No matter where you are in your financial journey, your credit score is a figure you should understand. Because your credit score determines whether you’ll get approved for a loan or credit card and, ultimately, what interest rates you pay on those loans and credit cards (in general, the higher the credit score, the lower the interest rate), it’s important to understand how your score is calculated.
Credit scores typically range from 300 to 850 and the higher the score, the better. There are five key factors that credit bureaus consider in calculating credit scores. These factors can (and usually do) change from month to month. This information will help you not only understand why your score is changing but also what you can do to improve your score.
Here are the five key factors, along with some valuable information on each and just how much each factor accounts for your overall score.
1. Payment History: 35%
Your payment history (whether or not you’ve consistently paid all your bills on time, over time) is the number one factor in determining your credit score. In fact, it makes up 35% of your overall score. Before loaning you money, lenders want to know how likely you are to pay it back. To figure this out, your credit score takes into account:
- Whether you pay your bills on time for every account you own;
- If you do occasionally pay your bills late, how late you generally are (the later you are, the more negatively your score will be affected);
- When you missed a payment or made a late payment (the longer ago this was, the less effect it will have on your score);
- Whether any of your accounts have been sent to collections; and
- Whether you have any bankruptcies, liens or anything of this nature attached to any of your accounts.
2. Credit Utilization: 30%
How much debt you have compared to your amount of available credit is called your credit utilization ratio. This makes up 30% of your credit score.
There is no exact number, but it is recommended that you use no more than 30% of your available credit to keep your credit utilization low and, in turn, your credit score high. This means that if you have available credit of $10,000 across all your credit cards, you should aim to have an outstanding balance of no more than $3,000 across all your cards at any time.
Other than keeping your spending low, another way to lower your utilization is to pursue credit card consolidation to pay off your debts. There are a few credit card consolidation options, like taking out a loan to pay off your credit cards, which could actually cause your utilization ratio to decrease and your credit score, in turn, to increase.
3. Length of Time You’ve Had Credit: 15%
15% of your credit score is determined by the length of time you’ve had credit – and generally speaking, the longer, the better. You might have heard the advice to keep old accounts open, even if you infrequently use them. This is the reason. If you have an old credit card account, it’s age alone will help to boost your credit score.
If you do decide to close an old account, for example, if it carries a large annual fee, your credit score might decrease. Before closing any cards, weigh the positive factor (no more annual fee) with the negative one (a decrease in your credit score) to make your decision.
Don’t worry if you are new to credit and only have recently-opened accounts. Over time, if you keep your accounts open and consistently pay your bills on time, the length of your credit history will naturally increase along with your credit score.
4. New Credit: 10%
The number of new accounts you’ve opened comprises about 10% of your credit score. Your credit score is impacted by both 1) how recently you opened an account and 2) the number of accounts you’ve recently opened.
Every time you apply for new credit, your lender will perform a “hard inquiry” on you, checking your credit information. Hard inquiries show up on your credit report and negatively influence your credit score. However, only hard inquiries made within the previous twelve months factor into your credit score, so any decline in your score will rebound within that time if no further hard inquiries are made.
5. Types of Credit: 10%
Finally, the types of credit you carry account for 10% of your total score. The greater the mix of credit, such as installment loans (like a monthly car payment), store accounts, and credit cards, the higher your score.
While it is best to have a mix of different types of accounts, it’s generally not advisable to open new accounts just to increase this mix. Over time, you’ll likely open up accounts of varying types and your credit score will naturally increase with the opening of these accounts.
Credit score vs Financial Freedom
Keep in mind that while maintaining your credit score is important, having financial freedom is more important than anything else. Don’t get caught up in trying to maintain a high credit score while risking your financial freedom. If you need to review your financial situation to see if you would benefit from Credit Card Consolidation or Debt Consolidation feel free to contact us for a free consultation. Remember, we have 30 years of combined experience in helping people gain financial freedom and we can help you too.