Credit scores are important. I know not everyone will agree with me and that’s fine – Ramsey followers, I’m looking at you – but I believe that a great credit score gives you financial flexibility and I’m therefore on board with the (responsible) use of credit. Like a lot of things in the financial realm, however, the calculation of credit scores can be confusing.
Let’s break it down.
There are five primary factors that affect a person’s credit score. Each factor carries a different weight and will therefore have more or less of an impact on your overall credit score, either positively or negatively. Knowledge is power – knowing how and why each factor matters is the best way to understand and improve your score.
Payment History: 35%
Your on-time payment history is the first thing lenders look to when considering you as an applicant. They’re essentially wanting to see, based upon your credit history, how likely it is that you’ll make payments to them as agreed.
Your payment history shows a list of all of your current and past lenders and creditors along with a detailed breakdown of your payments to them, month by month. It will indicate all of your on-time payments, all late payments (indicating how late as well – 30 days, 90 days, etc.), any accounts that have gone to collections, and any bankruptcies or foreclosures you have experienced.
Your credit history also shows how many of your accounts have been delinquent in comparison to your total number of accounts. For example, if you’ve had late payments reported to 4 of your 8 accounts on file, that ratio will be considered as well and will negatively impact your credit score.
Bottom line: Paying your creditors on time is critical.
Credit Utilization: 30%
Also important to lenders is how much credit you’re using, as compared to how much credit is available to you. This is your credit utilization. If you have a credit card with a $5000 limit but you are close to maxing it out each month, your credit utilization will be considered a negative factor. Ideally, your credit utilization should be less than 30% – i.e. $300 or less on a card with a $1000 limit.
Bottom line: Avoid maxing out your credit cards and stay within the 30% range if at all possible. Ideally, you should pay your revolving balances in full each month to avoid interest and maintain a low utilization number.
Length of Credit History: 15%
Your credit history includes information about how long each of your various credit accounts have been active. For the purpose of your credit score, lenders look to see how long your oldest account has been open and how recently you’ve opened your newest accounts. The longer your history, the better a creditor can assess your ability to manage credit and whether you are a high or low risk borrower.
Bottom line: The longer you have an account open the better. Closing accounts will (temporarily) lower you credit score.
Types of Credit: 10%
The different types of credit you have also affect your credit score, including revolving debt (credit cards) and installment loans (such as mortgages and student loans).
Lenders want to know that you are responsible for and can manage multiple types of accounts. Someone with a positive payment history, multiple credit cards, a mortgage and car loan, may therefore be more attractive to lenders than someone who has only had credit card accounts.
Bottom line: Multiple types of credit accounts can boost your score but don’t open accounts just to satisfy this factor.
Credit Inquiries: 10%
Also factored into your credit score is the number of “hard” inquiries on your report. Multiple hard inquiries – applications for new credit – negatively impact your credit score. Hard inquiries remain on your report for 2 years, but only impact your score for the first 12 months.
Bottom line: Don’t apply for new credit or loans without weighing the pros and cons since your credit score will likely take a hit.
Hard vs Soft Inquiries
Hard inquiries occur when a lender or creditor checks your credit report because you applied for new credit. Each inquiry is listed on your credit report and multiple inquiries are considered negative. A caveat, however: If you’re applying for a new mortgage for example, multiple inquiries within the same time frame (typically between 2 weeks and 1 month) are generally counted as one inquiry for that time period.
Soft inquiries are one of two things and DO NOT negatively affect your credit score:
- A check of your credit that is not initiated by you. This is typically when a creditor requests to review your credit report in order to preapprove you for a card (and then send you mailings with a credit card offer, for example). It can also be when creditors you have accounts with already do periodic reviews of your credit report (possibly looking for reasons to raise your interest rate).
- A check of your own credit report or credit score. Again, checking your own credit report and/or score has NO negative impact. I promise.
Credit Score Range
Finally, your credit score ranges from 300-850 points. Like with most things, the higher the score the better.
- 750+: Excellent credit
- 700–749: Good credit
- 650-699: Fair credit
- 600-649: Poor credit
- Below 600: Bad credit
Ideally, you want your credit score to be 750 or above. In the long run, a higher score means greater access to credit and lower costs associated with borrowing (i.e. interest rates), which saves you money overall. Consider the very basic example of a 30 year, $100,000 mortgage at 3.5% versus the same mortgage at 5%. The first will cost you roughly $61,000 in interest while the latter will cost you an extra $32,000 or $93,000 total, nearly double your original loan amount.
Your credit score can even affect your ability to rent a home or apartment as well as your auto insurance rate. Luckily, your credit score is composed of factors that are within your control. Simply put, you can actively work to improve your score, starting right now. If you haven’t done so already this year, make sure you get your free copy of your credit report and check it for errors since misinformation could be hurting you.
Want to know how to check and understand your credit report? Make sure to check out this post next!
Questions? Have advice to share? Let me know in the comments!