What Millennials Should Know About Credit Scores

If you're in your 20s or 30s, you likely are more focused on starting or advancing your career than you are on worrying about your credit score; but that could be a mistake. Obtaining a top-notch credit score when you're younger can mean lower interest rates on credit cards, autos, and home purchases, saving you thousands of dollars every year that, if saved or invested, can translate into big money when you retire.

Source: Flickr user Sean MacEntee.

How important is it... really?Most banks and lenders rely on credit scores calculated by one of the major credit bureaus, including market leaders Fair Isaac Corporation (NYSE: FICO) andEquifax (NYSE: EFX), to determine creditworthiness. How credit bureaus calculate credit scores is a black-box secret; however, researchers have spent enough time decoding credit scores to learn that a variety of inputs, including how frequently payments are made on time, play a big part.

Because credit scores rate borrowers based on their credit histories, and lenders use credit scores to determine how likely it is that they'll get their money paid back to them, credit scores are arguably more important than any other factor when attempting to get a new credit card, buy a car, or purchase a home. Importantly, because credit scores provide lenders with an ability to compare borrowers, lenders use them to compete for people who will be good customers -- and that means that people with the best credit scores are going to get the lowest interest rates.

According to Fair Isaac's myFICO loan savings calculator, an individual with a credit score between 760 and 850 (the highest range of scores) obtaining a $200,000 fixed-rate mortgage would pay an annual interest rate of 3.724% and a total of $132,382 in interest payments over the life of a mortgage. Meanwhile, an individual with a credit score of between 620 and 639 (the lowest range of scores) would pay an annual interest rate of 5.313% and $200,401 in interest payments over the life of the loan, or $68,019 more than the high-credit-score borrower.

That's a big difference, but the financial impact of a good or bad credit score is even bigger if the good-credit-score borrower were to invest his or her savings over the same period.

Using the figures from the previous example, the monthly mortgage payment for the person with the high credit score would be $923, while the low-credit-score borrower would pay $1,112 per month. If the high-credit-score borrower took that $189 in monthly savings and invested it in an account earning a hypothetical 6% annually for the entire 30-year mortgage-loan period, then they would have a retirement account that is worth a staggering $179,309.

What should millennials be doing?Most millennials are falling short in managing their finances in a way that maximizes their credit scores. According to CreditRepair.com, only 11% of people age 18 to 29 and 22% of people age 30 to 39 have a credit score that's at or above 760. That's substantially lower than the percentage of people who are older than 50.

Older people tend to have better credit because they have longer credit histories; but given that there are plenty of millennials who do have high credit scores, it's not impossible to be young and have a high credit score, too.

Because the biggest influence on a person's credit score is a history of paying bills on time, staying current on debts is the most important step a millennial can take to bulk up a credit score. Reducing credit utilization, or how much of a person's credit limit is actually being used, can also make a big impact. To calculate utilization, simply add up the money you owe in revolving credit, such as credit cards, and then divide that number by your credit limit.

Typically, credit utilization below 30% is rewarded by credit bureaus, but a utilization that's below 10% is best. Also, take note that if you tend to max out your credit cards and then pay them off each month, you could be getting unfairly punished with a low score, depending on when your lender reports activity to Fair Isaac or Equifax.

Millennials can also improve their credit scores by keeping unused accounts open rather than closing them, and by limiting how many new accounts they open at any one time. If too many accounts get opened in a short period, it can make lenders think that you're short on cash.

Taking these credit-score boosting steps should lead to more lenders competing for your business. Just don't forget to put away the money you save every month -- thanks to your high score -- in an investment that can offer you long-term financial security, too.

The article What Millennials Should Know About Credit Scores originally appeared on Fool.com.

Todd Campbell has no position in any stocks mentioned. Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may have positions in the companies 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.