This post is part two in the “What’s my credit score?” blog series.
- Part 1: What's the difference between a credit score and credit report?
- Part 2: Why it's critical to know your credit score
- Part 3: Here’s how you can get your free credit score in one minute
- Part 4: Five easy ways to help raise your credit score
Let’s say that you want to buy something that you can’t afford today, but could if you borrowed some money. That’s totally normal – it’s how most of us make some of our biggest purchases when we don’t have the cash to pay for it upfront today, like a new house or car. Your next step would be to apply for a loan with a bank or other provider.
From the bank’s perspective, there’s one main question to answer before they give you the loan: “If we extend credit to this person, will we get paid back in full and on time?” At the end of the day banks make money by loaning you money, generating a profit from the interest on the loan that you pay, and you get money in your pocket. They get something, you get something.
So how do banks decide who is a risk worth loaning to?
Mostly, by looking at how dependable you’ve been in the past – have you paid off your loans in full? Have you paid on time?
Banks also want to know how much credit debt you have outstanding right now. All things being equal, a creditor is much more comfortable extending credit to someone who doesn’t have a big debt obligation.
Where do the banks get all of this information?
There are three competing credit-reporting agencies, TransUnion, Experian and EquiFax, all of which generate credit reports that provide lenders your entire financial history, including how you’ve paid off things like mortgages, credit cards and car and student loans.
These three agencies also use their own respective proprietary algorithms to generate your credit score – basically, a three-digit number that “grades” your credit report. This number signals to lenders what kind of a risk you are, when compared with the entire population of other consumers with a credit history.
The most commonly used credit scoring system is the one developed about 25 years ago by Fair Isaac Inc, called FICO. It’s used by all three credit-reporting agencies. FICO scores generally range from about 300 to 850, but some versions can have slightly different ranges depending on the type of loan or credit issued. In addition, some lenders can use a FICO score that they customize based on how they rank various credit-risk factors.
Like most scores, the higher the better. For the most part, anything above 720 is considered “excellent,” while anything above 690 is “good.” Bad credit is widely considered to be anything with a FICO score below 629. Late last year, FICO said the average US consumer FICO score was 695.
Why does my credit score matter?
Creditors are looking at your credit score to do two things:
- Decide whether to give you that new loan or credit, and
- Determine what terms to offer you
Here’s an example of why a good credit score matters:
Adam is paying a $500,000 mortgage off over 30 years at an annual percentage rate of 3.8 percent. He has a FICO score of 810.
Belinda across the street has the same mortgage but her APR is 5.4 percent because her FICO score is 625.
Over the course of 30 years, Adam will pay the bank $838,723 including interest. But Belinda will pay $1,010,755. That’s right – nearly $200,000 more over the course of the loan because of her lower credit score and an interest rate difference of 1.6%!
As you can see, your credit score matters a lot when it comes to getting a good loan terms.
MoneyLion’s free credit monitoring service lets you quickly learn your credit score from our credit bureau partner TransUnion after answering just a few brief questions. Once you sign up on your mobile device have your credit profile right at your fingertips along with our Credit Score Simulator tool that lets you see how different actions can impact your credit score (like getting a new credit card, missing a payment, etc.). We’ll also alert you of any changes in your credit report that may impact your score.