A Credit Score is a measure of… Trustworthiness
So what is a credit score anyways? Well remember when I talked about trustworthiness in part 1? A credit score is essentially a measure of your financial trustworthiness.
You see using credit gives you a rating that is all important in our western modern society. This rating is called a credit score and it is not just used for bankers to determine whether you can make them rich.
This credit score has evolved to basically reflect your character as a responsible citizen. Some employers even pull your credit score to determine whether or not you’d make a good candidate for the job. They want to know if they can trust you.
However, by far the most important function of a credit score is to determine how much someone should charge you in interest when you take a loan.
Initially your score will be low because they wont have much data to go off of, but as you use your credit and build credit history, your score will change to reflect your financially responsible — or irresponsible behavior.
But why would I need a Loan?
Sure you could probably do without ever having to get a credit card… but unless you plan on being a multimillionaire pretty soon. There is probably going to be a point where you might need to make a large purchase for something important.
- Start a business
Now most of the time you don’t have the thousands of dollars on hand to make such a purchase. This is where a loan will come in. You borrow the thousands of dollars and agree to pay it back a little at a time over several years… with of course — interest.
How much interest they will charge you for this loan is going to depend on your credit score…
And you can’t have a credit score unless you have a credit card! (Or a different form of credit)
Someone one with an excellent credit rating is going to get “cheaper” loans than someone a bad credit rating.
Even if you feel like any of the above reasons is not any immediate concern of yours now. If you want to get a grown-up job, an apartment, your own cellphone plan, all of these things may check your credit score to determine if they can trust you!
Okay whats the the Credit Score scale?
Everyone starts at the same credit score, and that is… no credit score. No credit score is essentially the same as a poor credit score. Credit Report Bureaus, organizations that track your credit history and provide lenders with a score, do not yet have enough information on you to know how trustworthy you are.
If you apply for a loan or credit at this stage, the lender pulling your credit score will see a “too new to rate” message instead of an actual score.
At this early stage your credit/loan options will be really limited (I’ll explain this further) but after you hold a credit account for at least 6 months you will finally get your first score.
The average credit score in the United States is about 695. If you display good credit management during those first six months you will start somewhere close to the middle of 300 (the lowest score) and 850 (the highest score). Since you still have limited credit history, the credit algorithm is likely to output a lower confidence number around 500 to 600.
Whats a “good” score anyways?
If you are like me you are probably wondering what you can really get with any given credit score. The graphic above shows your chances of getting approved for different quality credit cards at different scores.
You see not all credit cards are created equal. There are special rewards credit cards reserved for more proven trustworthy that have additional perks such as cash back, travel benefits, hotel discounts, and even road side assistance. For those with bad credit records or no credit history, the only choice is often a secured card — a card that will require you to deposit the cash value of the credit account. For example if you deposit $300 you will receive a secured card with a limit of $300. The $300 you deposit still belongs to you, but if you prove to be untrustworthy, the credit company can use that money to cover your debt.
This graphic shows the rates you can get an car for a certain credit score. The higher your credit score, the more you can borrow and the lower interest you will have to pay on it.
So now we understand a bit about how a credit score works, the next essential thing is understanding how to manage it, get it high, and keep it high.
In the Next Episode we will talk about Managing Credit.
The TL;DR (Too Long; Didn’t Read)
- A credit score shows how financially responsible you are
- A credit score is used for many things but most importantly, determining how much interest you will pay on a loan
- You may need a loan in the future to; buy a house, buy a car, pay for school, etc so it pays…or rather saves to have a good credit score
- Everyone starts with NO CREDIT
- Credit scores range from 300 (the lowest) to 850 (the highest). Above 700 is good, between 700–620 is average, below 620 is BAD
- Good credit scores get you approved for special credit cards, and lower interest rates.
- In the next episode I’ll cover how good credit scores are created and maintained