Credit scores are one of the most essential yet least-understood aspects of personal finance, and it's crucial to understand what drives the rating system so you know what activities can make or break your credit profile.
Understanding Your Credit Score
Credit scores are one of the most essential yet least-understood aspects of personal finance. They play an important role from approvals for credit cards, loans, and mortgages to what your interest rate will be on those same loans. If you're looking to improve your credit score, it's crucial to understand what drives the rating system so you know what activities can make or break your credit profile.
What Is a Credit Score and Why Is It Important?
Your credit score, or FICO® score, is a number from 300 to 850 that represents your creditworthiness. The higher the number, the more likely you are to repay loans and other lines of credit on time and in full. Basically, suppose you have an 800+ credit score. In that case, lenders will view it as unlikely for you to default on debts, making them willing to give out loans with better rates than if the score was lower.
While your credit score helps determine your eligibility for different larger lending opportunities, like mortgages or car loans, there are other, lesser-known ways, credit scores are used that have an impact on the way you live and work. Those include:
- Employment (many employers run your credit with a background check and you may not get offered a new job if credit is bad.)
- Cell phone (your credit can affect plan rates and eligibility for certain phone plans)
- Utilities (in most cases you cannot be denied public utilities based on bad credit, but they can ask you to pay a deposit.)
- Insurance (credit scores can influence rates and eligibility for certain insurances.)
- Landlords (may not accept your lease application to rent a home if credit is poor, or, charge you a higher rental rate.)
- Government (can use your credit score to determine your ability to pay child support and determine if you have unreported income.)
How Is My Credit Score Calculated?
The most significant factors that affect your credit score are how much you owe and what types of credit accounts you have. Your payment history (how long it's been since payments were late or not made) also affects the overall number. But to a lesser degree than balance and type of account information.
This is because lenders want to know if you can afford to repay any debts on time before offering up their services. This means maintaining low balances will help immensely as well! For example, you'll be graded more favorably by creditors who see that you don't max out your cards regularly. Using just enough available credit can make all the difference in getting approved at better rates when applying for loans or other lines of credit down the line.
What Affects My Credit Score?
Several factors affect your credit score. These factors are broken down into these categories:
- Payment history (how many payments were late or not made)
- Length of credit history (how long have you had open credit lines)
- Types of credit in use (how much debt you have across all credit types, including home mortgages and student loans, etc.)
- Credit utilization ratio (the percentage of your available credit that you use monthly, for example, do you have one card with $100 in debt and another with an unlimited balance? The second one would be considered high risk because it is easy to max out instead of the first, which has limited usage.)
- Types of accounts held (what kind of account information does the lender see. Suppose you only have low-limit cards versus holding multiple lines of credit at higher limits. In that case, this could affect their perception about what kinds of risks they think you might present.)
Negative items on current or previous accounts (this includes late payments, defaults, and judgments against you, bankruptcies, and tax liens) can stay on your report for up to seven years, depending on the state where they occurred.
If there is derogatory information included in one of your credit reports, make sure to dispute it with the credit bureau. All these factors impact how your credit score is calculated and what it looks like.
How to Improve Your Credit Score
Let's face it. Sometimes life happens, and you miss a credit card payment or two. Given the uncertainty of the economy during COVID-19, some people have let certain debt payments slide to feed and house their families. Unfortunately, missed or late payments are reported to the credit bureaus, decreasing your credit score. Still, there are a few things you can do to get your credit back on track:
- Paying credit card balances in full and on time.
- Keeping your account balance below 50% of the credit limit for that account (this can show lenders you are maintaining a responsible level of credit utilization).
- Only applying for one or two new lines of credit at any given time, if possible. If this is not an option, make sure to wait until it's been six months since your most recent application before applying again.
While many elements contribute to how your score will be calculated, these simple steps may help improve your scores over time with positive changes in behavior.
Staying Up to Date on Your Credit
You can request a free copy of your credit report from each company Equifax, Experian, and TransUnion, once every 12 months by visiting AnnualCreditReport.com or calling (877) 322-8112 to order it over the phone.
You can also get your credit score online for free at FreeCreditReport.com. Or, if you want to constantly monitor your credit progress and receive helpful suggestions on how to improve your credit score, sign up for an account at Credit Karma. Free credit scores are just one small way you can reach your financial goals. Use these resources to stay on top of your personal financial information and treat it as a priority to maintain good scores.
Everyone has different economic backgrounds and lifestyles. You may not know your credit score, but it affects many aspects of your life. Knowing what factors affect your credit score is the best way to manage it and improve your overall financial situation. Being informed on your credit score, how your score is calculated, and how to repair and rebuild your credit will help you make better financial decisions and help you reach your life goals.
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