A credit score is a number that lenders use to determine the risk of lending money to a given borrower. Credit card companies, auto dealerships and mortgage bankers are three common examples of types of lenders that will check your credit score before deciding how much they are willing to lend you and at what interest rate. Insurance companies, landlords and employers may also look at your credit score to see how financially responsible you are before issuing an insurance policy, renting out an apartment or giving you a job.
In this article, we'll explore the five biggest things that affect your score: what they are, how they affect your credit, and what it all means when you got to apply for a loan.
Your credit score shows whether you have a history of financial stability and responsible credit management. It can range from 300 to 850, but the higher the score, the better. Three credit agencies - Experian, Equifax and TransUnion - compile credit scores (also known as FICO scores) based on the information in your credit file. Each agency will report a slightly different score, but they should all paint a similar picture of your credit history.
Payment History - 35%
The most important component of your credit score looks at whether you can be trusted to repay money that is lent to you. This component of your score considers the following factors:
· Have you paid your bills on time for each and every account on your credit report? Paying bills late has a negative effect on your score.
· If you've paid late, how late were you - 30 days, 60 days, or 90+ days? The later you are, the worse it is for your score.
· Have any of your accounts gone to collections? This is a red flag to potential lenders that you might not pay them back.
• Do you have any charge offs, debt settlements, bankruptcies, foreclosures, suits, wage attachments, liens or judgments against you? These are some of the worst things to have on your credit report from a lender's perspective.
Amounts Owed - 30%
The second-most important component of your credit score is how much you owe. It looks at the following factors:
· How much of your total available credit have you used? Less is better, but owing a little bit can be better than owing nothing at all because lenders want to see that if you borrow money, you are responsible and financially stable enough to pay it back.
· How much do you owe on specific types of accounts, such as a mortgage, auto loans, credit cards and installment accounts? Credit scoring software likes to see that you have a mix of different types of credit and that you manage them all responsibly.
• How much do you owe in total, and how much do you owe compared to the original amount on installment accounts? Again, less is better.
Length of Credit History - 15%
Your credit score also takes into account how long you have been using credit. How many years have you been using credit for? How old is your oldest account, and what is the average age of all your accounts?
A long history is helpful (if it's not marred by late payments and other negative items), but a short history can be fine too as long as you've made your payments on time and don't owe too much.
New Credit - 10%
Your FICO score considers how many new accounts you have. It looks at how many new accounts you have applied for recently and when the last time you opened a new account was.
The score assumes that if you've opened several new accounts recently, you could be a greater credit risk; people tend to open new accounts when they are experiencing cash flow problems or planning to take on lots of new debt.
For example, when you apply for a mortgage, the lender will look at your total existing monthly debt obligations as part of determining how much mortgage you can afford. If you have recently opened several new credit cards, this might indicate that you are planning to make a bunch of purchases on credit in the near future, meaning that you might not be able to afford the monthly mortgage payment the lender has estimated you are capable of making. Lenders can't determine what to lend you based on something you might do, but they can use your credit score to gauge how much of a credit risk you might be.
Types of Credit In Use - 10%
The final thing the FICO formula considers in determining your credit score is whether you have a mix of different types of credit, such as credit cards, store accounts, installment loans and mortgages. It also looks at how many total accounts you have. Since this is a small component of your score, don't worry if you don't have accounts in each of these categories, and don't open new accounts just to increase your mix of credit types.
What Isn't In Your Score
The following information about you is not reported to credit bureaus and is not reflected in your credit score:
· Marital status
· Receipt of public assistance
· Employment history
· Rental agreements
• Participation in a credit counseling program
What It All Means When You Apply for a Loan
Following the guidelines below will help you maintain a good score or improve your credit score:
· Watch your credit utilization ratio. Keep credit card balances below 15-25% of your total available credit.
· Pay your accounts on time, and if you have to be late, don't be more than 30 days late.
· Don't open lots of new accounts all at once
· Check your credit score about six months in advance if you plan to make a major purchase that will require you to take out a loan, like buying a house or a car. This will give you time to correct any possible errors and, if necessary, improve your score.
• If you have a bad credit score and lots of flaws in your credit history, don't despair. Just start making better choices and you'll see gradual improvements in your score as the negative items in your history become older.
The Bottom Line
While your credit score is extremely important in getting approved for loans and getting the best interest rates available, you don't need to obsess over the scoring guidelines to have the kind of score that lenders want to see. In general, if you manage your credit responsibly, your score will shine.