By Zack Taylor, Associate
Wouldn’t it be nice to be able to buy everything you wanted in cash and not have to worry about payments? Of course, but is that realistic for more expensive items such as cars or homes? Probably not. The fact is that most Americans are going to have to finance one item or another throughout their lives. Many people are not able to buy these items outright, a person’s credit health will be an essential part making these purchases possible. The first step in building a strong credit score is to consider the question, how is a credit score calculated? There are 5 major aspects to determining credit score and knowing these are essential to becoming a financially savvy borrower. The mix of what determines an individual’s score include the following:
1. Payment History 2. Credit Utilization 3. Length of Credit History 4. Credit Mix 5. New Credit Inquiries
Each of these factors and the weight of their importance in determining credit score will be described in further detail below.
Payment History (35%) – The most important and heavily weighted aspect of having a strong credit rating is making payments on time. One late payment made more than 30 days late can lead to a significant drop in a person’s score. Late payments remain in the credit bureau’s record for a period of seven years before falling off. While accounts sent to collections, foreclosures or bankruptcies can lead to worse, longer lasting consequences that are difficult to recover from. Payment history is the most heavily weighted factor and is responsible for 35% of a person’s credit rating so be sure to make these payments on time.
Credit Utilization (30%) – The total amount of money borrowed compared to the total credit limit available has a significant effect on a person’s credit score. This is known as your credit utilization ratio. Individuals with the highest credit ratings are known to keep their credit utilization ratio at or below 10%. While this is the most ideal percentage to keep utilization under, credit will not be negatively affected until reaching over 30% of credit available. For example, let’s say a person had a credit limit of $1,000. Their credit would be most positively impacted by keeping their balance to $100 or less while paying it off in full each month. However, their credit would not be negatively impacted until maintaining a balance of more than $300. Paying down these higher balances first will lead to a more rapid increase in a person’s credit score. Credit utilization is responsible for 30% of how credit score is calculated.
Length of Credit History (15%) – The credit bureaus place significant importance on how long a person has been able to effectively manage debt and debt payments. Consequently, a longer history of good debt management will lead to a higher score than someone who just opened their first credit card this year. They evaluate this by looking at a person’s oldest debt, their newest debt, and the average age of all combined debts to determine their length of credit history. While it is best to maintain long-term accounts, some may close over time. However, as long as they were closed in good standing, (no late payments) they may remain on the credit report for up to 10 years. This length of account history accounts for 15% of a person’s credit rating.
Credit Mix (10%) – A less significant, but still important aspect of a person’s credit rating is having multiple different types of debt accounts. Having a variety of debt types shows the ability to manage different styles of debt. This includes having debts such as credit cards, car loans, mortgages, personal loans, and student loans. Having and properly managing a range of different debts will lead to an increase in credit rating. Credit Mix comprises 10% of a person’s credit score.
New Credit Inquiries (10%) – Taking on new debt undoubtedly increases the chances of falling behind on old debts. For this reason, credit bureaus take account of hard inquiries to opening new lines of credit. Credit shopping for items such as car loans or mortgages done withing a two-week period count as one hard inquiry, thus not drastically affecting a person’s credit. However, credit cards do not receive the same treatment as each application counts as one inquiry. New credit inquiries account for 10% of a person’s credit rating.
Implementing wise credit habits that align with the credit factors mentioned above will lead to having a strong and increasing credit score. However, that is not to say taking on debt to obtain a strong credit rating is always a good idea. Sticking to a budget and implementing the aspects above in a manageable fashion is essential to maintaining strong credit health.