Credit scores are a single number (the higher the better) that attempts to represent how responsible you are as a borrower.

Think of it the same way we use Amazon ratings to determine what product to buy or how we use Google ratings to determine if we should eat at a restaurant.

They strongly influence our financial options to build wealth through credit and loan approvals. They can even be used by landlords when looking to rent and by managers when hiring for jobs.

Putting aside whether credit scores are actually good at determining your trustworthiness with money, they are used to show whether you meet all the surface-level boxes lenders are looking for.

Despite its potential near-term impact on unlocking additional financial options and long-term impact at being able to unlock enormous wealth building through more affordable rates, it is often poorly understood.

Overview

One of the most common credit-scoring systems is the FICO score, which is used by major credit agencies to determine creditworthiness and ranges between 300 and 850.

Within this range, there are certain subranges that are used to generalize borrowers as Very Poor, Fair, Good, Very Good, and Exceptional.

67% of Americans have a Good or better FICO score, which means that they have at least a score of 670.

Speaking from personal experience, I started out around 670 with no history and steadily built my credit through steadily opening many lucrative rewards credit cards. For anyone just starting out and worried about building credit, during this period I was able to build my credit into the upper 700s while carrying student loans!

Every lender potentially has their own system they use to calculate a credit score for us, so don't be surprised if their credit score ends up being different from what we see.

The same way Google ratings, Rotten Tomatoes, and IMDB are all just different "scores" to judge a movie, lenders have different scores for our credit profiles!

When trying to get a read on our credit scores, my recommendation is to collect our estimated credit scores from a variety of sources. For example, Credit Karma and Mint provide estimated scores, issuers of credit cards often offer free services to check credit scores, or even request the major credit scoring companies to send you your info!

Never pay money to check your credit score as there are many free reliable sources. You are also entitled to a free copy of your report every 12 months from each of the nationwide credit reporting companies per the FTC.

Why Should I Care?

Leveraging the ability to use credit responsibly is an incredibly effective way to build wealth. The topic is too broad to cover effectively here, but I'll provide a few examples.

Credit Cards

Many credit cards offer very generous signup bonuses which in my experience can net you thousands a year. Even if we disregard the signup bonuses, they are still incredibly lucrative as they offer rewards of 1% - 6% on various categories (many with no annual fee).

Let's take an average cashback rate of 2% and say that we spend $40,000 every year on credit cards, that's still an extra $800 every year. The key here is to make sure that absolutely no interest is paid, payments are made on time and all fees are either minimized or non-existent.

Mortgages

Nerdwallet laid out a solid example demonstrating the difference 100 points could make buying a home worth $300,000 with a 20% downpayment on a 30-year fixed-rate loan. The difference in rates could be 0.5% between a score of 780 (4.0%) and a lower score of 680 (4.5%).

While that half a percent doesn't seem like much, this is an extra $62 a month, $744 a year, or $25,300 over the 30-years.

If you want to check yourself, feel free to check out the many mortgage calculators at sites like myfico.

Landlords and Employers

For the majority of the states in the US, employers are allowed to check a modified version of your credit and can use that deny you employment.

Landlords will often ask to check your credit before approving an application as a proxy to determine how likely you are to pay your rent consistently.

Regardless...

Even if you have no desire to move, open a credit card, or buy a home, plans change and life throws curveballs. One day you might want to and when the time comes, being able to take advantage of all the financial options available without being gated away from the best rates and options is incredibly empowering.

And while we always hope nothing bad happens, emergencies are inevitable and it's always a great stress reliever to know that if funds are needed we have credit options available to draw on to pay for any large expenses.

Components

In general, credit scores are generally calculated using the following 5 factors:

• Payment history (or on-time payments)
• Amounts owed (or credit utilization)
• Length of credit history (sometimes average age of credit accounts)
• Types of credit in use (or credit mix or total accounts)
• New credit (or recent inquiries)

Here's a dashboard from CreditKarma (a credit-checking site). Some of the terms may sound different, but it's effectively the same.

In order of what's generally viewed to be the most important to the least:

1. Payment history is how long you've been making on-time payments.

The longer you're able to do this, the more likely lenders will trust you to pay them back. It also makes logical sense. If you've been able to make steady, consistent payments over an extended period of time, then it stands to reason you will continue to do so in the future.

Not much to do here except to give it time. The longer the "streak", the more lenders will trust you!

2. Credit utilization is how much of your available credit you're using.

Lenders treat this as a signal of the ability to control spending and so the lower the credit utilization ratio, the better.

We can break this into two parts: how much credit you're using on a single card and how much credit you're using across all your cards.

Say you have a card with a credit limit of $1,000 and a $500 balance, that's a 50% ($500/$1000) credit utilization. In general, prevailing knowledge recommends that you don't exceed 30% utilization, and keeping utilization low will boost your score.

This 30% guideline also applies across all your credit lines. Say you have two cards with $1,000 credit limits for a total of $2,000 credit limit and have used $800. That's a 40% ($800/$2000) total credit utilization.

From personal experience and other sources, impacts to your credit score due to high credit utilization tend to be fairly temporary (as long as utilization eventually comes down).

I know especially when starting out with low credit lines it can be hard to stay below the 30% recommendation, so I wouldn't sweat it if it's not practical.

3. Derogatory marks occur when loans aren't paid back properly on any form of credit like student loans, credit card debt, or mortgages (among others).

These events include late payments, collections, bankruptcy, foreclosure, and liens.

Unfortunately, these have long-lasting negative impacts and there isn't much you can do about them except for preventing them from occurring in the first place.

Not very helpful to those who have these, but giving it time and continuing to responsibly use credit will build trust with lenders back up and rebuild credit scores.

4. Credit age often takes into account both the age of your oldest account and the average age of all your current accounts.

The longer the credit age, the longer the credit history, which is a signal to lenders whether or not you're experienced with credit and haven't opened too many accounts in recent years.

This is why it can actually hurt your credit score to close a credit card. If it's your oldest or one of your older cards, it can decrease both your oldest account on record and your average age. In general, I'd recommend leaving an old credit card alone and maybe using it once or twice a year to ensure that the lender doesn't close the account.

Protip: For those without much credit history and are just starting out, one incredibly effective method to boost your credit score if your parents have good credit is to ask them to add you to their cards! This will immediately add the full length of time they've had the card to your credit history and improve both your oldest card and average age.

Like payment history, there usually isn't much to do here but giving it time.

5. Total accounts or credit mix factors in both how many accounts you have open and what types of credit you have.

This can include regular credit card accounts, installment debt like student loans, auto loans, and mortgage loans. As long as all accounts are paid responsibly, then lenders tend to view this positively as it shows you can handle multiple forms of credit.

This is why for those with newer credit history, student loans when paid back responsibly can actually boost credit scores as they tend to add both total accounts, add in a new type of credit, and as per the above, increase your credit age over time.

Rather than the more the better, the focus should be on responsible use of credit.

6. Hard inquiries occur when lenders check credit and tend to stay on your credit report for up to two years.

Accumulating too many hard inquiries in a short period of time tends to hurt credit scores, as it's signaling to lenders that you may be taking on too much debt and be financially unstable.

However, though these can stay for up to two years, credit scores tend to rebound to pre-inquiry levels within a few months (~3 months) and if the account is used responsibly (low utilization and consistent repayment), credit scores can often recover above and beyond what they were at.

It's important to know that soft inquiries are not hard inquiries and do not show up on your credit report.

When applying for a big loan like a mortgage, try to limit any hard inquiries to at least for a year before applying.

In Practice

Credit scores are a single number that lenders use to determine whether to loan us money. While it may seem daunting, here are some general rules to follow to maintain a healthy credit score:

• Know your credit score. You can't improve what you don't know!
• Pay on time. If possible, set up autopay.
• Don't close credit cards!
• Plan ahead. If you're looking for a big loan, try not to apply for credit at least a year in advance.

The most important thing you can do is to show consistency. Repeated, steady payments increase both your payment history and credit age, which play a huge role in your credit score.

By no means are credit scores a perfect system, but in the absence of other information, it's how our system judges how trustworthy we are with money, which is why it's so important we understand the rules of the game.

Hopefully, this has better positioned you to make your money work for you rather than the other way around!