Trust is Money: A Credit Score Overview
Car loans, bank loans, mortgages, opening a new credit card – they all hinge on your credit score, a number that, at its core, represents your ability to repay a loan. Your credit score can make or break the loan process. What are the factors that make up a credit score? What can you do to both positively or negatively affect that score?
The Bureaus and Calculating Credit
There are three credit bureaus – Experian, Equifax, and TransUnion – that each independently calculate your credit score. Your score – often referred to as a FICO score (Fair, Isaac, and Co. created the original calculation in 1986) – is made up from a few factors.
Here’s a quick breakdown:
- 35%: Payment history – How have you paid back your lines of credit?
- 30%: The amount you owe on credit and your total debt
- 15%: Average ages of your credit history
- 10%: New credit
- 10%: The types of credit utilized
It’s important to note that the score reported from each bureau is unlikely to be exactly the same. The numbers above are generalized, but should give you a general sense of how the bureaus arrive at your score.
How to Check Your Score
You can check your score for free with each bureau once per year. The best way to do this is through AnnualCreditReport.com, which is the sole site authorized by the government to pull all three reports for free. While you can order a report through each bureau’s site, it may cost money. There are a number of services that will check your score monthly, for a subscription cost – TransUnion offers this, or instance – while others are one-time reports. Your score may also be available on a regular basis to you through your bank or credit card company.
What Does Your Score Mean?
The average credit score in 2015 was 695. This falls in the average to fair category. Ideally, you want your credit score to be above 720 – where lenders will give good deals to those with excellent credit. Experian has a breakdown of the different categories of credit, noting that in 2015, about 61 percent of Americans had a score of 579 or lower – poor credit and unlikely to be approved for credit.
What Other Factors Affect Credit?
There are a few other aspects1 to your credit score. Let’s look at some of them.
Lines of credit
How many lines of credit, or “tradelines,” do you have, and how many different types? Bank credit cards, store accounts, car loans, mortgages, and student loans are all pieces of this element of credit. Showing creditors that you can handle a variety of account types – and more importantly, make payments on those accounts on time – positively affects your score. Bear in mind you don’t want too many accounts total – but you want a variety of types.
Opening too many new accounts too quickly will negatively impact your credit score. It looks fishy to creditors, who then wonder why you would need that much credit in a short time – and whether you intend to pay back the credit.
How much of your credit you utilize can either negatively or positively impact your score, and is one of the fastest ways to change your score for the better. Luckily, unlike many other negative components of your credit score, this impact clears up in just a few months – typically about 3. If you start paying off your credit cards, you can often quickly raise your credit score. The ideal utilization ratio is 30 percent or less of your credit limit per account.
For example, your credit card has a $4,000 credit limit. You currently have $3,000 on the card – below the limit, but with a utilization of 75 percent. This is negatively affecting your credit. But, this is only reported once per month to the credit bureaus. In other words, if you have $3,000 on your account, but pay off $2,000 before the report is sent, your utilization will only show 25 percent for the month – reflecting positively on your credit score. If, instead, you let the $3,000 continually roll over, you will take a hit to your score, but not face ongoing penalties unless your percentage continually rises.
Average credit age
Continuing from our last example, your credit card – one of the first you opened – has $1,000 on the account, and the card carries yearly fees and high interest. You make payments regularly. Why not pay it down and focus on a few other cards when you have the extra cash? The average age of all your tradelines is taken into account. If you’ve had the credit card for a number of years, closing it out when you only have new cards could negatively impact your score.
A derogatory mark can be anything from late payments to bankruptcy. Tax liens, judgments, charge-offs, and accounts that have gone to collections are also derogatory marks. While there are ways to dispute and remove the marks, if the mark is not a mistake, it will take between 7 and 10 years before it is no longer counted against your credit.
Soft vs. Hard Inquiries
There are two different types of credit checks: soft inquiries and hard inquiries. While one does not affect your credit score, the other will result in a deduction to your score – and it’s needed whenever you seek a loan.
Soft inquiries, such as your free yearly check with bureaus, do not affect credit scores. These checks can also be made without your permission, such as your current car loan lender checking on your credit score to make sure you are still loan-worthy. It’s also how you can be pre-approved for credit cards and loans. Requests related to employment and insurance also fall under this category.
Any time an inquiry is made at your request for a loan, such as for a car or mortgage, it falls under the hard inquiry category. A typical hard inquiry, according to TransUnion, can deduct 5 points from your credit score. However, if you are shopping around for a new car or comparing mortgage lenders, don’t be afraid to make multiple hard inquiries. This is seen as good financial sense, comparing options, rather than an abuse of inquiries, and will be treated as such. Hard inquiries will appear on your credit report for two years, but only impact your credit score for 12 months.
Fixing Your Credit
If you have low credit, some easy ways to quickly raise your score are correcting errors and disputing mistakes. In 2013, the Federal Trade Commission found that 5 percent of consumers had a mistake on one of the three bureau’s reports. The most common mistakes seen by the Consumer Financial Protection Bureau are identity errors, incorrect account status, data management or processing errors, and balance errors.
These, in turn, lead to higher interest rates on loans, costing consumers money. Be warned that for-profit companies who aim to help you with disputes may be trying to scam you. While there are non-profit organizations, such as the National Foundation for Credit Counseling, it may be easier to instead just pay down your debt unless you suffer from complex problems. Paying down your credit – lowering your utilization ratio – remains the best and quickest way to improve your credit.
Cole Mayer is an online marketing specialist and corporate blog writer. A former newspaper journalist, he spends his free time freelance writing, playing video games, and learning about every subject under the sun. Follow Cole on Twitter: @ColeMayer42
This post was updated June 25, 2017. It was originally published January 13, 2017.