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What Affects a Credit Score?

Despite how important your credit score is, very few people truly understand what affects it. Understanding what increases or decreases your credit score is vitally important.

Considering how this score is used for just about everything; from financing a car, renting an apartment, buying a home, or even getting a credit card, we’ll cover everything you need to know about your credit score below. 

What Is a Credit Score?

Your credit score is a number between 300 and 850. This number tells lenders how likely you are to repay a loan you are given or a bill. In the world of credit, the higher the number, the better. Keep in mind, it changes frequently.

You may have a high credit score but, you can ruin it if you stop paying your bills and debt on time. You can also have a low credit score and improve it if you start becoming more financially responsible. 

What Is a Good Credit Score?

It will fall into one of the following five categories:

  1. Very poor credit is when ones score is between 300 and 579
  2. Fair credit is when ones score is between 580 and 669 
  3. Good credit is when ones score is between 670 and 739 
  4. Very good credit is when ones score is between 740 and 799
  5. Exceptional credit is when ones score is between 800 and 850 

Why Is It Important to Have a Good Score?

Having a good credit score has a wide range of benefits. First and foremost, the higher it is, the more likely you are for a bank to give you money.

For example, getting a mortgage with a poor credit score can be challenging, but if you have a high score a bank will be more willing to lend you money. 

Secondly, if you were to get a loan or a mortgage with a poor credit score, the lender will charge you a higher interest rate. The lower it is, the more likely you are to default on the loan, or pay payments late. In order to offset this risk, a lender will loan you money at a greater interest rate

Even if you don’t plan on borrowing money, a bad score is still something you want to avoid. A landlord can turn you down from renting their apartment if you have a bad credit score. 

How Is a Credit Score Calculated? The 5 C’s of Credit

Your credit score is calculated through the following 5 C’s. 

Character

Credit history is also referred to as character. Character looks at the borrower’s reputation of repaying debt or bills. As the saying goes, ‘history repeats itself.’ If one has a track record of missing payments or defaulting on a loan, the lender may assume this behavior will continue.  

Conditions

The conditions of the loan refer to the interest rate, principal balance, and duration of the loan. 

Collateral

Collateral is something that the lender can take if the borrower defaulted on the loan. For example, if default on your auto loan, the lender reserves the right to repossess the vehicle. If you default on your mortgage, the bank will reclaim the property. 

Capacity

Capacity measures the borrowers ability to repay the loan. A common statistic that is used is the DTI, or debt to income ratio. Simply put, if you have low debt and a high income, chances are you are able to repay the loan. If you have low income and already existing high debt, you’ll have less money left over each month to repay any new debt. 

Capital

Capital refers to how much money a borrower puts towards the investment. The more money a borrower puts towards the investment, the more likely they are to be fully committed to the investment. The capital formula is often viewed when one is purchasing a home. The greater the down payment someone is willing/able to make, the more likely they are to get approved for a mortgage. 

What Key Factors Affect Your Credit Score?

To better understand how to increase your score, or how to prevent it from falling, you need to understand what variables affect it. 

Payment History

Payment history refers to how you’ve paid your bills in the past. Were you typically late paying the bills, or did you pay all bills on time and in full?

If you’ve missed payments, made partial payments, or were late on paying the bills, that will negatively impact your score. If you have a history of paying all your bills on time and in full, your credit score will be positively impacted. 

Examples of Payment History

Let’s take your cable bill as an example of payment history. If your bill is due on the 10th of each month, the credit agencies will look to see if you pay your bill on time each month. If your payment is late, or if the cable company ever had to send your account to collections, all of that will show up on your credit report and negatively affect your score. 

Amount of Debt

The amount of debt one has is an important factor to calculating one’s credit score. This is commonly referred to as one’s debt to income ratio. Your debt obligations cannot be greater than your income.

Most lenders want to see a debt to income ratio of 35% or less. Said differently, for every $100 of income, a lender likes to see no more than $35 being used to pay for existing debt expenses. 

Examples of Debt

Debt comes in all shapes and sizes. Make sure all of your debt is current or paid off. Don’t forget to look at; outstanding medical bills, the old gym membership, utility bills, and unpaid parking tickets. These expenses are easy to forget about, but catch up to you later on a credit report! 

Credit Age

Your credit age is a simple calculation. This formula divides the ages of your oldest and newest account by the total number of credit accounts you have. Its age makes up 15% of your total credit score. 

Examples of Credit Age

Lets view a real life example. Imagine if you have 3 credit cards, and all 3 credit cards were opened at different times:

  1. The first card is 5 years old
  2. The second card is 3 years old 
  3. The third card is 1 year old 

The total number of years is 8 (5 + 3 + 1) and your total credit age is 8 / 3 (because you have 3 different cards) = 2.66. The higher the number, the better. 

Account Mix

Roughly 10% of your credit score has to do with your account mix. Account mix looks at the various accounts/bills you have in your name. 

Examples of Account Mix

For example, if someone has a credit card, auto loan, student loan, and mortgage, they have four different accounts in their credit mix. Whereas someone who just had a credit card in their name has one. 

Having a diverse account mix, and demonstrating the ability to pay off a wide variety of expenses, will positively impact your credit score. 

Credit Inquiries

Credit inquiries happen when a company or individual is legally permitted to view your score and credit history. Each time someone pulls your credit, that is visible on your credit report and influences your credit score. 

Examples of Credit Inquiries

One of the reasons why credit inquiries are important is because it shows other lenders who have pulled and viewed your credit. If you’ve applied for a mortgage at bank A and were denied, bank B would want to know that as it may raise a red flag for them. 

Additionally, if you were applying for a mortgage on April 1st, but just opened three credit cards on March 15th, the bank may get suspicious and concerned as to what’s going on. 

What Other Factors Can Affect It?

There are other factors that can affect your credit score. Let’s explore some of the most common.

Reporting Errors 

Many people get a full credit report annually. This is a good way to keep track of everything and ensure there are no errors or surprises. Without question, mistakes happen. You may have an account in collections that was in fact paid off in full and on time. Identifying that early is always helpful as you can address and correct before applying or a loan. 

Requesting a Credit Card Limit Increase

Credit cards come with limits. Some cards allow the account holder to spend $1,000, whereas other cards allow the account owner to spend $5,000 before the card is maxed out. Requesting a credit card limit increases doesn’t always negatively impact your credit. If the credit card company pulls a hard copy of your credit report, that will be flagged as an inquiry, which could negatively affect your credit score. However, all credit card companies do not require a hard pull of credit. 

With that said, if you are requested a credit card limit increase because you are struggling to pay some bills and need the extra breathing room a credit card provides, keep in mind your debt to income ratio will also increase. Your debt to income ratio certainly impacts your credit score. 

Opening a Certificate of Deposit Savings Account

Although it doesn’t happen all the time, some banks and credit unions do in fact do a hard pull of your credit when you open a certificate of deposit. Having a CD does not hurt or improve your credit score, but the hard pull has an affect. If you’re working hard to improve your credit score, ask the financial institution if they do a hard credit pull before you open a CD with them. 

How Can You Increase Your Credit Score?

There are a few simple steps you can do to improve your credit score:

  • First and foremost, pay your bills on time! 
  • Secondly, pay off debt wherever possible to reduce your debt to income ratio. 
  • Dispute any inaccuracies on your credit report. 
  • Keep any unused credit card open so it improves your credit age metric. 

Take Your Credit Seriously

Your credit score has so much influence on your finances. A bad credit score is costly as banks will lend you money at a higher interest rate. A good credit score is a great asset to have. Not only will you be able to borrow money at a low interest rate, you’ll also be able to borrow more money. 

Financial advisors are great resources to discuss your credit score with! Not only can financial advisors help you invest money, they can also help you identify what debt you should pay off first, and help you establish a better saving and spending plan. Taking your credit and finances seriously will serve you well and will save you a large amount of money and headache.