates how much of your income is taken up with outstanding debt.
Debunking Myths About Credit Scores
There are many myths surrounding credit scores. Here are just some of them:
- Not having a credit card will give you better credit – This is false. Effective use of credit cards will increase your credit score. It depends on whether you pay back the credit on time.
- Income is related to credit score – This is false. The credit bureaus do not actually have access to your annual income and total annual income has zero impact on your score.
- It’s ok to miss a payment here and there – This is false. Aim to never miss a single payment. It is the most important factor in terms of a credit score.
- It’s impossible to get a loan or credit card without credit – This is false. There are many providers for loans and credit cards for people without credit. You can also use a co-signer or a secured loan if you don’t have credit.
- It’s always good to close unused accounts – This is false. But it is also a little complicated. Closing credit accounts might help your credit score, but it also affects your credit utilization ratio, which could lower your score. Age is also a factor, so it might not be good to close an old account that increases the history of your credit.
6 Things That Lower Your Credit Score (Regardless of Scoring Methodology)
Getting a good credit score is actually a lot simpler than it sounds. Just take out one or two credit accounts. Use the accounts every month, but only to about 30% of maximum utilization. And make payments every time. After this, just download your credit report every year and keep an eye on errors. Your score will rise.
#1 – Paying Bills Late
Paying bills and total credit utilization make up 65% of the total credit score as per the FICO rankings. And with other rankings, the numbers are similar. Paying bills late is the cardinal sin in terms of getting a good credit rating. It tells lenders that you are unreliable. So the number one way to destroy a credit report is to fail to pay bills on time.
Set up a system whereby you pay off the total amount owed each month. Use an application to check how much you owe and set up an alert. This is an area where it really pays to get organized. A poor credit score will make all of your financial endeavors more difficult.
#2 – Applying For Too Much Credit At Once
Every time that you apply for new credit, the lender will most likely conduct a hard pull on your credit history. This hard pull can lower your credit score by 5 points. Needless to say, a lot of hard pulls can really lower your score. This hard pull will stay on your record for over 2 months and is a sign of uncertainty. Hard pulls can be conducted when you are consolidating debt, refinancing a loan, even when you are renting a car (in some instances).
Opening up too many credit accounts at the same time also comes with other disadvantages. It will decrease the average length of your credit history, which may have an adverse effect. You will also be unable to use all of the credit accounts. This means that there will be a question mark over your spending history and financial institutions will be unable to assess your true creditworthiness.
#3 – Using Your Credit Card Too Much
There are different opinions on credit utilization. However, as a general rule of thumb, you don’t want to use more than 30% of your max credit limit. Otherwise, it will seem that you are overly dependent on credit. A person who constantly maxes out their credit limit is a red flag, even if they do pay on time regularly. So you will need to strike a balance between using the card but not overusing it. Anywhere between 5% – 30% of the max credit limit could be an advantage.
#4 – Cancelling Your Credit Cards
Canceling a credit card is not the end of the world, but it can affect your credit score over time. It decreases your overall credit utilization. It might also mean that your credit utilization on remaining cards is higher, which sends an adverse signal to the agencies. On the other hand, there are certain instances when you most definitely should cancel your credit card, if you are constantly overspending or if the fees are too high.
#5 – Making Large Credit Card Purchases
This is related to the point surrounding using your credit card too much. If you make a very large purchase, it will extend your credit utilization ratio and mean that you have to make a large payment. Payments on purchases can accrue month on month, so make sure that you will have the funds to pay it off. In general, there are better financing options for large purchases with lower rates.
#6 – Not Checking Your Credit Report
Credit reporting agencies are actually notorious for making reporting errors. It’s always good to file a dispute if you notice anything out of the ordinary. Remember that all agencies give you one free credit report per year.
It’s best to check one report from each of the three bureaus every three months. You can check more than that if you want, but it will incur a fee. This will not affect your credit score, as it will only be a soft pull. In addition, multiple FICO 9 scores checked within a 45 day period only count as one inquiry.
FICO is by far the most relevant credit scoring system used by many lenders. But that certainly does not make things any easier to manage. Consider that:
- FICO updates its methodology, currently on version 9. Many institutions still rely on version 8.
- The information is constantly shifting and changing as the credit bureaus get updated information which is then scraped by FICO. This is partially why it takes such a long time to raise a credit rating.
- There are industry-specific and FICO credit scores relating, such as auto-related FICO scores and credit card FICO scores.
There are actually a total of 28 different FICO scores that a lender can use to evaluate your loan application. You cannot keep track of all of them – your best bet is to simply focus on meeting your existing payments on time. You have no way of knowing what your specific FICO scores are unless you pay a fee to FICO, and you cannot know which ones your lenders are going to look at.
The three credit reporting agencies (Experian, Equifax, TransUnion) will also have their own credit score. These credit scores are aggregated by FICO for an overall (and more highly regarded) score.
FICO 8 vs. 9 Explained
FICO periodically releases different versions of its scoring model. Right now, we are on FICO version 9. However, this does not mean that all lenders are using the latest model. In fact, most are still working off FICO 8 and will be for some time. Many still use older FICO scores or custom scores depending on the industry. This is because, in some industries, certain credit criteria might be more relevant.
The most common FICO models can vary greatly by industry. Mortgage lenders are still using FICO versions 2, 5, and 4 according to the official MyFICO page. Car lenders often use these FICO versions too. However, the most common version is still FICO 8. The main differences between FICO 8 and FICO 9 are that:
- Third-party collections that have been paid off no longer have a negative impact.
- Medical collections are treated differently than other types of debt. Unpaid medical collections will have less of a negative impact on FICO 9.
- Rental history, when it’s reported, factors into the score. This may be especially beneficial for people with a limited credit history.
What to Do Without a ‘Good’ Credit Score?
For the majority of lenders, you really only need a ‘Fair’ credit score. For example, to get a loan with OnDeck, the credit requirement is 600 and is only 580 with LendingClub. These are two of the biggest online lenders. Loanbuilder only requires 550, while Kabbage and Fundbox have zero minimum credit requirements. The point being, while it is always good to get your credit scores are high as possible, options are available. These lenders use the FICO lending system primarily.
Remember, the aim is not to simply get a loan. Even if you can get a loan with a very poor credit score, the rates are going to be pretty steep. This is how the lending platform offsets the increased risk of a poor credit rating.
It is best to stick with the lenders above if you have poor or no credit history. There are a large number of loan sharks in operation that promise a good deal. But they can come with insane rates and penalties for missed payments. These platforms are designed to prey on vulnerable or unreliable applicants. In some instances, it might be best to wait it out until you are in a better position.
A good credit score as per the FICO system is 670 and above. This is the minimum score you will need to get the top loan, such as the SBA(7)(a). But you can get excellent online loans with poor credit – 550 with Loan Builder and 580 with Lending Club. And no credit is required with Fundbox or Kabbage. With VantageScore, a ‘Good’ rating is 660 and above. The scores are different, but the 5 categories are almost identical between the two credit rating systems.
Those with poor credit should not wander too far from reputable lenders, or they could find themselves in a difficult situation with an aggressive loan shark. Stick to the platforms mentioned above (Ondeck, Kabbage, Loan Builder, Kabbage, Fundbox) if you have a poor credit score, as you are entering dangerous waters. For more information on getting a loan with poor credit, check out our page; Best Small Business Loans for Bad Credit. Or, check our loan finder.