February 9, 2022 – Your credit score is a number between 300 and 850 that “predicts” how likely it is that you will pay back a loan on time. The higher the score, the better you look to a potential lender. Anytime you borrow money, whether it be a mortgage, student loan, credit card, auto loan, or lease, the lender reports all transactions (borrowing and payments) to credit agencies. This credit reporting provides data to credit scoring models that determine your credit score. You are considered a “bad credit risk” if your credit score is below 580. While scores between 740 and 799 are considered very good. With a score of 800 or higher, you would be regarded as an excellent candidate to receive credit.
Why is having a good credit score important?
You can survive with bad credit, but it’s not always easy and it’s definitely not cheap. Here are some of the great benefits of having a good credit score:
- Lower interest rates on loans and credit cards.
- Better chance to get approved for a loan or credit card.
- More power to negotiate better rates and loan amounts.
- Better car insurance rates – auto insurers use credit scores to predict insurance risk.
- Avoid security deposits on cell phones and utilities.
- Bragging rights, something to be proud of.
What factors affect your credit score?
Most Important: Payment History
Your payment history is one of the most important factors and can significantly impact your credit score. One missed payment can impact the score despite a long history of on-time payments. The effect of late payments can increase the longer a bill goes unpaid. If you get a late notice, pay immediately – sometimes, there is a grace period before reporting. Never let the payment go to a collection agency, even if you try to resolve a dispute. If there is a disputed charge on your credit card, report it to the bank and let them help you solve the issue.
Very Important: Credit Usage
Credit usage is also an important factor and one that you can control and change quickly. The amount you owe on installment loans (personal loans, mortgage, student loan, auto loan) is part of the equation. But even more important is your credit utilization rate.
Your utilization rate is the ratio between the total balance you owe and your total credit limit on all your revolving accounts (credit cards and lines of credit). A lower utilization rate is better for your credit scores. Maxing out your credit cards or leaving part of your balance unpaid can hurt your scores by increasing your utilization rate. This is why paying off a student loan, or a mortgage can negatively affect your credit score over the short term.
But utilization rates on individual accounts can also affect your credit scores. This means you should pay attention to your overall credit utilization and the utilization of unique credit cards. Having a lot of accounts with balances might indicate that you’re a riskier bet for a lender.
Keep in mind that you can pay your bill in full each month and still appear to have a high utilization rate. The calculation uses the balance that your credit card issuers report to the credit bureaus, often around the time it sends you your monthly statement. You may have to make early payments throughout your billing cycle if you want to use a lot of credit and maintain a low utilization rate
Somewhat Important: Length of Credit History
A variety of factors related to the length of your credit history can affect your credit, including the following:
- The age of your oldest account
- The age of your newest account
- The average age of your accounts
- Whether you’ve used an account recently
Opening new accounts could lower your average age of accounts, which may hurt your scores. But the hit to your scores could also be more than offset by reducing your utilization rate and increasing your total credit limit, making sure to make on-time payments to the new card, and adding to your credit mix.
Closed accounts can stay on your credit reports for up to 10 years and increase the average age of your accounts during that time. Once closed accounts drop off your credit reports, the average age of your accounts could be lowered and hurt your scores. The impact could be more significant if the accounts were some of your oldest.
Somewhat Important: Credit Mix and Types
Having experience with different types of credit, like revolving credit card accounts and installment student loans, may help your credit health. But as this has a minor impact, I would not suggest that you take a new loan to add to your credit mix. Rather, consider having a credit card to add to your mix and improve your credit utilization ratio.
Less Important: Recent Credit
We all have waited while a store checks your credit to open up a new credit card account (to get another 10% one-time discount). A record of this “credit inquiry” can stay on your credit reports for up to two years.
Like those that come from checking your own scores and some loan or credit card prequalifications, soft inquiries don’t hurt your scores.
However, hard inquiries before a lending decision can hurt your scores even if you don’t get approved for the credit card or loan. Often, a single hard inquiry will have a minor effect. Unless there are other negative marks, your scores could recover, or even rise, within a few months.
The impact of a hard inquiry may be more significant if you’re new to credit, and it can also be greater if you have many hard queries during a short period.
That said, don’t be afraid to shop for loans. We always recommend that clients compare their options. Multiple inquiries for certain types of loans, like mortgage loans, auto loans, and student loans, may only count as one inquiry. However, try to keep your “shopping” to a two-week period.
The Bottom Line
It is essential to know that you do not have just “one” credit score. There are many credit scores available to you, as well as to lenders. Any credit score depends on the data used to calculate it and may differ depending on the scoring model, the source of your credit history, the type of loan product, and even the day when it was calculated.
Most banks now offer “free” credit score information sourced from one of the credit agencies (get ready for advertising). This will give you a sense of your credit score, and you could assess your creditworthiness and ways to improve your scores from the information provided above.