It's fairly common knowledge that you need good credit to borrow money or get a credit card; but what exactly is "good credit"? Unfortunately, there is no official cut-off point to determine whether or not your credit is good, but there are some guidelines that can give you an idea. Here's how to tell where you stand, and why you should aim to be better than just "good."
How to check your own credit
There are several credit-scoring systems out there, but the FICO score is, by far, the most widely used by lenders. Therefore, that's the one to check. Some "free credit score" sites will generate a score from the information in your credit report using a scoring model that is used by few, if any, lenders. If you want an accurate picture of where you stand, the FICO score is the way to go.
There are several ways to obtain your FICO score. For example, if you have a Discover credit card, you can monitor your actual FICO score for free, but just from one of the three major credit bureaus. You can also buy your score through Experian, or directly from myFICO.com, which is operated by the Fair Isaac Corporation, creators of the FICO score.
It's not terribly important where you obtain it, as long as it's an actual FICO score. After all, it's tough to know where you stand if you're not looking at the same score as the lenders you hope to borrow money from.
What is "good" credit?
FICO scores range from 300 to 850, and higher scores are better. The actual cut-off point for "good" credit depends on who you ask, and what you're trying to buy, but here are a few general guidelines.
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Bear in mind that what's considered good for one purpose isn't necessarily good for another. For example, a FICO score of 620 is generally considered "good" for mortgage purposes, as it's the cut off for most conventional loans. However, a 620 won't get you most credit cards with good reward programs or low interest rates. On the other end of the spectrum, to get the best mortgage rates, you'll probably need a score of 760 or higher, so that would be the "excellent" realm in this case.
Aim for a great score
If I could sum up the difference between good credit and great credit in one sentence, it would be this: Good credit will allow you to buy whatever you need, but great credit will let you buy those things with the lowest interest rates possible.
For example, with a credit score of 675 -- which is a "good" score as far as mortgage lenders are concerned -- you can expect to qualify for a 30-year mortgage with an interest rate of 4.288%. And with a 760 or above, which is the top tier, you can expect a rate of 3.675%. These interest rates may not sound that different, but if you get a $250,000 mortgage, the lower rate means that you'll save $31,767 in interest over the life of the loan.
To maximize your credit score, you need to know where your score comes from
The FICO scoring formula considers five categories of information when calculating your score.
- "Payment history" is the largest category, and makes up 35% of your score. Basically, to achieve a good credit score, you need to pay your bills on time, and avoid adverse account types such as collections and judgements. It's possible to still have a good credit score with one or two late payments on your record, and the longer you go with a perfect payment history, the less a few old mishaps will matter.
- "Amounts owed" makes up 30% of your score, and primarily considers how much of your available credit you're using. To achieve good credit, it's a bad idea to "max out" your credit cards.
- "Length of credit history" contributes 15%. Basically, the longer you've established good credit behavior, the higher your score. This category looks at the age of your oldest account, the age of your average accounts, and the age of individual accounts.
- "New credit" is 10% of your score, and looks at the number of recently opened accounts, as well as the number of inquiries on your credit report. A "good credit" behavior would be applying for and opening accounts sporadically -- not many at a time.
- "Types of credit used" is the final 10% of the formula, and looks at whether or not you have a "healthy mix" of credit accounts. If you have a mortgage, auto loan, and credit card all with solid histories, it shows lenders that you can handle all different types of credit.
Why it's important to get the highest score possible
I mentioned earlier that if you have a score of 760 or higher, you should qualify for the best possible mortgage rates. So, why would anyone strive to achieve a score of, say, 800 or even higher? Isn't that overkill?
Basically, the higher your score, the more "wiggle room" you have to live the kind of financial life you want. For example, let's say that you have a FICO score of 765, which is a "top-tier" score. If you apply for a new credit card, the combination of the resulting credit inquiry and new account could easily push your score down below the 760 threshold.
On the other hand, if you have a FICO score of 800, you can absorb a temporary hit from a new account and stay in the top level. In other words, you're free to buy what you want without worrying what it will do to your credit score.
An ultra-high credit score won't give you any additional benefits above a certain point, but it does give you more ability to absorb bumps along the road.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.