A common saying tells us that our credit score is the only grade that matters after we graduate from school. It is used for new credit, mortgage loans, phone accounts, job applications, and even dating. If it is so important, it is a good idea that you understand it.
What is a Credit Score?
A credit score is a number between 300 and 850 that tells a lender if you have been responsible with past credit. An “excellent” score is generally a score that starts around 720-740 and above. Between 680-720 you are considered to have a “good” score. 620-680 is an “average” score. Below that, you have either a low, bad, or poor score and will have trouble getting new loans or credit.
The credit score is also called a FICO score, named for the Fair Issac Corporation, the company that developed the credit scoring system. Your score is generally reported by one of three credit bureaus, TransUnion, Equifax, or Experian.
What Goes Into My Credit Score?
Payment History – 35% of credit score
The single most important factor in your credit score is making on-time payments. If you pay any credit account late, the bank can report it to a credit agency. I wouldn’t suggest playing with fire, but most do not report a payment as late until 30 days.
After that, your account will certainly show your late payment. Being 30 days, 60 days, or 90+ days late on a credit or loan payment will have a big impact on your credit score. Be smart and pay on time.
Collections, public records, foreclosures, and bankruptcies impact this portion of your score calculation.
Outstanding Debt – 30% of credit score
We all have credit cards. (If you don’t, you really should have at least one.) We don’t all carry balances. How much debt is sitting on your credit cards, or any revolving debt, has the second biggest impact on your credit.
To calculate this portion of your credit score, the credit agencies calculate your credit utilization ratio. To calculate your ratio, add up the limit of all of your credit cards. If you have 3 cards with a limit of $5,000, $7,000, and $1,500, your total limit is $13,500.
Next, add up your total balance on all of your revolving credit accounts (don’t include installment loans like a car loan, student loan, or mortgage). If you have balances of $500, $200, and $0 on those three accounts, your total balance in $700.
Last, divide your total balance by your total limit to calculate the utilization percentage. In this example, your credit utilization ratio would be 5%. The lower your number, the better your credit score. Over 20-25%, your score will suffer and you will have a tough time getting new credit.
Keeping a small balance to raise your score IS A MYTH. Having a utilization of 0% is the best way to keep a high credit score.
Length of Credit History – 15% of credit score
The average length of time your credit accounts is open makes up 15% of your score. Take the total number of months all accounts have been open and divide by the number of accounts to find your average. This calculation includes all accounts closed within the last seven years, so closing accounts quickly will lower your credit score.
My average age of credit is currently 3 years and 5 months. Having an average age of credit over 8 years is ideal, but difficult for young people.
New Credit – 10% of credit score
Applying for new credit gives you a “hard hit” on your credit report. Getting new credit both lowers your average age of credit and increases your new credit. That will lower your score.
If you are in the market for a new home or car loan in the near future, avoid all new credit to ensure your score does not suffer.
Credit Mix – 10% of credit score
When I got my mortgage loan in 2011, my credit score went up more than ten points! Why? Because I added a loan that indicates a stable and responsible borrower. If you only have credit cards, you are considered a riskier borrower than someone with installment loans as well.
Adding a car loan does not help you a whole lot, but adding a conforming mortgage can help bump up your score a lot. Of course, that doesn’t mean you should buy a house to help your credit, your credit should help when you decide to buy a house.
Why Does My Credit Score Matter?
Your credit score will help underwriters determine whether you are credit worth for a new loan or line of credit. It will also impact your interest rate. Better scores help people qualify for the best interest rates available.
If you want a new mortgage loan, for example, your credit score may tell a bank that you don’t qualify at all. If you do, you may be able to save tens of thousands of dollars, or more, in interested depending on your score.
How Can I Make My Credit Score Better?
YES! You can make your score better. To increase your score, I suggest closing all of your revolving credit accounts with negative information and keeping your accounts with a perfect history open. After seven years, the bad information will drop off and your good information will stay.
Don’t apply for lots of new credit if you want your score to go up. Patience and time will fix it. Also, make sure to dispute inaccurate negative information on your credit report. You can get a free credit report annually by law.
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Originally published Oct 16, 2008. Updated January 11, 2013.