By: Jennifer L. Lopez, Debt.com Financial Fitness Trainer
Many people know that having good credit is important, and that not paying your bills in a timely manner can cause you to end up with bad credit. But what actually makes up that three-digit number that determines your credit worthiness is more of a mystery. Today we are going to discuss your credit score decoded.
1. Payment History—This is an easy one. Credit is described as “the ability to obtain goods or services before payment, based on the trust that payment will be made in the future.” How do you find out if someone is trustworthy? You check out their previous history. Have they taken out previous loans and paid them? Do they make their payments on time? Have they ever been late 30, 60, 90+ days? Have they ever defaulted and failed to pay a debt? Your payment history is the #1 factor that affects your credit score, between 31- 35% depending on whom you ask. This explains why those who are new to using credit can have a low score, as they have not developed any payment history yet.
2. Credit Usage—This one involves seeing how you use your established credit. It can also be considered your debt ratio. They look at the credit lines that you have and how you use them. Do you not use them at all? Considered a negative. Do you use them and get close to or exceed the limits? A sign of irresponsible behavior. Do you have credit, use it sensibly, and then pay it back? This will contribute to a positive in this department. It is recommended that you never exceed 30% of your individual credit card limits, as well as no more than 30% of your total available credit on all accounts. Likewise, do not close accounts that you rarely use, as the change will lower your available credit, and affect your ratio adversely. Credit usage counts for about 30% of your total credit score, so always use responsibly.
3. Credit History—This involves the length of time that you have had open credit accounts. The longer that you have had an account open, the better. It also concerns the length of time since the account’s most recent activity. This unfortunate aspect makes it impossible for new credit users to have a perfect credit score, as they have not established a long-term credit history. Additionally, too many new accounts opened at the same time can issue a red flag, as it can suggest signs of financial distress or that you may be likely to overuse this newfound credit. Once again, do not close old credit card accounts that are in good standing; this will only wipe away part of your established positive credit history and lower your score. Credit history makes up 15% of your score.
4. Type of Accounts—This category looks at the type of credit lines that you have. It can also be called your “credit mix.” Revolving accounts allow consumers to borrow up to a limit, like credit cards. These are looked at more closely than other types of credit. It can also include installment accounts, like a mortgage, auto, or student loan, as well as monthly bills that you pay, like your gas and electric utility bills. They look at what different types of credit that you have, and how you manage them. The ability to handle a combination of different credit types is looked upon favorably. Your credit mix makes up about 14% of your total score.
5. Inquiries—This factor is the least considered, and can be rather tricky. Inquiries are simply times when your credit is pulled for review. It can be done by the credit reporting agency, yourself, potential lenders, current companies that you do business with, or for the purposes of employment. Some of these affect your credit, and some do not. A soft inquiry (or soft pull) does not affect your credit—this is what happens when you check your credit, a solicitor sends you a potential offer of credit, or an employer reviews your credit as part of a background check. However, a hard inquiry (or hard pull) does affect your credit adversely. When you apply for a new credit card or bank loan, they pull your credit, it gets listed on your credit report, and too many hard inquiries within a short length of time can pull down your credit score. Due to this, it is wise to avoid applying for numerous forms of credit at one time. Inquiries make up 10% of your credit score.
Decoding your credit score can help you to avoid taking actions that will negatively influence your score. The background knowledge can also provide you with a game plan of steps to take to actively increase your credit score. For tips on improving your credit score, check out this Debt.com article: “Practical Ways to Improve your Credit Score.”