The credit score is a number derived from information about your credit history. Lenders, such as auto dealerships, credit card companies, mortgage bankers, and more use this number to determine how reliable you are and how risky the loan it will be to them.
It is important to have a good credit score as it will signify that you are financially responsible and that your life is on the right track. It can also drastically reduce the rate of interest for new loans or even allow you to be able to rent your perfect place, as some landlords may perform credit checks!
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How Your Score Is Determined
Your credit score can range from 300 to 850 and since we want to have a good credit score, the higher the score, the better it will be.
The five factors that affect your credit score are:
- Payment History (35%)
- Amount Owed (30%)
- Credit History (15%)
- New Credit (10%)
- Types of Credit (10%)
Payment History: 35%
The most important factor of your credit score is your Payment history as it is 35% of your score. This is pretty self-explanatory and is largely dependent on how often you pay on time for your loans. If you have late payments or even loans in collections, it will hurt your score a lot.
Amount Owed: 30%
The second biggest component of your credit score is how much you owe or how much credit is being used out of your given credit line. Personally, I like to call it “Credit Utilization” instead.
The general guideline is to never go over 30% of your total credit limit.
For example, if you have a credit line of $1,000, using any balance above $300 could hurt your credit score.
Now if you have a credit line of $100,000, using anywhere from $0 to $30,000 would not hurt your score as it is below 30% of your total credit limit.
The same guideline applies to each individual credit line you own as well.
So if you have two cards with a credit limit of $10,000 each, it is recommended to use only up to $3,000 on each card, giving you a total of $6,000.
You can increase your total credit limit to decrease your credit utilization by calling the banker and asking for a credit limit increase. Alternatively, you could also apply for new cards and increase your total credit limit with the newly added card’s credit limit.
At the same time, if you close a credit card, your total credit limit and utilization ratio will decrease and your credit score will drop.
It is recommended to pay off your balances to reduce your utilization ratio before applying for new cards as credit bureaus will see a lower utilization ratio and there will be a higher chance of approval.
Credit History: 15%
Coming in third is your credit history, which makes up 15% of your credit score.
Your credit history takes account the average age of all of your accounts and the lower the average age, the lower your credit score will be. Generally speaking, a longer credit history will yield a higher credit score.
To calculate the average age of all your accounts, you would simply total up the amount of years held for all accounts and divide by how many you have.
For example, if you have a 10 year old credit card and a 4 year old credit card, then the average age of your credit cards would be 7 years ((10 + 4)/2 = 14/2 = 7) .
Types of Credit: 10%
The fourth component are the types of credit reported in your credit information. These types of credits can be student loans, auto loans, mortgages, etc.
The more types of credit you have, the better you score will be. As this is a small part of your credit score, don’t open up new accounts to increase your credit types and instead focus on the larger factors like Payment History, Amount Owed, and Credit History.
New Credit: 10%
Last, but not least, there is New Credit, which affects 10% of your credit score. This is how many accounts you have recently applied for and when they were opened.
Every time you open a new account (auto loan, mortgage, credit card, etc), the lender will check your credit and you will obtain a hard inquiry on your credit report. The lower the amount of inquiries on your credit history, the higher your credit score will be.
The good thing about hard inquiries are that they stop factoring into your score after one year and completely fall off your report within two years.
The bad thing is that too many hard inquiries will make it harder for you to get approved for new credit cards, loans, etc. You should plan accordingly when considering applying for new loans, as a high number of hard inquiries may lead the lender to give you a higher interest rate loan.
Keep in mind that while inquiries are important, there are other factors that banks look at while considering your loan application.
Check Your Credit Score For Free
In today’s age, there are many free ways to check your credit score. Credit card companies, such as American Express, Bank of America, etc, offer free credit score services that accompany their credit cards. An example of a credit card that does this is Discover’s Free Credit Scorecard.
Furthermore, you can get a free report every year from each of the three credit bureaus (Transunion, Equifax, and Experian) at annualcreditreport.com. I don’t recommend getting any of the add-ons, the primary goal is to just get your free credit report and score.
Having a good credit score is crucial for getting approved for loans and receiving the best interest rates available, but it is not something that needs to be obsessed over.
As long as you manage your finances and credit responsibly, your score will increase and will be great overtime.
Finally, keep in mind that your credit score may differ among the credit bureaus
What do you guys think? How is your credit situation? What do you do to check your credit score and do you have any cool tips to share?
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