Many of us learned the concept of borrowing while growing up. We might have borrowed clothing from an older sibling, a video game from a friend or even the family car from Dad. When it comes to borrowing money via a loan, however, it takes more than friendship or trust; your creditworthiness is the key to approval. In this blog, we will discuss the impact of your credit score on loans and the importance of a healthy credit history and how it can boost your financial wellness.
What Is a Credit Score?
When applying for an auto loan, home loan, credit card or personal loan, lenders such as credit unions and banks will review your credit to determine how likely you are to repay the loan on time. Your creditworthiness is determined by your credit history and your credit score.
A credit score is a rating that is built upon how likely you are to repay a loan. Lenders use your credit score to determine the interest rate on the loan. The higher the credit score, the better the interest rate offered to the applicant.
Credit scores are made up of an individual’s payment history, outstanding loan balances, credit history, credit utilization and inquiries. Each of these factors can increase or decrease your score. Other factors considered by lenders are your income, years of employment and current debt.
How Does It Affect a Loan?
Having a good credit score will increase the chances of getting approved for a loan and will get you the best rate possible. Since higher interest rates make borrowing more expensive, you will save money with a good score. Credit scores range from 300 to 850. Lenders generally set a minimum score of 660 to 670 for loan approval. Anything lower than a 660 score could decrease the maximum amount you can borrow, along with increasing interest rates, according to Bankrate.com.
Good Scores for a Personal Loan
Personal loan approval requirements vary by lender based on their credit score thresholds. A good rule of thumb is to have a score of 670 or above. Credit scores range from poor to excellent. Here a breakdown of the ranges:
- Excellent: 800 to 850
- Very Good: 740 to 799
- Good: 670 to 739
- Fair: 580 to 669
- Poor: 580
These are credit score rankings that are determined through a company called FICO, which is not always used by all financial institutions or lenders. Knowing your credit score can help you decide the best time to apply.
Improve Your Score for a Better Mortgage Rate
Mortgages generally have different minimum credit score requirements than other types of loans. Home loans tend to have longer terms of up to 30 years, meaning having a high interest rate could cost you a lot more over the life of the loan. During that same time, however, you could improve your credit and refinance your mortgage to a lower rate, if market conditions are favorable, according to Bankrate.com.
Here are some steps to improve your credit score before you apply for a home loan:
- Review Your Credit: Reviewing your credit score and credit history will let you know where your credit stands and give you time to correct any inaccuracies. Your credit report will show all the loan accounts you have opened, their existing balances and your payment history for every account. You can get a free credit report at AnnualCreditReport.com.
- Make Payments on Time: Pay all your bills on time, especially credit card, personal loan, auto loan and mortgage payments. Doing so will keep your credit in “good standing” because lenders will report positive payment histories on these accounts.
- Reduce Credit Card Balances: Credit card utilization could have an impact on credit scores. Credit card balances should not exceed 30% of the total available credit. For example, if you have a credit card with a $10,000 credit limit, you should not carry a balance of more than $3,000 to avoid negatively impacting your credit. If you have high balances, work on paying them down to improve your credit.
- Avoid New Accounts and Inquiries: If you are in the process of buying a home, avoid opening new accounts or large purchases during escrow to maintain your credit standing. The addition of new balances and the new inquiries on your credit report when you are buying a home may negatively impact your credit.
Common Myths About Credit Scores
There are a few misconceptions about which actions make your credit score increase or decrease. Here are some myths that could potentially save you stress should you run into these scenarios, according to CNBC.com:
- Myth 1: Closing Old Accounts Improves Your Credit Score
Closing an old account willingly does not improve your credit score. In fact, having an old active account can be beneficial because of the credit history that it holds. Instead, if you really do not care to use that account, letting it close on its own due to inactivity is better than you initiating the account closing.
- Myth 2: Checking Your Credit Lowers It
Reviewing your credit score does not necessarily lower it. There are two main types of credit checks: soft pulls and hard pulls. Reviewing your credit yourself is considered a soft pull that does not affect your credit score. But if you have a financial institution check your credit for a loan, that is considered a hard pull, which slightly lowers your credit. Ensure you have soft pulls to your credit when possible.
- Myth 3: Income Directly Impacts Credit Score
Salary and income are not considered as part of your credit score. Income does not show up on your credit report. Instead, income should be viewed as a capacity to pay bills and will impact your ability to borrow from lenders.
- Myth 4: Good Credit Means You’re Rich
Having a good credit score does not mean you are rich. A credit score measures your ability to repay bills on time and in full. Also, having a high income does not guarantee a higher line of credit.
- Myth 5: Credit Score Isn’t Important Until Older Age
The minimum age to apply for credit is 18 years of age so that is when to start taking your credit seriously. Focus on building your credit and accumulating a positive credit payment history. Your credit history is a major part of your credit score so start keeping tabs on it beginning as a young adult.
- Myth 6: Getting Married Merges Spouse’s Credit Score
Credit scores are unique to individuals and they do not merge into a single score if you get married. A spouse can be added to a loan application and both individuals can be on the same loan, but their credit scores are separately considered.
How TCU Can Help
Understanding how your credit works can help you build a path toward financial wellness. At Travis Credit Union, we have the resources to help you establish and build your credit so you can get your best rate for an auto loan, home loan and credit card. For example, our partnership with Experian Boost lets you improve your FICO credit score instantly. Also, we have a credit-builder credit card for those who need to get started on their credit. Visit our Financial Wellness Hub to learn how you can plan, save, spend and borrow better.