Credit Scores: What’s in a Number?
You’ve probably heard a lot about your credit score over the years, but have you ever actually looked under the hood and try to better understand it? If you’re answer is no – don’t worry, you’re not alone. Surveys have shown that Americans simply don’t know enough about how credit scores work and the effects their score can have on their lives. We’re here to help. Here are your credit score basics.
Your credit can influence whether or not you can rent an apartment, what kinds of credit cards you qualify for, and what your interest rate on those cards will be. You could also be leaving money on the table if your score is not as high as it can be. That means paying hundreds or even thousands of dollars in extra interest charges on a home or auto loan over time. So if one 3-digit number carries this much weight, isn’t it time to understand exactly how it works and what you can do to improve it?
Credit Score Basics
Think of your credit history like a school transcript that includes all of your financial decisions over the years. Your credit score is your GPA. A single number that is calculated to represent how you’ve done and show a potential lender how risky of a borrower you would be in the future. The higher the credit score, the better.
Your score can range from 350 to 850. There are three credit bureaus, Experian, Transunion, and Equifax, who all collect information about your credit history and calculate scores. Each does this a little differently so you may notice your score differ slightly between the three bureaus. Even within each of the bureaus, there are different algorithms (the most commonly known is FICO) for calculating your score.
Confused yet? Here’s the bottom line: don’t stress about the differences between one score and another. Focus on one score and monitor it over time. You can get your credit score for free (with no negative impact) from CreditSesame or it may even be offered by your credit card company.
For a more in-depth review of credit scores and credit report, read our guide called Know Your FICO.
What Affects Your Score?
One of the biggest points of confusion when it comes to credit scores is what factors cause it to move up or down. Some may seem obvious, like paying your bills on time, but others can be less intuitive.
The most important factor of your credit score is whether or not you pay your bills on time. Even one late payment can have a significant negative impact on your score. If you do happen to be late on a payment, your score will go down the longer you wait to make the payment: 30 days, 60 days, 90 days, or if the amount owed was sent to collections. Bankruptcies, judgments, or any other part of public record will also affect your score.
What to do about it: Automate your bills, credit cards, and other loan payments so you never have to worry about being late.
This is often referred to as your credit utilization and represents the percentage of your available credit that you actually use. For example, if the limit on your credit card is $10,000 and your balance is currently $5,000, your credit utilization is 50 percent. The higher the utilization, the more negative an impact this will have on your credit score since it may indicate that you are stretched too thin and may be riskier to lend to.
What to do about it: Keep your utilization below 30 percent of your available credit at all times on both your individual credit cards and overall. Create a balance alert on each of your cards to make sure you are aware if your utilization goes beyond 30 percent.
Length of Credit History
This factor is calculated by averaging the age of all your open accounts including credit cards, mortgages, student loans and any other line of credit. The longer your credit history the better, since it provides more information to a potential lender. There is no magic number here that will give you the best credit score, but some studies have shown that credit scores that top 750 have an average age of 7.5 years for open accounts.
What to do about it: Do not close old credit cards since it will shorten the average age of your credit accounts.
This factor includes the number of different credit accounts you have as well as different types of credit. A greater number of accounts can boost your score since it indicates more lenders were willing to give you a line of credit in the first place. Having both types of credit, revolving (credit cards) and installment (auto loan, student loan, or mortgage), can also increase your score.
What to do about it: Do not take out a line of credit you don’t need to try and improve your score. This factor is weighed less heavily than others and there are easier ways to boost your score!
This factor considers how many new credit accounts you have recently opened and how many hard inquiries were made on your credit. Hard inquiries result from a lender or credit card company pulling your credit information in order to decide whether or not to approve you for a loan or credit card. The more inquiries and new accounts you have, the lower your score because it may indicate that you are having cash flow problems and are a greater credit risk.
What to do about it: Limit the amount of new credit inquiries to 1-2 per year in order to avoid a significant negative impact on your score.
The Bottom Line
There’s a lot that goes into your credit score and no one factor alone can cause it to tank (or soar). Rather than stressing about whether or not you have the magic number of accounts, aim to manage your credit responsibly by paying your bills on time and never taking on more debt than you can handle. Your credit history won’t be made overnight, but a solid score built up over time can really pay off in the long run.
Related: How to avoid credit repair scamsTags: credit, credit bureau, credit score, credit utilization, loans