Often, people become aware of their credit score only once it has become a problem. For example, a loan or other application gets turned down, and you find out about reports with more detail on your financial history than you remember.
Rather than wait for your credit report to become a problem, learn more about your score and manage it to your advantage.
What financial factors make up a credit score?
Credit scores are a commonly used way to measure credit risk. In order of importance, here are the components that make up a credit score:
1. Payment history
At 35 percent, this is generally the largest portion of a credit score, though scores are weighted differently depending on how relevant each component is to an individual's situation. Your payment history takes into account how well you've kept up with payments on credit cards and loans in the past. It also looks at whether you have any history of bankruptcy or debts referred to a collection agency.
2. Amounts owed
The amount of money you currently owe generally will comprise 30 percent of your credit score. This includes:
- How many different accounts you owe money to
- What percentage of your available credit you are using (AKA credit utilization)
- What portion of any existing loans you have paid down
3. Length of credit history
This will usually represent 15 percent of your credit score. It takes into account your oldest and newest sources of credit, as well as the average age of all your credit accounts. Note that from a credit utilization standpoint and in terms of the age of your accounts, closing old accounts might actually be counter-productive.
4. Credit mix
Around 10 percent of your credit score will be based on the type of credit accounts you have. It is considered beneficial to have a mix of credit card accounts and installment loans (such as a mortgage or student loans), as long as you have a good payment history with them.
5. New credit
Another 10 percent or so of your credit score is based on how many new accounts you have opened recently. Opening several new accounts in a short period of time can be a red flag.
The connection between credit history and creditworthiness
Credit scores are useful because they take a number of factors and boil them down to a single, readily comparable number. There has been a movement in recent years to encourage lenders to consider other factors when a person has had limited access to credit in the past. In any event, credit score is not the only thing a potential creditor is likely to look at.
To a large extent, credit scores represent your history with credit, while overall creditworthiness is a function of both your past performance and your future ability to repay the loan. Income (particularly your income in proportion to your overall financial obligations) is an important factor in creditworthiness, as is the length of time you have held your current job.
4 keys to good credit
Obviously, there are many things that impact creditworthiness, but there are four things that should increase your credit score:
1. Work to establish a good credit history
You might think of having no debt as being a sign of financial rectitude, but to potential creditors it simply means you are an unknown. Establishing a history of modest borrowing and timely payments shows that you have had successful experience with managing credit.
2. Think before you open or close an account
A big part of what creditors are looking for is stability, so be aware that too many changes, like closing older accounts, can upset that stability.
3. Make your payments on time
It's not enough that you eventually pay off your debts - you have to demonstrate that you generally make your scheduled payments on time. Use automatic bill payments if they help you keep on track, and maintain a regular schedule for paying your bills.
4. Focus on paying off balances
Don't take on debt simply because you can make initial or minimum payments. Budget for the future to make sure you can pay down the debt within a reasonable time and make any balloon payments that you'll face in the future.
Maintaining good credit impacts more than your ability to qualify for loans and credit cards. It can also affect your insurance rates, and may be a factor that potential landlords or employers look at as an indication of your reliability. Because your financial history is such a big factor in determining creditworthiness, it is something you have to start managing even before you have a need for credit.
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