Credit has become such a big part of our lives, from buying a house or car to obtaining health insurance and undergoing employment background checks. There’s no denying credit is important. Here’s why.
How Your Credit Score is Calculated
There are standard credit scoring models that analyze one of your consumer credit reports and then assigns a score (often ranging from 300 to 850) using complex calculations. FICO and VantageScore are the two main consumer credit scoring models.
When your credit scores are calculated, there are several factors examined and each factor carries a certain weight.
Your score can also vary depending on the type of credit score and which credit report from the three national credit bureaus is used when calculating the scores.
Payment history, credit history, your credit mix (meaning the various types of credit you have), amounts owed and new credit are the factors looked at under the FICO scoring system.
Good Score, Bad Score
For a score with a range between 300 and 850, a credit score of 700 or above is considered good. If you have a score of 800 or above on the same range, it would be considered to be excellent.
Black Americans typically have lower levels of creditworthiness than other racial groups. About 54 percent of Black Americans report having no credit or a poor to fair credit score, according to a recent survey of 5,000 U.S. adults by Credit Sesame. Compare this to 37 percent of white Americans who report having bad or no credit.
“While the credit system was created to be blind, this data shows that Black and Hispanic Americans are being unfairly shut out of the system,” Jay Moon, general manager of credit at Credit Sesame, said in a statement.
High student loan debt among Blacks plays a factor in lower credit score ratings.
Your Payment History
When a lender or creditor looks at your credit report, a key question they are trying to answer is, “If I extend this person credit, will they pay it back on time?” One of the things they will take into consideration is your payment history — how you’ve repaid your credit in the past. Your payment history may include credit cards, retail department store accounts, installment loans, auto loans, student loans, finance company accounts, home equity loans and mortgage loans.
Payment history, which is the most important factor in calculating your credit score, will also show a lender or creditor details on late or missed payments, bankruptcies and collection information. Credit scoring models generally look at how late your payments were, how much was owed and how recently and how often you missed a payment. Your credit history will also detail how many of your credit accounts have been delinquent in relation to all of your accounts on file.
Amounts owed, or your credit usage, is the second most important factor in determining your credit score. It includes how much you owe on loans and how many of your accounts have balances. The main consideration here is your credit utilization ratio.
Your credit utilization ratio, or rate, is determined by comparing the current balances with the credit limits on your revolving accounts. Your credit utilization ratio, is calculated by adding up the balances on all your credit card accounts, dividing that number by the sum of all your credit card limits, and then multiplying that figure by 100 to get a percentage. Lower utilization ratios are better for credit scores.
Length of Credit History
Credit scoring models take into account the age of your oldest account, newest account and the average age of all your accounts.
When you apply for a new credit card or loan, it can result in a hard inquiry — a record of the fact that someone reviewed your credit to make a lending decision. Hard inquiries can lower your credit scores.
Having a mix of accounts can help your scores. There are two types of credit: revolving and installment. Installment credit has a fixed end date with a series of payments due every month; this can include mortgages, student loans, auto loans and personal loans.
Revolving credit doesn’t have a specific end date or set balance. A minimum payment is made each month. Credit and store cards are the most common type of revolving credit. A home equity line of credit is another type.
It is ideal to have a mix of installment and revolving loans on your credit report.
Are You a Good Credit Risk?
Your credit can tell a potential lender if you are a good credit risk or not. A higher credit score means there’s a lower chance you will miss a payment. A higher credit score can help you qualify for favorable rates and terms from lenders.
People with a good credit score will almost always qualify for the best interest rates and will pay lower finance charges on credit card balances and loans.
How to Improve Your Credit Score
- Get a free copy of your credit report from one of the reporting agencies: Equifax, Experian, and TransUnion. This will tell you where you currently stand with your credit. Everyone is entitled to a free copy of their credit report annually. Check to see if the information is correct and if there are any corrections to be made.
- Work with creditors to clear up any past-due accounts. Past-due (overdue) accounts really hurt your credit score. Clean these up now. Contact your creditors and set up payment plans if necessary. If you have the cash right now to work out a settlement agreement with that creditor, do it. Just be sure that you get the agreement in writing and that you have agreed on how the account will now be reporting on your credit report.
- Become an authorized user on an account in good standing. In this case, you are not the credit card holder, but by submitting your social security number, you will get the benefit of the payment history associated with the card. You can do this with a parent or spouse and if kept in good standing, this account will help boost your credit score.
- Start paying your bills on time. This might seem pretty self-explanatory, but it really is about committing to doing it. Do not think you can skip a month or play catch up with paying your bills. It doesn’t work like that. Many late payments are reported every month, so even missing one payment can hurt you in improving your credit. If you need help with this, automate your payments.
- Set it and forget it. If you need a little help with paying bills on time, automate your payments. With this option, you will never be late (unless something unforeseen happens), you will maintain an accurate record of payments through the bank and the worry about meeting due dates will be gone.