Understanding the factors that make up a credit score will help you uncover where you can take immediate action to improve it in the future.
There’s a lot of information that funnels into this three-digit number and it’s not a one-size-fits-all approach. Credit ratings vary by your unique circumstances. The score itself is derived from an algorithm that helps lenders predict financial risk. Let’s break down what goes into a credit score and how you can better understand each factor.
The five main factors that affect your credit score are:
Payment History: 35%
Credit Utilization: 30%
Length of Credit History: 15%
Different Types of Credit: 10%
New Credit: 10%
Credit scores usually range from 300 to 850 based on the FICO Score. The higher your credit score is, the better. A good credit score (700 or above) may make it possible to buy your dream home or open a business, while a bad score can present challenges.
By breaking down these components, you can better understand what steps to take to improve your credit and build your credit score.
Payment history makes up about 35 percent of your credit score. Put simply, payment history is if you make payments on time for your accounts. This factor has the biggest impact on your credit score.
Your payment history will also show late payments, collections and charge offs, as well as public records like bankruptcies, judgments or liens. Certain things can remain on your credit report for up to seven years or more.
The primary goal of a lender is to determine what the odds are that you will repay a debt. Your payment history is the best indicator they have of your overall credit risk. The assumption made by lenders is that you will continue to behave in the future as you have in the past.
If lenders see that you have a solid payment history, you’re more likely to get approved for a loan or credit card. Late payments and other delinquent items may keep them from lending to you. If they do lend to you, you’ll likely be subjected to higher interest rates and other fees.
The rule of thumb is to keep your credit utilization at or below 30 percent of your overall credit limits. To calculate your credit utilization ratio, take the amount of credit you’re currently using and divide that number by the total amount of credit available to you.
Your credit utilization ratio applies to revolving credit, which includes accounts like credit cards. Credit reports look at your average utilization ratio for all your accounts as well as your utilization ratio for each individual account. What factors into your credit score, though, is your average utilization ratio for all your accounts.
Your length of credit history is how long you’ve been using credit. This accounts for 15 percent of your credit score. This part of your credit score looks at your oldest credit account and the average age of all your accounts. It also looks at the length of time since these accounts have been used.
Without credit history, lenders have no real basis for making a decision on whether to extend you credit. This makes you a significant risk when it comes to qualifying for a loan or a line of credit.
Typically, the longer a credit history, the better. In order to calculate a credit score, FICO needs to see an active credit account for a minimum of six months.
There are also misconceptions about closed accounts. You may think if you don’t use a credit card now, but did in the past and paid them on time, you’ll have a good credit history. Once an account is closed, it usually remains on credit reports for 10 years. If you stop using credit, and these accounts fall off, then it will be as if you never had credit. Some consumers may not even be able to access a credit score because there is no longer enough information for credit bureaus to generate one.
Different types of credit account for 10 percent of your credit score. The general rule of thumb when it comes to this component is to maintain a diverse mix of accounts. Lenders want to see that you have successfully managed a variety of accounts, which may include credit cards, home, auto or student loans.
There is no one-size-fits-all formula to determine the perfect credit mix, but the more diverse your accounts are, the better. However, you shouldn’t apply for new accounts just to improve this part of your credit score.
New credit applications make up about 10 percent of your overall score. This part of your credit score is calculated by looking at how often you’ve applied for new credit in the most recent 12-month period. This is why it’s important to think strategically about credit and loan decisions.
Each time you apply for a new account, a hard inquiry occurs. This drops your score a little bit with each application. If you have one or two hard inquiries, it’s likely not going to have a significant impact. Applying for too many accounts in a short period can drop your score a lot and it also raises a red flag to lenders.
Opening new cards and taking on new debt just for the sake of your score is never a good idea. You should only make strategic choices based on your individual finances and needs.
There are several things you can do to improve your credit score:
Make payments on time.
Keep balances low on revolving credit cards.
Don’t close old credit cards to improve the length of your credit history.
Don’t apply for too much credit to avoid inquiries.
Always pay off your highest interest debt first.