Your credit score is a significant number that will have a strong influence on your financial stability. A good credit score allows you to get loans and credit more quickly. You can even get more favorable credit terms if your score is high enough. A bad credit score can increase your cost of raising finances and also close the door on many opportunities in the market.
The credit score is affected both positively and negatively by a variety of factors. Let’s go over each of the five major factors.
Your history for clearing payments on time is crucial for a good score. It determines how responsible you are as a borrower and also informs creditors that you can settle debts on time. If you consistently pay off monthly dues such as mortgage payments, insurance payments, and bills, etc., your score builds up.
Every time you miss a payment, your credit score drops a little. Serious payment delinquencies like bad debt write-offs, forced collections, bankruptcies and repossessions of property can significantly damage your credit score.
Payment history is a significant factor for all credit scoring firms. For FICO, payment history determines 35% of the credit score.
Your level of debt also affects the credit score. The more debt you have, the riskier you become as a borrower and the higher the impact on your credit score.
Credit rating agencies look at a few critical factors for determining the credit score based on outstanding debt. The debt to income ratio is one of them. The higher your monthly payments become compared to your income, the more it affects the score.
The amount of credit balance compared to the credit limit also affects the score. As a rule of thumb, you should maintain a credit card balance to less than 30% of your card limit. Once your credit card balance goes over 30% and stays there for some time, your credit score begins to get affected negatively.
The FICO score is determined by 30% by the outstanding balance owed.
The type of debt that you put on your card also affects your credit score. There are two basic types of debt.
First, there is revolving debt like the one you probably have on your credit card. For this debt, you can take on credit based on your cash flow needs and pay interest each month. When you pay off an amount more than your month’s interest, it reduces the outstanding balance. There is a minimum amount that must be paid for each period but no fixed date for the repayment of the full credit, hence the name, revolving credit.
The second type of credit is installment based where you are required to pay off the outstanding balance in monthly installments for a fixed period. Part of the payment goes towards interest and the other part is used to repay the principal amount. The total amount that you are required to pay for the duration of the loan is fixed.
The interest rate is generally higher for revolving credit than fixed installment based loans. Mortgage payments or your mobile carrier’s monthly payments are good examples of installment based credit.
Credit debt that is used to buy assets like a car or home is considered good debt. Credit balances that are used to purchase items like groceries, clothing and fashion accessories are regarded as bad kinds of debt. Good debt has a lesser negative effect on your credit score than the bad kind of debt.
FICO score is based on 10% on the type of debt.
Another factor that affects your score is the number of inquiries you make for credit. Every time you try to get a new loan, your lender makes a check against your card. This check becomes a permanent part of your card’s history.
One or two inquires once in a while do not affect the score by much. However, if you make five or six checks in a short time, let’s say three months, it can indicate that you may be facing some financial problems. Credit ranking agencies flag it as a negative and your credit score can go down, even if all your credit applications are approved.
What happens when your request for credit is declined? If the loan is denied for any reason, your score drops right away because you are deemed a high-risk borrower right away.
There are ways to work around this. For example, some lenders offer to make a check against your credit that would not appear on your card history. In this case, your score is not affected even if the loan is denied.
The good news is that credit rating agencies only consider inquiries made within the last 12 months for credit score determination. Inquiries are completely removed from the credit report after 24 months.
FICO assigns a value of 10% to new inquiries.
Finally, the age of your credit history is also taken into account for determining your credit score If you have had a credit history for ten years, your score is likely to be higher than it would be if your credit history is only one year old.
Having a long history of credit is considered better because it shows that you have had some experience with managing credit. You are likely to do well with money in the future as well, and lenders are more willing to offer you credit.
Age of credit is determined in three parts.
1. How long have you had accounts?
2. How long have specific types of accounts been open?
3. The period that has passed since those accounts have been last used.
When you open a new bank account, it affects your average age of credit history by reducing the age of your credit history. For example, suppose you have had a checking account for five years and get a credit card for the first time today. Since your credit card account is completely new, your average age of credit history would be 2.5 years, roughly. This is a simplified calculation, and the average age is determined with more factors under FICO.
FICO score is determined 15% by the length of credit.
Here’s a snapshot of FICO factors for determination of the credit score.
For most people, their credit score is determined by the five major factors identified above. However, some additional factors can impact the credit score for people.
1. The number of times you have spent above your credit card’s spending limit can impact your credit score negatively. If you max out your credit card, it could cause a drop in your score. A maxed-out credit card shows creditors that your usage is high and you take up more debt than you can pay off. To avoid this, keep your short-term balance below 30% of the card limit, and ideally below 20% for longer time frames.
2. If your lender sends your debt to a third party for collection, it can cause a significant drop in your credit score. This can only happen after your creditor has given you plenty of notices and opportunities to pay off the balance. Mostly, you will be able to work out a deal with your creditor, as an installment plan, to settle your debt. If the debt is not settled even by the collection firm and the matter is resolved through the court, it can damage your credit score even further.
3. A credit default and write-off occur after all avenues for debt collection have failed. It becomes a permanent part of your credit history and remains on your books for years. Lenders are generally unwilling to extend credit to someone with a default history.
4. An error in reporting can also affect your credit score. If you have cleared payment on time, but the transaction does not go through, the credit rating agency can raise it as a missed or delayed payment.
5. Parking tickets and utility bills payment delays can also show up on the credit report and affect your score.
6. When you close a credit card or apply for a new credit card, it has a small effect on your credit score.
7. Failure to pay your taxes on time also shows up as a missed payment and negatively impacts your score.
8. Change of address can also affect your credit record. Some properties are identified as a higher risk before the owner or a previous occupant had defaulted on their credit. If you move into such a property, it can negatively affect your credit score. Likewise, if you move out of a property with a negative credit history, your score can pick up by a few points.
You can use different types of credit accounts to monitor your credit score through a strategy called credit mix. It involves maintaining various kinds of credits, like mortgage, a car loan and revolving debt. In most cases, a strategy of mixed credit accounts leads to a better credit score than having just one type of account.
There are two main types of credit, three if you consider the very rare ‘open credit’.
Revolving credit is one of the most popular types of credit accounts. It is the default type of borrowing on a credit card and you can freely get it from your card provider.
This type of credit has a ‘cap’ or a credit limit that is determined at the time of card issuance. The credit limit is based on your monthly income, current expenses, and any assets in your possession.
You can use this type of credit at any time for any purchase from a new card and assets to grocery, shopping, and fuel. It generally requires monthly payments and the borrower is charged interest based on their outstanding balance each month.
This is the traditional type of credit that has been in use for centuries. With installment credit, you get a set amount of money with a fixed interest and payment term period. Both the term of the credit and interest rate are determined at the time you agree to take on the loan.
Installment loans have several subcategories: mortgages, auto loans, student loans, personal loans, asset leases, etc. This type of credit facility is quite common.
Open credit is much rarer to find. Most borrowers will never see it on their credit reports. It is used for special accounts where you can borrow up to a maximum amount (similar to a credit card), but this balance must be settled back in full each month.
Open credit is usually available for charge cards that are similar to but still distinguishable from credit cards that are used for revolving credit.
The credit scoring formula looks at both the number and types of accounts that are listed on a borrower’s credit report. The number helps credit agencies determine how many credit accounts you can manage successfully.
The more you can manage without delinquencies, the better prospect you become as a borrower.
Having different types of credit accounts is also important. It helps creditors determine that you are capable of clearing debt for different types of revolving and installment-based accounts.
A person who is experienced in both types of accounts is considered more knowledgeable about assessing their exact credit requirements.
Some people have misconceptions about certain factors that can affect your credit score. Contrary to belief, the following actions do not affect your credit score.
1. Checking your own credit score through a soft inquiry.
2. Your employment and income level does not directly affect your credit score. However, if you lose your job, it can affect your ability to pay bills and delinquencies hurt your credit score.
3. Your education level is not taken into consideration when determining your credit score.
4. The balance in your savings and checking accounts does not affect your credit score.
6. Another myth is that delayed insurance payments can affect your credit score. That is not true. If you miss an insurance payment, your company may cancel your policy but it won’t affect your credit score.
7. Going to a credit counseling firm to help repair your credit score will not affect your credit negatively.
Your credit score can have a significant impact on your finances.
1. A low score reduces your chances of getting approved for loans, mortgage, insurance and other types of credit.
2. A bad score can also increase the cost of your payments and bills.
3. When you are applying for a home or car insurance coverage, your insurance agent will make a check for your credit rating. If your score isn’t high enough, your application can be denied.
4. Your credit score can also affect and change the way you pay for things. A good score can get you approved for cards that have a high cashback rate, allowing you to shop on credit more often for discounts.
5. Your credit score can also affect your employability. Financial institutes and banks often consider the credit report of potential employees to check for any red flags.
Keeping your credit score high is important to get approved for new loans, insurance, and credit. A good credit score also helps reduce the interest charge you pay. The higher your score, the less risky you become to creditors. The lesser your risk, the lesser the interest you will be charged on outstanding balances.
It is important to have a thorough financial understanding of your credit score and how your decisions affect it. A healthy mix of credit that includes revolving debt and installments is the way to go.