What Goes Behind Your Credit Score?
There's a lot more to your credit score than just paying off your debts and not missing payments. Fifteen points out of
850 are the result of factors you can control, and each factor is worth some weight. So how much does it matter?
You'll find out all about that and other things going behind your credit score in this blog post!
The article discusses the importance of having a good credit score because people with a higher one can better their life by being able to borrow money without needing to put too much up as collateral or applying for loans onerous terms. It goes deeper into how lenders determine your credit score and provides links to a series of posts from the blogger's own blog on how you can improve your credit score.
Then, it discusses in greater detail some of the components of your credit score, so that you can figure out how to work on improving it.
The most important part of this discussion is understanding why each factor is weighted the way it is. The writer gives two reasons: The first one has to do with statistical probability—for example, if you have a car loan, then there's always a chance that you'll get into an accident or get your car stolen, which will have repercussions for your loan. So, the lender adds points to your score for having a car loan to offset the risk. The second reason has to do with preserving the lender's assets. If you have all of your credit cards maxed, then it increases the risk that you won't be able to pay them off and, therefore, that the bank will lose money. So, they add more points to your credit score for having more than a certain amount of debt on any card (typically 30% or less).
1. Credit Score Basics: How is Your Score Calculated?
All three major credit bureaus—Equifax, Experian and TransUnion—collect purchase data on you through something called a "credit report. "
Based on your credit report and on information from the credit bureau, a formula called the FICO score is used to determine your credit score. This is done for each of the three major credit bureaus ( Equifax, Experian and TransUnion).
Lenders use these three scores to help them assess your risk as a borrower. They take into account that people with high scores are generally more likely to pay off their debts.
For an overall score of 750 or higher, you're considered what's considered "excellent" as a borrower.
The chart below shows how lenders look at your score:
1. What's Your Payment History?
People who consistently make payments on time, especially when they're paying off a credit card, are seen as more reliable borrowers.
As you can see in the chart above, you get points for having a good payment history (and lose points if you have a bad one).
If your payment history accounts for 35% of your overall score, this means that having at least one late payment every year will knock off 100 points. This also means that if you pay off your credit cards every month and make payments on time, then this is worth the equivalent of at least 300 additional points!
2. What's Your Credit Balance?
Having a high credit balance (meaning that you have a lot of available credit) is also a factor in your credit score. The chart above shows the effect it has.
In theory, the more you have to borrow, the higher the risk of default because you could potentially go into debt over your available credit limit. Therefore, for every 100 points lost for having a large credit balance, lenders will add another 100 points.
3. What About Lines of Credit?
Another factor that affects your score is whether or not you have lines of credit, such as loans and mortgages with an above-average interest rate (over 10%).
4. How about Your Length of Credit History?
Your credit history is also a factor in your score. The longer you have a credit history, the higher your score is likely to be.
5. How Important Is Paying Off Credit Card Balances?
And what about all those pesky credit card balances that seem to haunt us every month? I bet you're paying at least some of those off every month! (Don't worry—I have a plan!)
The chart above shows the effect that paying that old debt down is going to have on your credit score.
If you pay $100 off your credit card balance every month and make no new purchases, this will add 100 points to your overall score.
6. And What about the Types of Credit You Have?
For example, if you have a car loan and any kind of student loan, your score is going to be affected differently for each one.
The chart above shows how it works for car loans. Having one has almost no impact on your score. However, having too many car loans can have a negative effect on your score (which, as shown in the second chart, could be as bad as having a late payment!).
Why? Because having multiple car loans exposes you to more risk of defaulting on payments because you're likely overextended. So, it affects your score negatively (it costs points).
7. How About Your Credit Card Usage?
The amount of debt that you have on each credit card affects your score—the more you owe on any particular card, the lower your score.
However, this is offset by the fact that you're probably paying down at least some of that debt either every month or every year. So, if you have multiple credit cards and only use them for emergencies, and then pay them off in full each month, then this won't cost you any points.
8. What about Your Credit Mix?
Finally, the last component of your score is how you use different types of credit. This is different than how much debt you're carrying.
There are two types of credit mix: "diversified" and "concentrated."
A diversified mix consists of a variety of different types of credit, such as student loans, home equity loans and car loans. A concentrated mix involves just a few different types of credit.
In theory, the more diverse your mix, the better it is for your score because it indicates that you have a wide range of options available to you when it comes to borrowing money.
Conclusion
There are many ways to improve your credit score, and this guide is just the beginning. I'll post more articles in the future listing further ways to improve your score.
However, if you follow this guide and take action immediately, you should see an improvement in your score within the next couple of months (6 months maximum).
One thing that I haven't mentioned yet is something called "payment history" on each card. The fact that you pay off these cards every month is going to count for a lot more than people think.