The Ins And Outs Of Credit Scores

We sometimes view our credit scores the same way we look at household appliances or cars: we don’t think very much about how they work, but when we do, it’s usually because something has gone wrong and is causing us discomfort or inconvenience (often both). However, understanding how it works can help you maintain a better score (and better appliances) so when you need it, it will work best for you.

Here’s a closer look at what influences our personal credit scores and why this information is important.

Why does your credit score matter?

There is the obvious, of course. When you want to borrow money, good credit means you can get the loan you need and at a competitive rate. There are also some less obvious reasons to keep your credit score looking good, because your credit history can also affect:

  • Your ability to get the job you want
  • How much you pay for insurance
  • Renting an apartment or home
  • Paying a security deposit (or not) for utilities and cell phones

How credit scores are determined

Our friends at the credit reporting agencies here in the U.S. (Experian, Equifax, TransUnion) rely upon the following set of weighted credit behaviors when calculating credit scores:

  • Paying on time (35%) – Late payments hurt. Use your bank or credit union’s auto-pay feature to avoid late payments.
  • Utilization (30%) – Keep credit card balances below 30% of your credit limit. This is why carrying around a “maxed out” credit card hurts your score. Although keeping or opening a second card with a zero balance can help your overall utilization ratio, the maxed-out card can still hurt your score. Credit reporting agencies count your per-card utilization as well as your overall credit utilization.
  • Length of credit history (15%) – Having “older” loans and credit accounts helps your score because it indicates experience with managing credit. Closing older accounts and opening new lines of credit can lower your score because these actions reduce your average credit age.
  • Variety of credit lines (10%) – Having a combination of both installment loans (e.g., car or student loans) and revolving credit (e.g., credit cards) helps your score somewhat. However, this only accounts for 10% of your score, so opening up additional credit lines just to round out the mix isn’t going to help your score very much (and if not managed well, might hurt your score).
  • Number of inquiries (10%) – Whenever you apply for new credit (personal loan, auto, student loan, credit card, mortgage, etc.), this results in the lender performing a credit check. These credit checks are recorded on your credit history and can affect your score for up to one year. They only account for 10% of credit score, so the best practice here is to not open too many new lines of credit within a 12 month period.

Which actions and behaviors affect your score the most?

Whether you are trying to repair an iffy credit history or you simply want to make sure your stellar credit score remains that way, here is a breakdown of the major things we should and shouldn’t do in order to have good credit:

DEFINITELY DO:

  • Check your credit score for free at sites like CreditSesame or CreditKarma. Checking your own credit score does not count as an inquiry and will not lower your score.
  • Pay the bills on time, every time. This action alone affects your credit score more than anything else.
  • Keep revolving balances (credit cards) below 30% of the borrowing limit. Aim for paying them off in full every month so you don’t carry a balance and pay interest on it every month. Loan balances have the second largest impact on your credit score.
  • If you miss payments and a loan is sold to a collection agent, pay this off as fast as you can, even if it means selling possessions or taking on an extra job. Collections items are like a heavy anchor on your score and constitute a financial emergency.

AVOID DOING:

  • Opening additional lines of credit if you don’t need them.
  • Opening several new lines of credit all at once.
  • Ignoring late notices. The next step is often a call or letter from a collection agent (and a nosedive for your credit score).
  • Paying someone to “repair” your credit. This is an additional cost for doing something you can do yourself.
  • Borrowing from your retirement plan at work (401(k), 403(b), etc.) to pay off debt balances. There are exceptions, but avoid this unless you are facing more serious consequences, such as filing bankruptcy.

Like any good financial habit, creating and maintaining a healthy credit history (and therefore, a healthy credit score) requires some knowledge and effort. Fortunately, the two criteria that carry the most weight – paying on time and limiting balances – are well within our control.

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