Everyone talks about credit score but what exactly is it?
Essentially, your credit or FICO score is a calculated rating of risk a lender takes when lending you money. Depending on which credit bureau you use (Equifax, TransUnion, and Experian) your score can be slightly different but generally speaking, the numerical range is between 300-850 where 300 is high risk and 850 is low risk.
Why does it matter?
Having a good credit score can give you the upper hand in getting better deals on loans, insurance, mortgages, and other bills. Who wouldn’t want to pay a lower amount on other life expenses? If your credit score is not great, you will have trouble getting a loan for major expenses, such as a car or a house, because lenders will feel as though they will never see their money ever again. Even if you are approved for the loan with a low credit score, your interest rate will be significantly greater than someone with a higher credit score.
How is it calculated?
There are several factors that contribute to your credit score and those factors depend on which credit bureau you are looking at. For now, we will look into FICO credit score:
- Payment history: 35%
Your payment history is the largest factor of your credit score. FICO looks at what you owe, if you are paying on time, the length of time since missed payment, and any collections/bankruptcies. Obviously, if you are consistently paying your bill late or even not at all, you will have a hard time finding someone who will lend you money. If you find yourself having to pay your bill late, pay as much as you can on time then pay the remaining amount back as quickly as possible.
Essentially, lenders want to ensure that they will receive their money back after they lend it to you so showing that you are capable of paying it back on time and in full will show them that they can trust you.
- Money owed: 30%
This one seems confusing yet, is simple once broken down. Credit utilization ratio is the measurement of the amount of debt you have compared to your credit limit. The less money you spend, the better according to this score due to the fact that if you spend less, you are less risk to the lenders. In other words, if you spend $30 with a $400 limit, you are more likely to pay it back over an individual who spends $300 with a $500 limit.
This also applies to how much you owe on specific accounts. A mortgage is examined slightly different than a credit card.
- Length of credit history: 15%
Length of credit is pretty self-explanatory, but I will still explain. The longer you have had your credit for the better. Lenders can see a more consistent timeframe for your payments. FICO looks at all of your accounts: oldest, newest, and an average of all the lengths to get a better idea of your payment history.
- New credit: 10%
Lenders look at any new accounts you may have and also any accounts you recently applied for. They perform what’s called a hard inquiry which is when they check your credit information during the approval process. This type of inquiry can briefly decrease your credit score because if you are applying for more credit, you are at greater risk of spending more and not paying back what you borrowed. Typically, individuals who apply for several accounts in a short period of time are flagged because those individuals tend to be tight on cash. In other words, if you are applying for many new accounts, it’s generally because you lack the liquid cash, thus you use borrowed money instead.
- Total accounts: 10%
Looking at the amount and type of accounts is a small portion of your credit score. Having a variety of accounts, credit card, mortgage, car payment, etc. is great bot not vital to your credit score. You do not need to have multiple types of accounts to have a good credit score.
Developing good habits
Pay on time- paying your bills on time is extremely important to your credit score because if you cannot pay your bills on time, lenders will assume you will not pay them back at all. To avoid late payments, plan accordingly by setting aside money every paycheck to pay off the credit card. If you are doing this, you will not have to wait for your next paycheck to come so that you can pay off the bill.
Pay in full- paying each statement balance in full is essential to establishing and maintaining a good credit score. The amount due increases when you do not pay in full thus resulting in more owed. If you do not pay in full, there is a chance you will not pay the balance off and spiral into debt. It is OK if there are times where you cannot pay in full, but do not make it a habit. In the case where you cannot pay in full, contribute as much as you can then pay off the remaining balance as soon as possible.
Light use- maxing out your credit card even if you pay it all off when it is due can affect your score. This puts you at a riskier position because you are racking up more money borrowed and there is a chance that you cannot pay it off. Ideally, consistent, light use of the card is perfect to building up your credit. Every now and then you will spend close to the limit but if you are doing well with payments, it will not affect your score as much.
Avoid closing cards- Closing a credit card will in fact lower your credit score especially if the card you are closing has a high limit and you have other loans or cards with high balances. Leaving the card unused is typically better than canceling it all together but if you have an annual fee on it, it is up to you whether you want to bite the bullet and close the account.
Overall, being aware of your credit score is extremely important to your financial life and can essentially make or break your finances. If you are willing to pay more for loans or not be able to get a loan at all, then by all means don’t be careful with your credit. However, if you want to be in control of your financial life, make note of all the strategies you can develop to get, maintain, and protect your high credit score.