Understanding Credit Scores: How They Affect Your Loan Eligibility
In the United States, the average FICO credit score reached 715 in 2024, indicating that most Americans have a good credit standing. However, recent economic shifts, such as the resumption of federal student loan payments, have led to a rise in delinquencies, affecting many borrowers’ credit scores.
It is crucial to know what your credit score hides, as it plays a significant role in determining your eligibility for loans and the interest rates you’ll receive.
What Is a Credit Score?
A credit score is a three-digit number that represents your creditworthiness, essentially predicting how likely you are to repay borrowed money. Lenders use this score to assess the risk of lending to you. The two most commonly used credit scoring models are FICO® and VantageScore.
How Credit Scores Are Calculated
Your credit score is not random. It is calculated using information from your credit report, which reflects your borrowing and repayment behavior. Lenders use this score to predict how likely you are to repay money you borrow. Different scoring models exist, but most follow similar rules. Here’s a breakdown of the key factors and how they influence your score:
1. Payment History (35%)
This is the single most important factor in your credit score. It tracks whether you pay your bills on time. Missing payments, making late payments, or defaulting on loans can significantly lower your score. Even one missed payment can hurt, especially if it becomes 30 days or more overdue. On the other hand, consistently paying on time boosts your score and shows lenders that you are reliable.
2. Amounts Owed (30%)
This refers to the total amount of debt you have compared to your credit limits. For example, if you have a credit card with a $1,000 limit and a $900 balance, you are using 90% of your available credit, which can lower your score. Keeping your balances low, ideally below 30% of your credit limit, shows lenders that you are not overextended and can manage debt responsibly.
3. Length of Credit History (15%)
Lenders like to see that you have a track record of managing credit over time. The longer your credit history, the more data there is for lenders to judge your reliability. Even if you have a few accounts, having them for many years can be better than having many accounts opened recently. Closing old accounts can sometimes shorten your history, which may slightly reduce your score.
4. Credit Mix (10%)
Having a variety of credit accounts can improve your score. This includes credit cards, installment loans (like car loans), mortgages, and student loans. A good mix shows that you can handle different types of credit responsibly. However, you should not open accounts just for variety, only take on the credit you need and can manage.
5. New Credit (10%)
Each time you apply for credit, lenders check your credit report, creating a “hard inquiry.” Too many inquiries in a short time can lower your score slightly because it may indicate financial stress. Opening several new accounts at once can also reduce your average account age, which may negatively affect your score.
Key Takeaway:
Payment history and amounts owed have the biggest impact on your credit score. Even if other factors are strong, missing payments or carrying too much debt can significantly lower your score. On the flip side, managing debt wisely, paying bills on time, and maintaining a mix of accounts can steadily improve your credit rating.
Why Credit Scores Matter for Loans
Lenders use it to evaluate how risky it would be to lend to you. A higher credit score can open doors to better loan options, while a lower score may limit your choices or cost you more. Let’s break down how credit scores affect different aspects of loans:
1. Loan Approval
Lenders often set minimum credit score requirements for loans. If your score meets or exceeds that requirement, you are more likely to be approved. If your score is below the threshold, your application may be denied. For example, many conventional mortgage lenders prefer scores of 620 or higher.
2. Interest Rates
Interest rates are the cost of borrowing money. A higher credit score usually qualifies you for lower rates. Lower interest rates mean you pay less money over the life of the loan. For instance, consider two borrowers:
- Borrower A has a credit score of 760 and is offered a mortgage at 3% interest.
- Borrower B has a credit score of 640 and may receive a 5% interest rate.
Even on a $200,000 mortgage, that 2% difference could add tens of thousands of dollars in extra payments over 30 years.
3. Loan Amounts
Lenders may offer larger loan amounts to borrowers with strong credit scores. A higher score signals that you are financially responsible, making lenders more comfortable lending larger sums. Conversely, a lower score may limit how much you can borrow.
Categories of Credit Scores and What They Mean
Credit scores are typically categorized as follows:
- 300–579: Poor
- 580–669: Fair
- 670–739: Good
- 740–799: Very Good
- 800–850: Exceptional
A score of 715, as mentioned earlier, falls into the “Good” category, which is favorable for most loan applications.
Tips to Improve Your Credit Score
Improving your credit score takes time and consistent financial habits. Small, steady steps can make a big difference. Here are some practical strategies:
1. Pay Bills on Time
Your payment history is the most important factor in your credit score. Even one late payment can hurt your score. Set up reminders, automatic payments, or a calendar system to ensure bills like credit cards, utilities, and loans are paid on time. If you’ve missed a payment, try to pay it as soon as possible and stay current on future payments.
2. Reduce Debt
High credit card balances or large loans can lower your score. Focus on paying down debt, especially revolving credit like credit cards. Aim to keep your credit utilization, the ratio of your balances to your credit limits, below 30%. For example, if your credit card limit is $1,000, try not to carry more than $300 on it at any time.
3. Avoid Opening Too Many New Accounts at Once
Each time you apply for credit, a “hard inquiry” is recorded on your report. Too many inquiries in a short period can slightly lower your score and signal financial stress to lenders. Only apply for credit when you need it.
4. Maintain Old Accounts
The length of your credit history matters. Keeping older accounts open can help improve your score, even if you don’t use them often. Closing old accounts may shorten your credit history and reduce your score.
5. Diversify Credit Types
Having a mix of credit accounts, like credit cards, car loans, student loans, or a mortgage, can positively impact your score. It shows lenders that you can manage different types of credit responsibly. However, don’t open accounts you don’t need just to diversify; only take on credit you can handle.
6. Monitor Your Credit Report
Regularly checking your credit report helps you spot errors or fraudulent activity. You are entitled to one free credit report per year from each of the three major credit bureaus (Experian, Equifax, and TransUnion) at www.annualcreditreport.com. Correcting mistakes can improve your score quickly.
Common Myths and Misconceptions
Credit scores can be confusing, and there are many myths floating around. Let’s clear up a few of the most common ones:
Myth #1: Checking your credit score will lower it.
This isn’t true. When you check your score, it’s considered a “soft inquiry” and does not affect your credit. Regularly monitoring your score is a smart way to catch errors or spot potential fraud early.
Myth #2: Closing old credit accounts will improve your score.
Not necessarily. Older accounts help show a longer credit history, which is good for your score. Closing them can shorten your history and sometimes lower your score. It’s usually better to keep old accounts open, even if you don’t use them much.
Myth #3: Carrying a balance on your credit card helps your score.
Some people think leaving a small balance helps, but it doesn’t. Paying off your balance in full each month is better. It avoids interest charges and shows lenders you can manage credit responsibly.
Conclusion
Your credit score is a vital component of your financial health. By understanding how it’s calculated and the factors that influence it, you can take proactive steps to improve and maintain a good score. This, in turn, improves your chances of securing loans with favorable terms, supporting your financial goals.