Do you want to start a new business or, perhaps, purchase something for your home, like a new car? Well, it is vital for you to understand your credit score and its implications to you accessing finance from different institutions.
A credit score is a figure given to an individual that represents their overall creditworthiness. It is based on a number of factors which financial institutions use to determine the ability of an individual to maintain their credit obligations.
Credit scores are commonly calculated through FICO scores, which constitute 90% of all lending decisions in the United States. The three major credit bureaus in the United States that collect, analyze, and distribute information about credit are Experian, Equifax and TransUnion.
By most measures, credit scores fall into five categories ranging from poor/bad to excellent.
Very Good: 740-799
Nationwide, the average credit score is 771, and it falls into the “Good” range. This national average has steadily increased over the past decade, from a prior average of 689 in 2010. Someone with a good credit score can more easily access loans and other forms of credit from different financial institutions. People with good credit (or better) generally enjoy lower interest rates and longer repayment periods.
Once you understand the factors that comprise credit scores, it is possible to calculate individual interest rates, and even your eligibility to purchase particular items.
There are five elements that make up credit scores, and it is important to understand them as relates to your creditworthiness.
1. Payment History
This is the most important factor to consider when calculating your credit score because it constitutes 35% of the total score.
Your payment history is just what it sounds like- a record of when you did- and didn’t- make required payments. When financiers are reviewing this specific factor of your credit score, they want to find out how consistently you make timely payments for loan and credit card payments. Particular focus is emphasized on your credit card activity because your ability to pay this specific debt on time is considered more important than other loan payments under your account.
Your payment history not only shows your commitment to paying off debt in a timely manner, but it also serves as an indicator of potential financial strain. Consistently late or missed payments signal an inability to pay, and thus that you as a borrower are riskier. Riskier borrowers have lower credit scores, and in turn, higher interest rates.
FICO maintains a long-term “file” on all of a person’s financial obligations that will eventually constitute their payment history. While on-time credit card payments are the most heavily weighted component of a person’s credit history (because they indicate a near-real-time snapshot of a person’s financial status), the general timeliness of all of their payments will be used to make a decision on whether to give someone access to financing.
The most effective way for you to ensure that you have a good payment history is to pay on time and in full for each loan and credit card you have open.
2. Credit Utilization Ratio
Your credit utilization ratio accounts for 30% of your credit score and is the amount of credit used (your balance) compared to the amount of credit you’ve been extended (your credit limit). This ratio demonstrates your ability to handle debt responsibly and not be financially over extended.
In order to maintain the highest potential score, It’s recommended that you keep your credit utilization at or below 30% of your total credit limit.
Banks and other lenders will analyze your credit balances to determine how efficiently you are managing your debts. If you have a tendency to max out your credit cards, your credit score will be lowered and financiers may lower your credit limit, as you’re now seen as a riskier borrower.
However, if you maintain low credit card balances- at below 30% of your total credit limit- and you rarely max out your credit card, you can maintain- and even improve- credit score. Financiers like to lend to people who rarely max out their credit cards, because it shows their ability to spend within their limits.
If you have a circumstance that requires you to regularly spend above 30% of your credit limit, but you have adequate funds to pay your credit card bill to zero each month, there’s still a way for you to maintain a strong credit utilization ratio. Simply pay your balance off more frequently- perhaps weekly vs monthly- to keep the utilization ratio in check. After paying your bill off completely for several months, you’ll have a demonstrable payment history and may be able to request an increased credit limit. A higher limit would allow you to spend more, while maintaining a credit utilization ratio at or below 30%.
Your credit utilization is a critical factor in determining your creditworthiness, as is only second in importance to your payment history. Keeping your credit card balance at or less than 30% of your limit demonstrates financial stability, and can help to maintain a good credit score from your credit utilization ratio.
3. Length of Credit History
The duration of time your accounts have been open and active constitutes 15% of your credit score, and it gives a picture of your long-term financial behavior in terms of income and expenditure history.
Your credit history length is important, as it demonstrates someone’s ability to keep up their payments, and thus consistent income sources. People with good credit or above usually have a longer credit history than someone who’s just recently applied for their first credit card.
However, it is not mandatory that you have had accounts open for a long time in order to avoid a bad credit score. The length of credit history will also highlight the effectiveness of the individual to make payments and settle debts within a definite duration. This is used as a basis to make decisions on whether to extend or facilitate new credit options for you.
If you’re able to show you’ve had a number of accounts opened for an extended period of time vs a short term credit history, creditors are likely to view you as a lower-risk borrower and reward you with a higher credit rating.
4. Credit Mix
Your credit mix – which accounts for 10% of your FICO/credit score- are the types of accounts from which you’ve borrowed money. Common forms of credit include credit card, mortgages, car loan, student loans, and even financing offered from medical/dental offices or cell phone providers.
Your ability to handle several creditors simultaneously, while repaying debts on time can help to demonstrate your creditworthiness.
For example if you have a credit card, car loan, and mortgage- and maintain a good payment history- you’ll likely qualify for a better financing option on a home purchase than someone who only has a cell phone bill. This is because having a credit from multiple lenders shows you can handle different types of credit, thereby reducing the risk of lending to you.
A good credit mix is an indicator of your flexibility- and ability- to handle financing from numerous sources, and this can prompt a good credit score, particularly if you have a history of paying on time.
5. New Credit
Acquiring new credit lines is an important aspect of your credit score and it influences decisions on your creditworthiness. This is the final factor of your credit score and makes up the final 10% of the score.
This can be a confusing component of the card, as opening new credit can both increase and decrease credit scores.
Taking out new credit can increase scores, as approval for multiple forms of credit indicates financial trustworthiness. Additionally, new credit can also increase your score if you apply for a card, but don’t use it often/for large amounts, as it’ll positively affect your overall credit utilization ratio.
However, simply taking out new credit for the sake of it may land you in trouble with credit bureaus. Any requests for new credit temporarily lower credit scores, as they can be an indicator of financial strain. Additionally, taking out a new line of credit will decrease the average age of your accounts, thus impacting your credit history length, and subsequently your overall credit score.
So long as you have sufficient payment history and credit utilization, taking on new credit for strategic reasons will be beneficial for your credit scores.
Know Your Credit Score
From everything to credit limits to the ability to get an apartment, credit scores affect SO many components of daily life. So it’s important to know your score.
Don’t know your credit score? No problem. You can check it for free in about 90 seconds with a company called Credit Sesame. In addition to quickly getting your free credit score, you can also learn tips and tricks on how to improve your score.
The question “why do credit scores matter?” is a very important one to understand for anybody looking to access financing, be it for a house, car, or even just a credit card or cell phone.
If you pay your bills on time, maintain lines of credit from more than one lender, and keep your credit balances to a minimum, you will likely be able to achieve a good credit score- or higher!
Regardless of your current circumstances, you should focus on maintaining a healthy credit score and keeping debt to a minimum, because they will determine your ability to access financing in the future.