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As you may be aware, your credit score is kind of a big deal.
A good score makes life easier, while a poor score can make it pretty difficult.
Trouble is, a lot of people don't realize what their credit score really is.
Or how having a bad credit score can hurt them and even cost them thousands of dollars if not improved.
Here's what you'll face if your score falls in the credit score range of very poor, poor, or even fair:
- Trouble obtaining new credit
- Higher interest rates and fees, if approved
- Higher insurance rates
- Trouble obtaining an apartment lease
- Inability to purchase a home
- Difficulty buying a new car or other big ticket items
- Difficulty getting a mobile phone or other contracts
- Requirements for deposits or full payment upfront for services
- Potential issues getting hired for certain jobs
What is a Credit Score and How is it Calculated?
Your credit score is a three-digit number between 300 and 850. Lenders use it as a tool to help them assess how risky it would be to extend credit to you.
Higher scores are better, meaning people with higher scores look less risky. The better your credit score, the more likely it seems you'll make payments as agreed.
Your credit score is calculated based on a number of factors obtained from your credit report.
These factors include:
- The number of credit accounts you have and the mix of credit types (revolving credit and installment loans) – approximately 10% of your credit score
- The length of your credit history and amount of new credit obtained – makes up 15% and 10% of your score, respectively
- Your payment history, so every late loan or credit card payment is known – your history can account for 35-40% of your score
- The amount you owe and your credit utilization ratio – the proportion of available credit (credit limit) you're using – can make up 30% of your score
Payment and non-payment activity on any loans or credit extended to you is reported to credit agencies and will affect your credit score.
There are three major credit bureaus, and your credit history may vary a little between them. This is because you might have an account with a creditor that's not reporting to all three.
A credit reporting agency can only calculate scores based on the information available to them, so missing information might cause some discrepancies.
What Doesn't Affect Your Score?
While your credit history is tied to you, some personal information and financial transactions are not included in your credit profile, and won't affect your score.
Your credit file contains your name, Social Security number, date of birth, address (current and previous), plus a bankruptcy, and any recorded liens or judgments against you.
But personal information including your age, sex, marital status, race, national origin, religion, or receipt of public assistance cannot be used when determining creditworthiness.
In some situations you may be asked for this information, however, it can not be used to discriminate against you in credit decisions
Activities that will not directly affect your credit score include:
- Checking your own credit report (known as a soft inquiry)
- Bank transactions such as using a debit card, or incurring an overdraft fee (unless your account goes into collections due to significant unpaid overdraft fees)
- Changing jobs or fluctuations in income
- Shopping for the best interest rate on a mortgage or car loan for example, when done in a short period of time
- Denial of credit – while potential lenders will perform a hard inquiry that is shown on your report, their decision to not lend you money is not recorded
- Payment of insurance premiums or tuition expenses
- Payment activity to utility and mobile phone companies, and other small businesses or individuals such as a hair salon, massage therapist, or landscaping company, unless your account is turned over to collections.
- Child support or alimony payments unless there's a failure to pay and a judgment is brought against you
- Rent payments, in many cases, are not reported to credit agencies, but failing to pay rent can lead to eviction and debt collection. While the eviction itself may not affect your credit score the collection record can.
Additionally, your spouse's credit score will not affect yours. But, joint credit accounts you hold together will affect you both.
What is a Bad Credit Score?
FICO® scoring models, developed by the Fair Isaac Corporation are the most common models used to determine scores today, with most lenders currently using the FICO Score 8 version.
It relies on data only available in your credit report and does not factor in things like income, length of employment, or type of credit you're applying for.
FICO scores range from 300 to 850, with scores of 669 to 580 considered fair and those under 580 considered very low or poor.
Another credit scoring model you may hear of is the VantageScore®, developed by VantageScore Solutions, LLC. This is a joint venture between the three major credit bureaus, Equifax, Experian, and Transunion.
The VantageScore ranges from 300 to 850 and breaks down as follows:
- Excellent: 750 to 850
- Good: 700 to 749
- Fair: 650 to 699
- Poor: 550 to 649
- Very Poor: 300 to 549
VantageScore 4.0 also relies on information from your credit report but incorporates a trend data concept to acknowledge specific positive behaviors of creditors such as actively paying down debt.
As you can see, with this model a score below 650 is a poor credit score and anything below 550 is considered a very bad credit score. A fair credit score can also present some problems.
Greater benefits are seen when scores are 720 and higher.
Side Effects of Poor Credit
A credit score in the poor range can have a significant effect on your personal finances and may affect your ability to build wealth, at least in the short term.
If your credit profile and score are on the lower end of the scale, here's what you can expect:
Bad Credit Score = Trouble Obtaining Credit
When you have a less than positive credit history, it's challenging to get new credit on a favorable term.
If you have a history of not paying your bills on time, you likely have a lower credit score. That low score is a signal to lenders. It tells them they can't rely on you to make on time payments.
That makes you a risk. What if you don't pay at all?
When late payments on outstanding debt are not resolved, your lender may start a debt collection process, further negatively impacting your score.
When you think about it that way, it makes perfect sense lenders don't want to loan money to people with bad credit scores.
With a Bad Credit Score, You May Face These Challenges
While some types of loans and credit products are harder to get approved for than others, a credit score in the poor range will make it difficult to qualify for anything. And even if you are granted credit it may come at a high cost.
Inability to become a homeowner
If a mortgage lender won't approve you for credit, you can't get a home loan without a strong co-signer on your mortgage loan application.
While homeownership is not right for everyone, some people who plan to stay in one place for a long time would prefer to build equity in their own homes rather than pay rent.
If you have a bad credit score, renting might be your only option.
Difficulty buying a car or other big ticket item
When buying a car, your best financial bet is usually to pay cash. However, if you don't have the cash, you need to look at financing options.
Unfortunately, if you have a poor credit score, it will be difficult to get approval for an auto loan.
If you can't buy a car, your transportation options will be limited to public transit, paying for a taxi or rideshare, relying on others for rides, or walking to your destination.
Without a vehicle, your job opportunities may also be limited which can affect your ability to pay off debt and boost your credit score.
High-interest rates and fees
If your credit score falls in the fair range (and sometimes even if it's poor), you may still qualify for some types of credit.
Unfortunately, the catch is you'll face higher interest rates than people with healthier scores.
You may see a credit card company or used car lot advertising they approve customers with bad credit. What they don't boast about is the unfavorable loan terms and hefty price tag attached.
If you need a car and this is the only type of loan you qualify for, you'll end up paying much more than the car is worth over the length of your loan. Not a situation you want to be in!
Higher insurance rates
In some states, poor credit can have a big impact on insurance rates.
One report showed a homeowner's insurance premiums could double for someone with poor credit compared to those with excellent credit.
It's important to find out if the quotes you're receiving from insurance companies are based on your credit score.
Shopping around for insurance can always save you money but when your credit isn't great, it's the only way to get the best rate possible.
Trouble obtaining contracts
Did you know that mobile phone companies do a credit check before issuing a contract?
This is because they want some indication you're not going to take the discounted phone and skip out on your bill.
Unfortunately, your bad credit score will not inspire confidence. They may refuse to give you a contract, or ask for a security deposit.
If you can't get a contract, you'll have to buy a phone outright and go prepaid. Depending on your needs, this could end up being pretty costly.
Difficulty securing a lease
Same as cell phone providers, landlords may run a credit check before leasing you an apartment. If it turns out you have a poor credit score, they may not want to rent to you.
This reduces your options and means you might end up paying more or living in an area you don't want to be in.
Deposit or payment upfront requirements
Similar to mobile phone companies and property owners, utility companies may also check your credit score before taking you on as a customer.
When your credit profile is on the negative side they'll likely require a deposit from you before turning on service.
Other service providers may require payment upfront if their application process determines you're a credit risk.
Possible issues getting hired
Depending on where you're applying, prospective employers might conduct a background check, including pulling your credit report.
Having a poor credit score can hurt your chances of being hired. This depends on the nature of the job, but being limited in your career options is never a good thing!
Steps to Improve a Low Credit Score
Now that you know the different ways a poor credit history and score can negatively impact you, you probably want to start thinking about ways to improve it.
The good news is you can achieve a good credit score rating. Yet it will take time and some sound financial decisions.
It might be easier to go from a good to an excellent credit score than it will be to go from very poor to good, but it is indeed possible. Just remember, promises of quick fixes in a short time frame are likely too good to be true.
Use these 9 steps to start repairing a poor score and building good credit habits:
- Obtain all 3 of your credit reports and thoroughly review them – here's how.
- Sign-up for free credit scores and reporting with services such as Credit Karma or through your credit card issuer or financial institution. For extensive credit monitoring consider services such as myFICO.
- Dispute any credit report discrepancies.
- Make your monthly payments on time for all debts, and get current on any past due loans
- Pay down outstanding debt, especially revolving debt such as credit card debt to keep credit utilization low. Aim to pay your credit cards in full each month and strive to pay more than the minimum payment on lines of credit with outstanding balances.
- Avoid closing credit card accounts which can impact your credit mix and credit utilization rate.
- Also be careful about applying for a lot of new loans, credit cards, or lines of credit, as each credit application means a creditor runs a hard credit inquiry that stays on your credit file. (Note: When you run your own credit report it is known as a soft inquiry which does not harm your credit score.)
- For some, a secured credit card or personal loan may be worth obtaining to display timely installment loan or monthly credit card balance payments.
- Consider freezing your credit to make it more difficult to apply for new credit and to help protect yourself from identity theft.
For details on these steps and more tips for those just starting out who want to build a strong credit score, read “How to Build a High Credit Score and Keep it There“.
A poor credit rating today can greatly affect your financial life in the short term.
Still, you can repair a bad credit score and financial history by taking the steps mentioned here and in the linked article.
Feel free to reach out to us if you need help finding additional resources and tools to improve your financial health.