Previously, I’ve shared the importance of saving money to assist with getting started on the road to financial freedom and living within means without feeling too restricted. This month, I’ll be detailing the importance of your credit score and the factors that can impact your score. As a matter of fact, the topic of credit is so important I have to break it up into two segments so I don’t overwhelm you with information! I’ll provide an introduction and overview this month. This will help you gain an understanding of the report.
So, what is in a credit score? A credit score is a three-digit number used by financial institutions to evaluate your creditworthiness, or the likelihood that you’ll pay back your debts. When a consumer applies for a credit card, mortgage, student loan, auto loan or other line of credit, a lender usually pulls a credit score to help the lender decide whether or not to extend credit.
Your credit score plays a pivotal role in your financial journey. As far as numbers go, it’s one of the most important digits that’ll ever be attached to your name. Here are some key aspects of your life it could impact:
Whether or not you’re approved for credit. Many people scorn credit, but the simple fact of the matter is that in most situations, your credit score is a deciding factor in whether you’ll be approved for a mortgage, car loan, credit card or another type of loan. Lenders want to be paid back, so if your score indicates that you’re an unreliable borrower, you may not get the credit you need. And although there are loans available to those with weaker (or no) credit, you probably don’t want to rely on payday loans, pawn shop loans or other loans with sky-high interest rates and fat fees.
How much you pay in interest. Want to save a lot of money? Improving your credit health can help you qualify for the best rates and terms. It may sound simple or too good to be true, but the higher your score, the less interest you’re likely to pay each month and overall.
Did you know that if you have a credit score of 650 and get a 30-year, $400,000 mortgage, you could pay over $70,000 more in interest than someone with a 750 credit score and the same mortgage? That’s huge! Forget clipping coupons– your credit score probably has the most potential to save or cost you your hard-earned money.
Other factors. If you don’t plan on applying for credit in the near future, you may think that your score isn’t that important. However, your score doesn’t just affect your ability to get favorable loans and great credit cards. If you’re looking for an apartment, your score may impact your probability of getting approved, the size of your security deposit and how much you pay in fees. It can also impact how much you pay for home and auto insurance and might even decide whether you’re approved for a new cell phone plan. Clearly people other than lenders care about your credit score– and you should too!
There are six key credit-influencing factors that are commonly used in calculating your credit score, although the actual credit score number may differ depending on which credit bureau (Equifax, Experian or TransUnion) pulls the information and what kind of credit score model is used.
Here are the six main factors and how they can impact your credit score.
- Credit Card Utilization – High Impact
Lenders generally like to see that you aren’t using too much of your available credit. The more credit you use, the harder it may be to pay back.
Calculation: Total Credit Card Balance ÷ Total Credit Card Limit = Credit Card Utilization
Lenders often look at how much of your available credit you’re using when determining whether you use credit responsibly. A good rule of thumb is to use your credit, but keep your utilization to less than 30% of your limit. You can start building your credit history by opening a secured credit card and keeping a low balance. If you’re in good standing with your creditor, consider asking for a credit limit increase on one of your credit cards. This could help you keep your utilization rate low.
- Payment History – High Impact
Your percentage of on-time payments represents how often you make payments on time. Lenders often look at your on-time payment history to determine whether you’re likely to make future payments on time. It’s often a heavily weighted factor in calculating a credit score, so just one or two late payments could significantly affect your score.
Calculation: On Time Payments ÷ Total Payments = On Time Payment Percentage
If you haven’t already, set up automatic bill pay to make monthly payments more convenient.
- Derogatory Marks – High Impact
Derogatory marks may include accounts in collections, bankruptcy, foreclosure or tax liens and can severely impact your score. Check that this collections account is accurate. If it isn’t, you could file a dispute with the credit bureaus. Focus on areas of your credit that you can build while you wait for derogatory marks to fall off your report. Derogatory marks typically take seven to ten years to clear from credit history, and they generally cannot be removed earlier. A derogatory mark could severely influence your chances of getting approved for credit; it indicates to a lender that you may have significantly mismanaged credit in the past.
Calculation: Open Accounts in Collections + Negative Public Records = Total Derogatory Marks
- Age of Credit History – Medium Impact
The longer you responsibly manage credit, the more you demonstrate your creditworthiness to lenders. This factor averages the ages of your open credit cards, mortgages, auto loans, student loans and other lines of credit on your credit report. If your credit history is lengthy, lenders have more information to accurately assess creditworthiness. It’s also frequently an indication that you have been able to successfully manage your credit. For this reason, closing your oldest credit card account is typically ill-advised. It will shorten the average length of your open credit lines and reduce your available credit, possibly increasing your credit utilization rate. Think carefully about when you may want to close an old credit card account, and when you may want to avoid doing so.
Calculation: Age of credit history is the average age of your open credit accounts.
Use your older cards regularly to make sure the issuer doesn’t close them due to inactivity. Remember to pay them off though!
If you’re considering closing a credit card that charges an annual fee, first contact your bank to see if they’ll waive it.
Consider becoming an authorized user or joint account holder on someone else’s account to help build your credit.
- Total Accounts – Low Impact
This credit score factor totals up your number of credit cards, auto and student loans, mortgages and other lines of credit. Consumers with a higher number of credit accounts generally have better credit scores, since they’ve been approved for credit by more lenders. Also, having various types of credit–both revolving and installment–on your profile can positively contribute to your creditworthiness. However, it’s typically not recommended to open several new lines of credit simply to increase your total number of credit accounts. This factor of your credit score is usually weighed less heavily than the rest. If you are in the market to apply for new credit, make sure you first read reviews and research which product is right for you. Lenders generally like seeing several (and varying) accounts on your report because it shows that other lenders have trusted you with credit.
Calculation: Open accounts + Closed accounts = Total Accounts
Focus on keeping your current accounts in good standing. If you don’t need more credit, it’s often not worth the risk of creating additional debt by opening more accounts.
- Credit Inquiries – Low Impact
The final factor commonly used in your credit score is your total number of hard credit inquiries. Applying for a new line of credit will generally result in a hard inquiry. A lot of hard inquiries on your report may suggest that you’re desperate for credit or aren’t getting approved by other lenders. Hard inquiries occur when a financial institution, such as a lender or credit card issuer, checks your credit in order to decide whether to approve you for a loan or credit card. A hard inquiry may occur when you apply for any of the following:
One hard inquiry could negatively affect your credit score by a few points, but the effect typically will begin to lessen after a couple of months. Multiple hard inquiries generally will more significantly impact your credit score, and can communicate to lenders that you are desperate for credit or are unable to qualify for credit. For this reason, it’s a good idea to avoid applying for several lines of credit at once. Review your TransUnion and Equifax reports to check for unauthorized inquiries. See an inquiry that looks wrong? You could dispute it with the credit bureau.
Try to avoid unnecessary hard inquiries. See if you have any pre-qualified credit card offers before you apply so you’re less likely to get turned down.
It’s important to know that, while some of these factors are weighted more heavily than others, no one factor works independently of the others. Each one can contribute to your overall credit score. Now that you have gained an understanding of the factors in determining your credit score, next month we’ll focus on credit repair, how often your score changes, when to pay off debt, and potential credit effects.