Are you looking to make a major purchase this year? Did you know your credit score plays a huge factor in the interest rate on your loan? The better your score, the better the terms of your loan. If you've taken a look at your credit score lately and have no idea what it means, keep reading.
Understanding how credit scores are calculated and how debt affects credit scores is crucial for managing personal finances effectively. Here is everything to know about credit scores, how they are calculated, how debt affects credit scores and strategies for managing debt and improving credit scores. To get started, first, check out your credit score for free.
What is a credit score?
A credit score is a three-digit number representing an individual's creditworthiness or the likelihood that they will repay a loan or credit card balance on time. Credit scores range from 300 to 850, with higher scores indicating a better credit history and a lower risk of default.
Credit scores are calculated based on several factors, including:
- Payment history: This refers to whether an individual has made payments on time or missed payments in the past. Payment history is the most critical factor in determining credit scores, accounting for 35% of the score.
- Credit utilization: This is the amount of credit an individual is using compared to their total available credit. High credit utilization can undermine credit scores, indicating a higher risk of default. Credit utilization accounts for 30% of the credit score.
- Length of credit history: This refers to how long an individual has had credit accounts open. A longer credit history is generally seen as a positive factor and can improve credit scores.
- Types of credit: This refers to the different types of credit an individual has, such as credit cards, loans, and mortgages. A diverse mix of credit types can improve credit scores.
New credit: This refers to how many new credit accounts an individual has opened recently. Opening too many new credit accounts can undermine credit scores.
How debt affects credit scores
Debt can have a significant impact on credit scores, as it affects several of the factors used to calculate credit scores. High levels of debt can lead to a lower credit score while managing debt responsibly can improve credit scores.
Credit utilization is one of the most significant factors affected by debt. It is calculated by dividing the amount of credit an individual is using by their total available credit. For example, if an individual has a credit card with a $5,000 limit and a balance of $2,500, their credit utilization is 50%.
Credit experts recommend keeping credit utilization below 30% to maintain a good credit score. High credit utilization can indicate a higher risk of default, which can reduce credit scores.
In addition to credit utilization, debt can also affect credit scores through payment history. Late or missed payments can lead to a lower credit score, as payment history accounts for 35% of the credit score. It is essential to make payments on time to avoid damaging credit scores.
What does your credit score mean?
There are several different scoring models, including the FICO Score and VantageScore, which use different algorithms to calculate credit scores. However, the following ranges are the ones used most commonly:
- Poor: A credit score below 580 is considered poor. Individuals with poor credit scores may have difficulty obtaining credit or loans and may be subject to higher interest rates and fees.
- Fair: A credit score between 580 and 669 is considered fair. Individuals with fair credit scores may be able to obtain credit or loans, but they may face higher interest rates and fees than those with higher scores.
- Good: A credit score between 670 and 739 is considered good. Individuals with good scores are generally considered to be creditworthy and may be able to obtain credit or loans with favorable terms and conditions.
- Very good: A credit score between 740 and 799 is considered very good. Individuals with very good credit scores can obtain credit or loans with the most favorable terms and conditions, including lower interest rates and fees.
- Excellent: A credit score above 800 is considered excellent and is very hard to achieve. Individuals with excellent credit scores are generally considered to be highly creditworthy and may be able to obtain credit or loans with the most favorable terms and conditions.
Strategies for managing debt and improving credit scores
If your credit score is less than ideal, don't worry. There are some easy ways that you can start improving it. It will take some time, but being diligent about your financial habits will have a big payoff. Managing debt responsibly is crucial for maintaining a good score and overall financial health. Here are some strategies for managing debt and improving credit scores.
Creating a budget is the first step in managing debt effectively. A budget can help individuals track their income and expenses and identify areas where they can cut back on spending to reduce debt.
Prioritizing high-interest debt is the best idea to dig out of high debt. If an individual has multiple debts, it is essential to prioritize paying off high-interest debt first. High-interest debt, such as credit card debt, can quickly accumulate and become difficult to pay off.
Making payments on time is key. Payment history is the most critical factor in determining credit scores, so it is essential to make payments on time. Setting up automatic payments can help ensure payments are made on time.
By implementing these strategies, individuals can take control of their debt and improve their credit scores, leading to better financial outcomes in the long term. Discover Card offers a free credit score check at any time, and will even alert you for any inquiries on your credit. It's a great way to be on top of your score and see any fraudulent activity as soon as it happens.
