Your credit score can be a very important piece of any financial decision. A good one can lead to better loan rates and many other opportunities not offered to those with a lower score. Credit scores are mostly used to determine how likely a new borrower is to default on a loan given their past experience with credit. If the person taking a loan has a high score, they are less likely to default based on their past habits. A credit score can also be used by hiring managers, property managers, and others to assist in their consideration of employees or tenants. With lower interest rates and more opportunities on the line, it is important to know how a credit score actually works.
There are a few different scoring companies, and they all have slightly different metrics. The scores generally range between 300 and 850, and they pull information from the three credit bureaus for their calculations. The three bureaus are Experian, Equifax, and Transunion. These are the three companies that create your credit reports. You can request a free report from each of the companies once per year, and it could help your score to look at your report and clear up any bad marks on the report. Every so often, a mistake is recorded, so it’s a good idea to review your report at least once a year.
*A credit score is made up of 5 different components. Although the percentage of each factor’s effect on the score is not completely disclosed, here is an estimate accompanying each of the following five elements:
- 10% - Types of Credit
Credit that is positive for your score is long-term debt like a mortgage or car loan. A high amount of revolving credit like credit cards can be a negative with regard to a credit score.
- 10% - New Credit
When you apply for new credit, the company will check with the credit bureaus with what is called a “hard hit” on your credit. The rule of thumb is no more than three hard hits in any 90-day window. If you have too many credit checks over a period of time, it can show that you are trying to get a lot of credit all at once and are a higher risk for future lenders.
- 15% - Length of Credit History
This one is easy. More is better. While easy, it takes time to build. This is why it’s usually in your best interest to keep the credit card you’ve had for the longest period of time, even if you don’t use it anymore. Just use it to buy a pack of gum or something every two years so the credit card company won’t cancel your account for lack of activity.
- 30% - Amounts owed and Utilization
The credit scoring companies look at your debt to income ratio. They don’t say exactly what the percentage is that they’re looking for, but having too much debt with regard to your income will be a negative on your score. Utilization has to do with how much of your revolving credit is being used. You should aim to use less than 30% of a credit card balance. For instance, a credit card with a $10,000 limit will start to negatively affect your credit when you have a balance above $3,000 month over month.
- 35% - Payment history
Payment history makes up the largest part of a credit score, and the best way to make sure that payment history is positive is to pay on time. At least pay the minimum that you can every month, by the payment date. Having a payment that is 30 days late could affect a credit score negatively.
In the end, there are a few things you can do, or not do, to improve your credit score:
- Keep balances low on all revolving credit
- Pay off debt rather than moving it around
- Don’t close an unused account to raise your score
- Long-term accounts improve your score
- Don’t apply for too much debt at one time