Credit Score

What is a Credit Score 

A credit score is a three-digit number that rates your creditworthiness. It’s based on your credit history, which includes information like the number of accounts, total levels of debt, repayment history, and other factors. Lenders use credit scores to evaluate your creditworthiness, or the likelihood that you will repay loans in a timely manner.

Why Credit Score is important 

Credit scores are important because they determine whether you get loans and the rates you pay. They can affect your ability to rent an apartment, get a cell phone contract, and even influence certain job opportunities. A higher credit score can lead to better interest rates, which can save you money in the long term.

Different Types of Credit Scores 

The two main types of credit scores are FICO and VantageScore. Each uses a different model to calculate your score. There are also industry-specific FICO scores for things like auto loans and credit cards.

What are Credit Score Ranges 

Credit scores typically range from 300 to 850. Within that range, scores can usually be placed into one of five categories: poor, fair, good, very good, and excellent.

• Poor: This category typically includes scores that are significantly low. Borrowers in this range may face difficulty securing loans, and if they do, the interest rates are likely to be quite high.
• Fair: Borrowers in this range may secure loans, but the interest rates could still be relatively high.
• Good: Borrowers with good credit scores can usually secure loans with moderate interest rates.
• Very Good: Borrowers in this range are likely to get loans with lower interest rates.
• Excellent: Borrowers with excellent credit scores are likely to get the best available interest rates.

The range of credit scores and interest rates for each group changes often. But the higher your credit score, the lower your interest rates will usually be, which means thousands of dollars saved. Conversely, a lower score can lead to higher interest rates or outright loan rejections.

It’s important to note that even small differences in your credit score can have a significant impact on your interest rates. For example, if your score is just a few points below a higher tier, improving it could potentially bump you into that higher tier and qualify you for lower interest rates. Before making a major financing decision, always check your credit score.

How Credit Score is computed 

Credit scores are calculated based on five factors: payment history, amount owed, length of credit history, new credit, and credit mix. Each factor is weighted differently in the calculation of your overall score.

Payment History

Payment history is a crucial factor in determining your credit score. It’s a record of your payment behavior on all credit accounts, such as credit cards and loans. Here’s how it impacts your credit score:

1. Payment Information on Individual Accounts: This includes how timely your payments were on different products like credit cards, installment loans, and mortgage loans.
2. Public Records and Collections Items: This includes whether you have bankruptcies, accounts in collections, or lawsuits listed on your credit reports.
3. Details on Missed Payments: This includes how many days past due your payment was (30, 60, 90, etc.), the amount owed, how recently you missed payments, and how many missed payments you have.

Payment history accounts for 35% of what makes up your credit score. The extent to which it impacts your credit score depends on the severity of lateness, how recently a late payment was made, and how frequently you make late payments.

Late payments typically can go on your credit reports and affect your scores only if you are at least 30 days past due. After a late payment is reported, the later the payment—and the more recent the late payment—the greater the negative impact on your credit score.

Consistently making on-time payments is crucial because, it’s possible for a borrower’s credit score to drop up to 180 points after a late payment. Therefore, maintaining a strong payment history is a necessary part of building a healthy credit profile.

Amount Owed

The amount you owe, also known as your debt level, significantly impacts your credit score. It accounts for 30% of your credit score. Here’s how it works:

1. Total Debt: The total amount of debt you carry is considered. However, the amount of debt you have is not as significant to your credit score as your credit utilization.
2. Credit Utilization Ratio: This is the percentage of your available credit that you’re using. For example, if you owe $1,000 on your credit card and your credit limit is $10,000, you’re utilizing 10% of your credit limit. Using a high percentage of your available credit means you’re close to maxing out your credit cards, which can negatively impact your credit score. On the other hand, using a low percentage of your available credit can have a positive impact.
3. Number of Accounts with Balances: A larger number of accounts with amounts owed can indicate a higher risk of over-extension.
4. Debt on Different Types of Accounts: In addition to the overall amount you owe, your credit score considers the amount you owe on specific types of accounts, such as credit cards vs. installment loans.
5. Remaining Installment Loan Amounts: How much of the installment loan amounts is still owed, compared with the original loan amount. For example, if you borrowed $10,000 to buy a car and you have paid back $2,000, you still owe (with interest) more than 80% of the original loan.

While carrying a lot of debt does not necessarily mean that your credit scores are doomed, you could potentially be in trouble if you are revolving a high percentage of outstanding debt from month to month. Therefore, managing your debt and maintaining a low credit utilization ratio can help improve your credit score.

Length of Credit History

The length of your credit history is a significant factor in determining your credit score. It refers to how long any given account has been reported open. Here’s how it impacts your credit score:

1. Length of Credit History: This refers to the age of the accounts on your credit reports with the three major credit bureaus: Equifax, TransUnion, and Experian. The longer your credit history, the higher your score will be, as long as you have a history of using credit responsibly.
2. Credit Age: This is calculated by averaging the ages of your open credit accounts. It’s all but impossible to get a score higher than 800 if you’re young, because your credit age likely will be low.
3. Account Age: This includes both the age of your oldest account and the average age of all your accounts.

The length of credit history accounts for 15% of your FICO score and around 20% of your VantageScore credit score. A long track record without any major slip-ups suggests that your credit behavior will be similar in the future — and lenders and credit card issuers like that.

New Credit

New credit refers to credit lines or loans that you’ve applied for that you did not have before. It impacts your credit score in several ways:

1. Hard Inquiries: When you apply for new credit, lenders typically perform a hard inquiry, which involves requesting access to your credit report from the credit bureaus. Hard inquiries can cause your credit score to drop slightly. However, the impact of inquiries begins to decline after a month or two. If there is a new account, that will be the main thing lenders are interested in. If there isn’t a new account in a month or two following the inquiry, the impact of the inquiry goes away as it doesn’t represent any risk to the lender because there is no new debt associated with it.
2. Credit Utilization: If you open a new credit card and use a lot of that line of credit, it can result in a bigger drop in your credit score. This is because your credit utilization ratio (the percentage of your available credit that you’re using) can increase, which can negatively impact your credit score.
3. Average Age of Credit: New credit can lower the average age of your total accounts, which can subsequently lower your credit score. This is because the length of your credit history, which includes the age of your oldest account and the average age of all your accounts, is a factor in calculating your credit score.
4. Number of Accounts: If you have only one or two other cards, and they are only a few years old, getting a new card can negatively impact your score because it will decrease the average age of your credit.

The “new credit” category is triggered any time you apply for credit that you did not have before. It’s important to note that new credit accounts for 10% of your FICO credit score. While applying for new credit can cause your score to slip a bit, the impact is usually minimal and scores recover quickly. Too many inquiries within a short period of time may be seen as a sign of financial stress and can therefore negatively impact your credit.

Credit Mix

Credit mix refers to the diversity of credit accounts you have, such as credit cards, student loans, mortgages, and car loans. It’s one of several factors that affect your credit score, and credit scoring companies FICO and VantageScore both consider it to gauge how you’ve handled different types of credit. Here’s how it impacts your credit score:

1. Types of Credit: The types of credit in your credit mix can include revolving credit (like credit cards), installment credit (like car loans, student loans, or mortgages), charge accounts, and open accounts.
2. Diversity of Accounts: Having a variety of different types of credit accounts can show lenders that you’re capable of managing different types of credit responsibly.
3. Number of Each Type of Account: It isn’t just the number of each type of account you have, but how each account relates to others among all categories, and how they interrelate with the other score factors.

Credit mix determines 10% of your FICO credit score. In the VantageScore model, age of credit and credit mix are combined to make up 20% or 21% of your total score, depending on the score version.

While having a diverse credit mix can help improve your credit score, it’s important to note that it’s not advisable to open different types of credit accounts just to improve your credit mix. Opening too many new accounts in a short period of time can lead to hard inquiries on your credit report, which can temporarily lower your credit score.

Importance of factors

While credit mix is a factor, the most significant factors affecting your credit score are payment history and credit utilization. So, it’s crucial to focus on maintaining a good payment history and keeping your credit utilization low, along with considering your credit mix.

How to Monitor Credit Score 

You can monitor your credit score through credit monitoring services, which notify you of changes in your credit report and check your financial accounts for possible fraud or theft. Many banks and credit card companies offer these services, often for free. You can also check your credit score for free through financial companies, like loan or credit card providers.