[Lesson] Credit Score 101

What is a Credit Score?

A credit score is a number determined by one of three credit bureaus (Experian, Equifax, and TransUnion) that is influenced by your credit history. A credit score influences everything from applying for a credit card, buying a house or car, getting other types of loans, and possibly renting a home/apartment. The higher your score, the better (scores can typically range from around 300 to 850). There are a number of factors that go into calculating a credit score which are compiled in your credit report. A credit report has information on five different aspects of your overall credit history:

Credit Payment

Believe it or not, every single loan or credit card payment you have ever had to make is factored into your overall credit score. Ideally, you want a boring history of just on time payments. However, many people have a much more “exciting” record scattered with late or no payment indicators. Having a perfect “track record” is one of the single best ways to keep your score high as even one or two missed or late payments can start bringing your credit score down very quickly. This portion of your score is the most influential accounting for 35% of your overall credit score.

Credit Utilization

Another major factor in computing your credit score is how much you currently owe compared to your overall credit. This is a very important factor because it can indicate potential financial issues for a person. Maybe a person has paid all their payments on time, but have only paid the minimum. Suddenly they are sinking deeper and deeper in a hole where they are credit score 02quickly maxing out their credit limits and cannot pay them off in full. This is a ticking time bomb: eventually they are going to hit their max and no longer be able to pay off all their debts on time and things will unravel very quickly for them. This portion of your credit report is a good indicator of whether or not you are on the road to financial hardship due to spending beyond your means. The less of your overall credit you are utilizing the better. However, using none of your credit technically can bring your score down too. The key is to keep your overall credit utilization under 30% of your total credit limit. But don’t worry if you happen to make a few large purchases every once and a while.  While this portion of your credit report makes up about 30% of your credit score, it is one of the most fluid portions that you can influence very quickly. Those large purchases might bring down your score a bit one month, but by next month when you paid your balances in full, suddenly your score is back up.

Credit Age

Your credit age is the average age of all your credit accounts. You always want to strive for a higher average age because it shows that you have experience and maturity with handling credit over a period of time. Unfortunately, a younger credit age can hinder someone when applying for credit cards or loans but this component only makes up 15% of your overall credit score. Although allowing time to pass is the main way to raise this part of your report, not closing your oldest credit accounts and not opening too many new accounts at once are good strategies to keep this part of your score higher.

Credit Varieties

Having a diverse background of credit accounts is a very good way to raise your credit score. While this section  only accounts for 10% of your score, having different types of loans and credit cards shows that you are mature enough to handle a variety of different accounts and stay on top of your payments. This section should naturally boost your score over time when you progress in life and start applying for credit cards, buying a car, or purchasing a house.

Credit Inquiries

Everytime you apply for a loan or credit card, generally the company or bank you are working with will do what is called a “hard pull” or “credit inquiry” on your credit report. This not only gives them your current credit score, but it also gives them access to everything on your report: the good and the bad. Although the number of credit inquiries only has a 10% impact on your credit score, more inquiries might lead to more questions by your lender or credit card company. Inquiries are inevitable and shouldn’t be feared, but having too many might raise some red flags. Only apply for a credit card or loan that you know you will get approved for. Having a hard pull and not getting anything out of it is a waste of a credit inquiry. If you do get denied, look carefully at what disqualified you before deciding to apply for something in the near future to avoid a series of hard pulls and nothing to show for it.

Why do Credit Card Companies Look at Credit Scores? 

When someone applies for a credit card it is almost like a job interview. The company issuing you the credit wants to know a little about you, what you have done in the past, and determine how you will perform in the future. When a bank or company allows you to use one of their credit cards they are taking on a degree of risk that you will max out your credit limit and never pay a cent back leaving them to foot the bill. Contrary to popular belief, credit card companies do not want you to get yourself deep into debt. Sure the initial interest is nice, but eventually if you just flat out stop paying because you spent too much, they end up losing a lot more. These companies make plenty of money off of the transactions you make with everyday purchases (at no cost to you!) and the high interest rates are really to help offset the small amount of payment defaults expected from a small percentage of their customer.

Before a company gives you a card they want some kind of idea what they are getting themselves into. If they see that you have responsibly handled other credit accounts (which in turn generally means a higher credit score) then they will be more open to allowing you to use their credit card services. So like with a resume you take to a job interview, you want to make sure you are always looking your best on paper for banks and credit card companies!

How Can You Improve Your Credit Score?

The very first thing that you can do to improve your credit score right now is to answer the question: do you have a credit card? If the answer is no, I highly recommend that you apply for one immediately. If your credit score isn’t well-established, look at a secure credit card or become an authorized user on a spouse’s or parent’s account, but no matter what find a way to start building your credit. Every day you wait to get one, is one less day you have to build your credit score. Once you have a credit card, always pay your bill on time (preferably in full). The same goes for any utility bills, rent, or other loan payments because not paying any of these will also adversely affect your credit score. From there slowly diversify your credit. Apply for a couple more cards as the months or years go on to build your credit portfolio and get more credit accounts on your credit report.  credit score 01

Another great way is always monitor your credit score. Know what is bringing your score down and what is raising it. This will help you to identify where you need to focus your efforts in improving it. In addition, the quicker you can detect major fluctuations the better. Many times people will have things appear on their credit report that do not belong like a utility company accidently reporting a missed payment even though you moved away months ago or an authorized account opened due to identity theft. Any negative remarks on a credit report, especially ones that should not be there, only get worse with time. The quicker you address them, the better chance they will have less of a lasting impact on your overall credit score.

Conclusion

Whether you like it or not, your credit score is a very important number that can affect many different aspects of your life. Taking the right steps today to ensure you have a good credit score for tomorrow is immensely beneficial. Mortgage interest rates will be lower, better credit cards will be attainable, and applying for any type of loan will be much easier. If you find yourself with a low credit score or even just starting out as a young adult with no credit history, be patient. Things won’t change overnight, but what you do on a day to day basis will matter and make a difference in the long run. It will take time but with the right steps before you know it you will be where you need to be with your credit score.

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