Everybody has a credit score, but many people still don’t understand exactly what it is and how it affects them, especially if they were never taught about managing finances growing up. Through our LiSA Initiative, the following Focus on YOUR Money webinar* tips will show you how to improve your credit score, as well as how it is calculated.
Simply put, credit is a way to gauge a person’s trustworthiness with regard to paying back the money that they borrow. If your friend asked you for $150 to pay for a new pair of shoes, you may ask yourself: how likely is it that he’ll pay me back? You might look to how much money he owes and how timely he has been at paying those loans back in the past. This is very similar to the risk assessment that credit card and mortgage companies do on you in the form of credit reports and credit scores.
Some financial advice columnists have recently become adamant about paying cash for everything, even your car, and your home. We don’t adhere to that philosophy; after all, if you’re using cash for everything, you’re not impacting your credit at all, and there are ways you can improve your score with every purchase you make. If done correctly, using credit can be a very positive and powerful thing.
The Difference Between Your Credit Report and Credit Score
Though related, your credit report and your credit score are actually two separate things. A credit report is a document that tells the history of your financial life. There are three major credit bureaus that collect your personal information (name, address, social security number) and financial data (loans, collections, bankruptcies, and number of accounts) and compile it all into your credit report.
The activity on your credit report is then used to derive your credit score, which is a number—usually between 300 and 850—that acts as a sort of “grade” that represents your creditworthiness. The higher your score, the lower the credit risk is to potential lenders, and vice versa.
You’re entitled to a free credit report every year through AnnualCreditReport.com. Take advantage of this by making sure you check your score every year. An easy way to remember to check your score might be to always do it during your birthday month. You can also have a service like Credit Karma check your credit score multiple times a year and report it back to you. Regardless of how you check your score, it’s important that you do so. You have to know your numbers to change your numbers, after all.
How is Your Credit Score Calculated?
Your credit score is made up of five aspects of your finances in the following proportions:
Payment History – 35%
The largest portion of your credit score is based on how timely you are in making payments on your loans. Late payments can stay on your credit report for up to 7 years, so the most important action you can take to keep up your score is to always pay on time.
Credit Usage – 30%
Credit bureaus will keep track of the amount of your available credit you are currently using. The more you’re using, the lower your score will be, which is why your credit utilization should always be less than 30% (e.g., if you have a $10,000 credit limit on your cards, you never want to be owing more than $3,000 in credit).
Average Age of Credit Accounts – 15%
The longer your accounts have been open, the higher your score. This shows how long you’ve been responsibly managing your finances. This also means you shouldn’t close any of your accounts—keep them open to improve the average age of your overall credit.
Account Types/Credit Mix – 10%
A diverse variety of open accounts will prove to lenders that you responsibly manage multiple forms of debt. For example, having ten credit cards will look less reliable than if you were managing a mortgage, car payment, student loans, and two credit cards all at once.
New Credit/Inquiries – 10%
There are two types of credit inquiries: hard inquiries and soft inquiries. Avoid the hard inquiries—these are the ones that affect your score, sometimes by up to five points. Hard inquiries are any applications for new loans, cards, or other credit lines. Soft inquiries are credit checks made by your landlords or by your employer when applying for things like apartments and jobs. Also, remember that you never get penalized for checking your own score.
Who is Calculating Your Score?
Your credit score is calculated by each of three major credit recording bureaus: Experian, TransUnion, and Equifax. Your score may differ between each of these three bureaus because each has its own calculation model. Models are specific methods of statistical analysis used by bureaus to evaluate your worthiness to receive credit. The two major credit-scoring models are FICO (or Fair Isaac Corporation) and VantageScore.
FICO scores are the most common credit score model. The FICO score is used in over 90% of U.S. lending decisions and has been an industry standard for over 25 years. You don’t need a large income to have a high FICO score,
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