Everyone talks about your credit score and yet it seems that very few actually understand what it is, why it is so important, and what affects it. I have discovered that there are a few essential facts that once you understand and keep in mind, your credit score is your good friend. Remember how I mentioned that good financial health takes a holistic approach and once you get in the habit of making wise decisions, you cease to be anxious about money? Your credit score loves this approach and once you are in the right mindset of controlling your money, your credit score will naturally go up and stay up.
As a note, there is a difference between your credit score and your credit report, but the relationship is important. Your score is based on your report. Your credit report is a report on your debts, payments, credit levels, and history. Your credit score is based on your credit report, but it is easier for companies to use the simplified credit score instead of trying to interpret your credit report. It is really the contents of your credit report that you need to pay attention. More on your credit report later.
What is a credit score?
Basically, your credit score is the statistical likelihood that you can be trusted. As cold, unfair, and rigid as it may seem sometimes (exceptions always exist), the numbers rarely lie. History repeats itself with how people act, even though they can give “good” reasons for their past actions and situations. Somehow, despite all the reasons, excuses, and stories, the numbers almost always hold true. Remember this when getting a loan or credit card; there is a good reason why they are looking at your credit score.
There are three companies that produce credit scores; Equifax, Experian, and TransUnion. They give your credit as number from 300 to 900. A score of about 720 and higher should be your goal. Your score will vary from each company but they will generally be close, i.e. one company won’t rate you 800 (everyone wants you) and the next one give you a 550 (no one will talk to you). Each company has their own formula for coming up with your credit score, but once again they are very similar so that the same rules and guidelines apply to all three companies.
So why is your credit score important?
I hear a lot of people say that if you don’t need to get a loan you shouldn’t worry about your score (this is usually stated in connection with doing something to damage their credit and finances). I believe we need to quickly create a list of uses for your credit.
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Creditworthiness – If someone is going to loan you money, obviously they check your credit first to see if they are going to get it back. This is a house mortgage, car loan, credit car, etc. This is what everyone thinks of when they talk about using your credit.
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Character – As a general rule, someone with bad credit also has character issues as there are indicators that they don’t honor their promises.
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Renting – Landlords run your credit before renting and the better applicant gets the home.
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Employment – Many employers check the credit of applicants to see how trustworthy they are, not to mention they need employees that can be approved to use company credit cards for business use. Bad credit commonly indicates that an applicant has issues managing their personal life which will carry over into their work.
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Required Deposits – Many utility companies will waive deposit requirements if your credit score is at a certain level. Many other companies that require deposits up front, like cable/satellite providers, also waive the deposits based on your credit.
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Insurance – Insurance companies use your credit report to develop their their assessment of your risk.
So, yes your credit score is important even if you are not trying to borrow money!
What makes up my credit score?
For some reason, everyone’s neighbor and friend is an expert on improving credit scores but they usually are clueless and give horrible and useless advice. The fact is that your credit score is made up of 5 different areas, and they all have an impact on your score as they indicate how trustworthy you are with money. The five areas are Payment History, Amount of Debt, Length of History, New Credit, and Credit Mix.
- Payment History (35%) – The largest factor affecting your credit score is your history of keeping your promises and making your payments on time. Your past performance is a really good indicator of how trustworthy you will be in the future.
- Amount of Debt (30%) – FICO takes into account how much debt you have in relation to how much credit you have available to borrow. The best example is the credit limit on a credit card. They want to see that in percentage terms you are borrowing only a small percentage of the available credit.
- Length of History (15%) – The longer your accounts have been open the better, as it shows a history of decisions (hopefully good decisions) and therefore the longer the credit history the better, provided it is good history.
- New Credit (10%) – This is where opening new lines of credit comes into play having inquires made on your credit. Basically, you don’t want it to look like you are searching for more credit as it might imply that you are becoming a higher risk with more debt.
- Credit mix (10%) – This is where having different types of credit like revolving (credit cards) and installment loans (home mortgage) shows that you can handle various types of credit. However, exactly how much it affects your score is vague and experts tend to agree it is better to have less debt than to try to have different types (amount of debt makes up 30% vs the 10% of credit mix).
What affects my credit score?
Remember, your credit score reflects how trustworthy you are with someone else’s money. Everything that you do that indicates that you might be a higher risk will lower your score, and of course the more evidence that you value their trust and the use of their money, the higher your credit score. Anything that indicates that you might be more or less trustworthy will affect your credit score. This is why things such as having a history of making on time payment is so important, because it shows you keep your promises. You might think this is an oversimplification but as long as you remember that your credit score is your risk assessment with someone else’s money, you have it made.
Your Credit Report
I told you I would get back to your credit report. Remember what I said at the beginning, that your credit is based on your credit report so it is actually your credit report that is important. Routinely checking your report for errors or issues and making improvements and corrections as needed are key to making sure your report is accurate. Here are some of the key areas that are reported on your report.
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Your payment history on each account – By far your history of making on time payments and paying your bills in full is the most important as it shows you can be trusted to keep your promise.
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Your total debt and available credit on each account – The more debt you have the higher the risk you are of defaulting so keep your credit card balances low. (If you follow my advice, you won’t carry any credit card balances)
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The length of your credit history for each account. The longer your credit history, the better example of how you handle money. Obviously, the more recent history has a stronger effect, but it all adds up. (as an additional tip, if you close a credit card account you have had for awhile, that history eventually disappears so you might want to keep some accounts open if you have good history on them.
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Inquires on your credit report – There are soft inquires and hard inquires. Soft inquiries are when someone checks to see if you have trouble managing money, think of a utility company deciding if they need a deposit or not to turn your electric on. A hard inquiry is when you are trying to borrow money ie. you will be increasing your debt load. A soft inquiry does not affect your credit as you are not trying to borrow money, whereas a hard inquiry indicates that you are increasing your risk by trying to borrow money so it does affect your score.