Key factors affecting your credit score
We have all heard the term “credit score” and know it’s good for that number be as high as possible. You know it’s important but do you know what factors make up your credit score? In this post I will go over the 5 factors that go in to that 3 digit number that plays such a big role in some of life’s biggest financial decisions.
Before we get in to what those 5 factors are let’s take a step back and see where the credit score came from. There are multiple credit-scoring systems out there, but the most widely used and accepted is the FICO score. The FICO score was created in 1989 by a tech company named Fair, Isaac, and COmpany in coordination with the 3 credit reporting agencies - Equifax, Experian and TransUnion- which are still around today. These reporting agencies needed a way to find the creditworthiness (i.e. how likely a borrower is to pay back a loan) of borrowers. The FICO score ranges from 300-850 and the higher your score, the more likely banks and institutions will be to lend you money.
Let’s make one thing clear: your credit score is NOT a direct reflection of your financial health; it is a reflection of how you manage debt. Theoretically you could make $1 million year, live well below your means, own your home outright, no car payment, but for some reason you consistently miss your credit card payment every month. In this scenario your credit score would be low because of how you are managing your debt payment.
5 Credit Score Factors
Payment History (35%): This is the big one making up 35% of your score. It is critical that you make payments on time every single month, even if it’s just the minimum. While paying the minimum is not a good long term strategy because you will continue to accrue interest on your balance, it will help keep things afloat while you get your finances in order.
If you are working to increase your credit score it will take about six months of on-time payments before you see a noticeable change in your score. To help ensure you don’t forget a payment, set up auto-pay.
Debt Utilization (30%): Debt utilization is a fancy way to say “how much of your available debt are you using”. Example - If you have a credit card that has a credit limit of $5,000 and you are carrying a balance of $2,500 then your debt utilization would be 50%.
Experts say to keep your utilization below 30%, the lower the percentage, the better your score will be. This is an area that should reflect fairly quickly on your credit score, so if you are working to improve your number this is a good place to start.
Length of Credit History (15%): Rod Griffin, director of public education at Experian, explains credit history as how long any given account has been reported open. Typically the longer you keep lines of credit open, the better it looks. So, if you have an old account you are considering closing, you may want to think twice. Consider closing an old account if you no longer use it and there is an annual fee or other administrative fees you are paying for. *Not only would cancelling an old account hurt your credit history, it would also lower your available credit, which increases your debt utilization*
Outside of keeping an older account open, there isn’t much you can do to improve your credit history. If you continue to use your available credit responsibly, over time your credit history will be a benefiting factor.
Credit Mix (10%): Having various types of credit (credit card, car loan, student loan) is also a benefit. While it is good to have some diversity in you credit history, it is a very small factor so don’t be tempted to take on more debt simply to increase your account types.
New Credit (10%): Whenever you apply for a new line of credit, there is a hard inquiry on your credit report. If you open several lines of credit in a short period of time, this is a red flag to the reporting agencies and your number will be affected. Try to avoid opening several lines of credit within a small window. Plan ahead and be smart about how and when you are opening accounts.
A good credit score can provide several benefits:
Better chance of getting approved for credit cards and loans…and lower interest rates on those accounts
Being approved for higher credit limits, resulting in lower debt utilization
Helpful when getting pre-approved for a home loan
Better car insurance rates
While these are beneficial, they can come at a cost if you are chasing a credit score and do not manage debt properly. It is far too easy to get caught up in credit cards and loans and lose control of what you are doing. Self awareness is critical when dealing with debt.
If you are debt averse and want to avoid a credit score all together, you can do that as well. Dave Ramsey proudly touts that he doesn’t have a credit score because he has no credit history. While this is possible, it does require a bit more hoops to jump through when applying for a home loan or renting certain apartments.
Regardless of how you view the credit score, whether you are trying to increase it as much as possible or have no credit score like Dave Ramsey, it’s important to make make any financial decisions with a long term mindset. The decisions we make today with our money will have a direct impact on our choices in the future.