Understanding credit scores
A credit score is a number that summarizes your credit history and reflects your creditworthiness. It is based on information from your credit report, which is a record of your past and current credit activities, such as how much debt you have, how often you pay your bills on time, and how long you have been using credit.
Credit scores range from 300 to 850, with higher scores indicating better credit. Different lenders may use different scoring models and criteria to evaluate your credit score, but the most widely used one is the FICO Score, which was created by the Fair Isaac Corporation.
Your credit score can affect many aspects of your financial life, such as:
- Whether you qualify for a loan or a credit card
- What interest rate and fees you will pay
- What credit limit you will get
- Whether you need a co-signer or a deposit
- Whether you can rent an apartment or get a cell phone plan
- Whether you can get a job or a security clearance
Therefore, it is important to understand how your credit score is calculated and how you can improve it. Here are some of the main factors that influence your credit score:
- Payment history: This is the most important factor, accounting for about 35% of your FICO Score. It shows whether you have paid your bills on time and if you have any delinquencies, collections, or bankruptcies. Paying your bills on time and in full every month is the best way to boost your payment history.
- Credit utilization: This is the second most important factor, accounting for about 30% of your FICO Score. It shows how much of your available credit you are using. For example, if you have a credit card with a $10,000 limit and a $2,000 balance, your credit utilization ratio is 20%. A lower ratio indicates that you are not overusing your credit and can manage your debt well. A good rule of thumb is to keep your credit utilization below 30% on each card and across all cards.
- Length of credit history: This factor accounts for about 15% of your FICO Score. It shows how long you have been using credit and how old your accounts are. A longer credit history indicates that you have more experience and stability with credit. However, this does not mean that you should keep old accounts open that you do not use anymore, as this may lower your credit utilization ratio and increase your risk of identity theft.
- Credit mix: This factor accounts for about 10% of your FICO Score. It shows the diversity of your credit portfolio, such as how many types of credit accounts you have, such as mortgages, car loans, student loans, credit cards, etc. A more varied credit mix indicates that you can handle different kinds of debt and payments. However, this does not mean that you should open new accounts just to improve your credit mix, as this may lower your average account age and generate hard inquiries on your credit report.
- New credit: This factor accounts for about 10% of your FICO Score. It shows how many new accounts or inquiries you have made in the past 12 months. A hard inquiry occurs when a lender checks your credit report when you apply for new credit. A soft inquiry occurs when you check your own credit report or when a lender pre-approves you for an offer. Hard inquiries can lower your score temporarily by a few points, while soft inquiries do not affect your score at all. A lot of new credit or inquiries may indicate that you are desperate for credit or taking on too much debt.
As you can see, there are many factors that affect your credit score and they are not all equally weighted. The best way to improve your credit score is to pay your bills on time and in full every month, keep your balances low relative to your limits, maintain a long and diverse credit history, and apply for new credit only when necessary.
By understanding how credit scores work and following these tips, you can build a strong credit profile that will help you achieve your financial goals.
Summary: A credit score is a number that reflects your creditworthiness and affects your financial life. Learn how it is calculated and how to improve it.
