Credit Scores: How They’re Calculated + How to Improve Yours
What is a Credit Score?
A credit score is one major way of measuring how financially responsible we are. It determines our creditworthiness. It's a number that financial institutions, renters, and car dealers, along with many others, look at to determine whether or not we're a dependable candidate to pay back what we'll owe them on time. So, it needs to look good.
How is it Determined?
Your credit score number is calculated by FICO (Fair Isaac Corporation.) A credit score can range from 300 to 850. A score that falls somewhere between 660-680 is considered good, and one above 720 is great. So, how is this number calculated? It's based mostly on these five factors:
- Payment History [33% of total credit score]: FICO first looks at the history of any bill payments under your name. These include, but aren’t limited to, credit card and student loan payments, rent and utilities, car payments, and so on.
- Amounts Owed [30% of total credit score]: The amount of debt you have, or how much you owe on anything you're still paying off – student loans, mortgage, auto payments, etc.
- Length of Credit History [15% of total credit score]: This area is based on how long you've been building credit and how long each line of credit you've had has been open (along with how it's been handled.)
- New Credit [10% of total credit score]: New credit is a result of your credit score being viewed in order to approve or deny your request to take out more credit (think for a car or other kind of loan.) The more times it's looked into by certain lenders (like car dealers), the more hits your credit score takes. Having your credit score checked won’t damage your score entirely, but you'll want to keep checks to a minimum.
- Types of Credit [10% of total credit score]: This encompasses different kinds of credit tied to your name. For example, student loans and credit cards.
How Can I Build a Good One?
Now that you know how a credit score is calculated, here are a few steps you can take to start building (or improving) yours.
- Payment History: Pay your bills on time! Pay the minimum balance when it’s due – or even better, before the due date. No longer using your first credit card or two? Keep old cards open instead of closing them, even if they're not being used. This shows that you have credit card history. Even better, gradually increase the limits on these (especially your first credit card) instead of opening new ones for a higher score. Finally, even if you’re more than able, don't pay off loans right away. It might seem like the sooner you pay them off, the better, but having a 12-24 month span of paying off a loan looks better for your credit, as it shows that you’re financially stable.
- Amounts Owed: Combat outstanding debt by using only 30-40% of your credit card limit each month. Do not max it out! In other words, keep your balance low on revolving credit.
- Length of Credit History: Mom was right: It’s good to start building our credit history early! If you're already in your early twenties and are just getting started, though, that's okay, too. Again, one of the main things you can do is keep any credit lines you do have open instead of closing them. When opening new accounts, gradually increase their limits.
- New Credit: The more you can minimize the number times you're applying for credit, the better. Essentially, your credit will be lowered a little when hit by several "hard inquiries" - that is, when potential lenders (car dealers, mortgage lenders) look into your credit score. Try to get pre-approved for a loan just once by visiting your financial institution ahead of time to avoid multiple inquiries into your score.
- Types of Credit: - It's beneficial to have several different skills when applying for a job, and the same goes for having a mix of different types of credit tied to your name. One example: being able to show that you’re managing revolving credit (like credit cards) on top of installment credit (like paying on student loans.)
Whew! Make a little more sense now? We get it. Understanding what a credit score is, maintaining a good one, and improving yours can all be really confusing. But it's also really important for your financial future.
If you still have questions or need some advice, we can help! Get in touch with 3Rivers today.