What is a credit score?
A credit score is a number that represents “creditworthiness.” Lenders use scores to determine who to lend to and under what terms according to their institution’s policies and risk tolerance. Credit scores are primarily tabulated through different algorithms by credit bureaus. The most well-known of these are Equifax, Experian and TransUnion.
A credit score ranges from 300 to 850, with a higher score signaling less risk for financial institutions. Good credit scores tend to come with better interest rates, more favorable terms and other exclusive perks. Depending on where you’re at in life, changing circumstances may affect the way you handle credit.
How is your credit score calculated?
Credit score calculations follow similar methodologies, but scores can vary widely from one source to the next. The discrepancy between scores comes down to different algorithms. Some calculations put more weight on different elements of the score, and each source may have different criteria for what information to consider within their calculation. There are five core components to any credit score: payment history, debt owed, length of credit history, types of credit and new credit.
Payment history. Consistently making payments on time will positively impact credit scores. Late payments can have an ongoing negative impact. Making a payment after the due date will not necessarily result in a “missed payment” noted on your credit report. Each lender has a policy in place for determining when to report missed payments to the credit bureaus. Be sure to read the terms and conditions from your lender to understand when a missed payment may result in a negative impact on your credit.
Debt owed. Most bureaus look at your debt to income ratio. If you have a lot of income, you can have more debt without it lowering your score.
However, the process is more complicated when you borrow money to make money. Debt that can increase revenue—including some types of property loans and many types of business loans—can actually improve your credit score, even though it raises your total liabilities.
The third factor here is your credit utilization ratio. It’s good to have available credit that you don’t use. That suggests that you borrow responsibly and keep the amount of credit you’re using lower than how much you have access to.
Length of Credit
Length of credit refers to how long you have had a particular line of credit. This accounts for 15 percent of your score (on average), and the premise is that having a longstanding line of credit is a sign that you are a reliable borrower. If you got a credit card 20 years ago and it’s still active, it will raise your score. Brand new lines of credit will typically lower your score, but as time goes on, the score will go back up.
Keep in mind that a line of credit does not have to incur a debt to positively impact this part of your score. Just having a credit card is good enough. It doesn’t need to carry a balance.
Types of Credit
Types of credit are usually tied to around 10 percent of your score. The idea is that not all types of credit are the same. Loans that develop equity (like a mortgage) are better for your score than loans that simply carry a balance and drain money (like credit cards).
New credit is also usually around 10 percent of the total score. It can apply to newly acquired credit, but more often it will reflect credit inquiries. When you apply for a loan (or a credit card), a formal credit inquiry will take place. Having too many of those inquiries in a short time can harm your credit, especially if you are applying for different types of loans at the same time (such as applying for a car loan, credit card, and a mortgage all at once). The good news is that they fall off automatically after two years.
How do you get a good score?
- Pay on time. This may seem obvious, but just by paying all of your bills on time, 35 percent of your credit score will be positive.
- Work on your debt to income ratio. The easiest way to improve this is to avoid using credit cards to pay bills as much as possible. This will lower your liabilities without changing your income. Also, when paying debts, focus on the highest interest debt first. That prevents your liabilities from growing due to interest.
- Keep lines of credit open. If you have old credit cards, keep them open. Remember, you do not have to carry a balance on those cards. You simply need the accounts to stay open for them to help your credit score.
- Strategize borrowing. You don’t always get to choose when you have to borrow money, but as much as possible, your existing debt should be in service to a gain in assets. For example, it’s better to take your time paying down your mortgage and rush payments to credit cards.
- Limit credit inquiries. There are typically two ways that credit inquiries get out of hand. One is when you get denied a loan and have to try again with another lender. In these cases, try increasing existing lines of credit first. Also, try looking for alternatives to a loan, like government assistance programs. The other frequent problem is fraud. If you ever have a fraudulent inquiry on your credit report, notify the authorities right away and work with the bureaus to ensure the fraud is resolved.
Make your credit work for you
Your life will change in many ways over the years, and your credit score (and report) will change along with you. Checking your credit report regularly and knowing how to maintain a good credit score can help you when you reach life’s big milestones, like your first home purchase or retirement. Learn more about maintaining good credit, understanding credit reports, and more here.