Have you ever wondered how lenders determine whether to approve your loan or credit card application? One of the factors they consider is your credit score. Your credit score is a number that reflects your creditworthiness and how likely you are to repay your debts. In this article, we'll explain how credit scores are calculated, including the percentages that make up your credit score, and provide some actionable steps and pro tips on how to improve your credit.
First, let's discuss why having good credit matters.
- Lower interest rates on loans and credit cards: When you have a good credit score, you are more likely to qualify for loans and credit cards with lower interest rates, which can save you money over time.
- Better loan and credit card terms: Lenders are more likely to offer better terms, such as longer repayment periods and higher credit limits, to borrowers with good credit scores.
- Higher likelihood of approval for loans and credit cards: When you have a good credit score, lenders are more likely to approve your loan or credit card application.
- Better insurance rates: Some insurance companies use credit scores to determine insurance rates, and individuals with good credit scores may be eligible for lower rates.
- Improved rental and job prospects: Landlords and potential employers may check your credit score as part of their screening process, and having a good credit score can make you a more attractive candidate.
- Ability to negotiate: When you have a good credit score, you have more leverage to negotiate better terms on loans, credit cards, and other financial products.
The five factors that make up your credit score
Your credit score is made up of five factors, each of which has a different percentage weighting. These five factors are:
- Payment history (35%): Your payment history is the most significant factor that affects your credit score. It refers to whether you have paid your bills on time and in full and whether you have any delinquencies or defaults.
- Amounts owed (30%): The amounts owed factor looks at how much you owe on your credit accounts compared to your credit limits. It also considers the amount you owe on different types of accounts, such as credit cards and loans.
- Length of credit history (15%): The length of your credit history is the amount of time you have had credit accounts open. This includes the age of your oldest and newest accounts, the average age of all your accounts, and the time since you last used each account.
- Credit mix (10%): Credit mix refers to the types of credit accounts you have, such as credit cards, loans, and mortgages. Having a mix of different types of accounts can be beneficial for your credit score.
- New credit (10%): The new credit factor looks at how often you apply for new credit and how many new credit accounts you have recently opened.
How to improve your credit score
Now that you know the five factors that make up your credit score, let's take a closer look at each one and how you can improve your score.
Payment history (35%)
Your payment history is the most critical factor that affects your credit score, making up 35% of your score. To improve your payment history, you should always pay your bills on time and in full. If you're struggling to make your payments, contact your creditors and try to work out a payment plan or a reduced payment amount. Late or missed payments can stay on your credit report for up to seven years, so it's essential to stay on top of your payments.
Pro tip: Set up automatic payments or reminders to ensure that you never miss a payment.
Amounts owed (30%)
The amounts owed factor looks at how much you owe on your credit accounts compared to your credit limits, making up 30% of your score. To improve this factor, you should try to keep your balances low and avoid maxing out your credit cards. A good rule of thumb is to keep your credit card balances below 30% of your credit limit.
Pro tip: Pay down your balances as much as possible, starting with the accounts with the highest interest rates.
Length of credit history (15%)
The length of your credit history makes up 15% of your score. To improve this factor, you should keep your credit accounts open for as long as possible, even if you're not using them regularly. Closing a credit account can lower your credit score by shortening your credit history.
Pro tip: Consider keeping your oldest credit account open, even if you no longer use it, to maintain a long credit history.
Credit mix (10%)
The credit mix factor looks at the types of credit accounts you have and makes up 10% of your score. Having a mix of Credit accounts, such as credit cards, loans, and mortgages, can be beneficial for your credit score. To improve this factor, you should consider diversifying your credit accounts if you don't already have a mix of different types.
Pro tip: If you're considering opening a new credit account, such as a loan or a credit card, make sure to research the best options for your credit score and financial situation.
New credit (10%)
The new credit factor looks at how often you apply for new credit and how many new credit accounts you have recently opened, making up 10% of your score. To improve this factor, you should avoid opening too many new credit accounts at once, as this can lower your credit score. When you apply for new credit, it can result in a hard inquiry on your credit report, which can also lower your score.
Pro tip: If you're shopping for a loan or credit card, make sure to make all your applications within a short period (usually 14-30 days) to minimize the impact of multiple hard inquiries.
In conclusion, understanding how credit scores are calculated and how you can improve them is essential for anyone looking to improve their financial health. By focusing on the five factors that make up your credit score and following the pro tips outlined in this article, you can take steps to improve your credit score over time. Remember to always pay your bills on time, keep your balances low, maintain a long credit history, diversify your credit accounts, and avoid opening too many new credit accounts at once. By following these simple steps, you can achieve a higher credit score and enjoy the benefits that come with it, such as lower interest rates, better loan and credit card terms, and greater financial freedom.