Have you ever wondered what actually makes up your credit score? Understanding each component that goes into calculating your credit score can not only help you make informed financial decisions but it can also give you peace of mind when you are trying to just begin your credit journey or are working to rebuild or maintain your credit score.
Your credit score, a three-digit number, is a critical metric lenders use to evaluate your creditworthiness. Let’s explore the key factors that impact your credit score, including length of credit history, payment history, credit utilization, types of credit used, and new credit inquiries.
1. Payment History
Your payment history constitutes the biggest portion of your credit score, accounting for 35%. This factor assesses whether you have paid past credit accounts on time. It includes:
- Timely Payments: Consistently paying your bills on or before the due date positively impacts your credit score. Late payments, on the other hand, can severely damage it.
- Delinquencies: Accounts that are overdue or in collections negatively affect your score—the more recent and frequent the delinquencies, the greater the impact.
- Bankruptcies and Defaults: Public records like bankruptcies and foreclosures are also considered. These can stay on your credit report for up to ten years and significantly lower your score.
2. Credit Utilization
The second biggest area, coming in at 30% of your credit score is credit utilization, and measures the amount of available credit you’re actively using.
You can find out your credit utilization ratio by dividing your total existing credit card balances by the amount of your total credit limits. For example, if you have a $4,000 balance on a card with a $12,000 limit, your credit utilization ratio is 33.33%.
Key points include:
- Low Utilization: A lower credit utilization ratio (generally below 30%) is preferable. It indicates that you don’t rely on your credit heavily.
- High Utilization: High utilization can signal financial distress, leading to a lower credit score.
3. Length of Credit History
Your credit history length contributes 15% to your credit score and reflects the duration you’ve been using credit. It includes:
- Age of Accounts: Older accounts can positively impact your score because they provide a longer track record of your credit management.
- Average Age: The average age of all your accounts is considered. Even if you open new accounts, maintaining older ones helps balance the average age.
- First Account: The date you opened your first credit account is a significant benchmark.
4. Types of Credit Used
Types of credit used, or credit mix, make up 10% of your credit score. It evaluates the variety of credit accounts you have, such as:
- Revolving Credit, which includes lines of credit and credit cards
- Installment Credit such as mortgages, car loans, and personal loans
A diverse credit mix can demonstrate your ability to responsibly manage different types of credit, which can positively affect your score. However, having each type of credit is unnecessary to achieve a high score.
5. New Credit Inquiries
The last 10% of your credit score is made up of new credit inquiries. This factor considers the number of recent credit inquiries and new accounts opened, which include:
- Hard Inquiries: When you apply for new credit, lenders perform a hard inquiry, which can temporarily lower your score. Several checks or inquiries within a short period can signal potential financial trouble.
- Soft Inquiries: This is when you check your own credit or when companies check your credit for pre-approval offers. Soft inquiries do not affect your score.
- New Accounts: Opening a bunch of brand new accounts quickly can lower your average account age and signal risk, negatively impacting your score.
Additional Considerations
While the above factors are the primary components of your credit score, a few additional considerations can influence it:
- Credit Limit Increases: Requesting higher credit limits can reduce your credit utilization ratio if your spending remains unchanged.
- Authorized User Status: Signing up to be an authorized user on someone else’s account can be either a positive or negative, depending on how that account is managed.
- Closed Accounts: Closing old accounts can reduce the average age of your credit history and can also increase your credit utilization ratio if you carry outstanding balances on other cards.
Strategies to Improve Your Credit Score
Improving your credit score will never happen overnight and requires a proactive approach, alongside consistent financial habits and at the end of the day, patience.
Here are some strategies:
- Pay Bills on Time: Set up reminders or automatic payments to ensure timely bill payment.
- Reduce Balances: Pay down existing credit card balances to lower your credit utilization ratio.
- Limit New Credit Applications: Avoid applying for multiple new credit accounts within a short period.
- Check Your Credit Report: Review your credit report regularly to discover errors and dispute any inaccuracies in a timely manner.
- Maintain Older Accounts: Keep your older accounts open to help with the average credit age.
Conclusion
Understanding how your credit score is calculated helps you manage and improve it effectively. Now, you are aware of all the different factors that play significant roles in determining your score.
By maintaining good financial habits and being mindful of these factors, you can achieve and maintain a strong credit score, enhancing your ability to secure favorable rates and terms on loans and other financial products.
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