By Obioha Okereke, College Money Habits
Credit is the power to borrow money to pay for things now, with a promise to pay it back later. Credit is a major responsibility, and can be stressful if you don’t understand the basics.
A credit score is what lenders look at to decide whether to offer credit. The higher the score, the more appealing the borrower looks to the lender.
The five main factors that go into calculating your credit score are:
- Payment History: 35%
- Credit Utilization: 30%
- Credit History Length: 15%
- Credit Mix: 10%
- New Credit and Loan Applications: 10%
Payment History: 35%
The most important factor used to calculate your credit score is your payment history. This is measured by looking at how often you have made on-time payments regularly on all your credit accounts.
For instance, if you have been making on-time payments for several years, this will have a very positive impact on your credit score. On the other hand, if over the span of 10 years, you have several instances of missed payments across different credit accounts, this can have a negative impact on your credit score.
To improve your credit score and build a strong payment history, make sure to do the following:
- Pay all your bills on time
- Regularly check your credit reports
Remember, if you are unable to make the full payment on any outstanding debts, always try to make the minimum payments. If you pay less than the minimum amount due on any of your credit cards, this will result in a missed payment. Missed payments will not reflect positively on your payment history and will lower your credit score.
Credit Utilization: 30%
Your credit utilization is a measure of how much of your available credit you are using.
The formula for calculating your credit utilization is:
Credit Utilization = (Amounts Owed/Credit Limit) x 100
For example, if you own a credit card with a $1,000 limit and charge $100 to it, your credit utilization would be 10%. If you made a $400 purchase, your credit utilization would be 40%.
If you have multiple credit cards, your credit utilization can be calculated by looking at the total amount owed across all your credit accounts, divided by your total available credit. In this case, you’ll want to keep track of your utilization per card, and your utilization across all cards.
Note: To maintain in good standing, it is important that you keep your credit utilization below 30%.
Curious to learn more about credit utilization, check out “Credit card utilization and your credit scores” by Credit Karma.
Credit History Length: 15%
Your credit history looks at the length of time you have had your various credit accounts. Remember, the longer, the better!
Credit history also takes into account the number of credit accounts you have, the types of your credit accounts you have, the amount of time each account has been open, and other factors such as bankruptcy or collections.
If you would like to increase your credit history length, one strategy is to be added as an authorized user on an old account with a healthy payment record.
Credit Mix: 10%
Your credit mix alludes to the different types of credit accounts you have. This can include mortgages, credit cards, student loans, car payments, etc.
Creditors and lenders want to see a diverse credit mix! This doesn’t mean you should open different types of credit accounts solely with the purpose of diversifying. Instead, focus on building a strong payment history around a mixture of installment accounts. Common examples of installment accounts would be mortgages, student loan payments, and car payments.
New Credit and Loan Applications: 10%
Every time you apply for a new credit account (this includes loans), it results in a soft or hard inquiry of your credit score. So, what is the difference?
A soft inquiry typically occurs when a person or company looks at your credit for a background check, or for “prequalified” credit card or loan offers. Checking your own credit scores is also a soft inquiry. None of these impact your credit score.
A hard inquiry, or “hard pull,” occurs when a financial institution checks your credit for a lending decision, such as a mortgage or loan. A hard inquiry can decrease your credit score by a few points, or it may have a negligible effect. And, the inquiry drops off your report after two years.
Keep this in mind when applying for new credit because applying for multiple loans within a short amount of time can result in multiple hard inquiries, prompting lenders and creditors to see you as a high-risk customer who is short on cash and racking up a lot of debt.
You normally have to approve any hard inquiries. If you are unsure whether a new credit request or loan application will result in a hard inquiry, do not hesitate to ask your lender!
Tip: Consider spreading out your loan applications.
By planning ahead, you can space out loan or credit applications by at least six months and keep your credit score high.
To learn more, check out How Long Should I Wait Between Credit Card Applications? by Nerdwallet.
If you have any questions regarding these personal finance resources and/or general questions about managing your personal finances, contact Obioha Okereke from College Money Habits at email@example.com
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