Your credit score impacts multiple areas of your financial life, from getting pre-approved for an auto loan to the interest rate you'll pay on your mortgage. It's essential to understand the numbers and how they're calculated so you can set yourself up for financial success.
No one naturally knows what's regarded as a good credit score, how credit scores work, or what's considered a bad credit score. These are all things you need to learn. Luckily, it's easier to understand your credit score than you'd think.
In this comprehensive guide, you'll learn what credit score is, the different factors that affect your credit score, and much more. Keep reading and you'll soon understand everything about credit scores and why they're so crucial.
Credit Score Explained
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A credit score, also defined as a risk score, is a number lenders use to determine the risk of lending money to borrowers. If you've got a high credit score, then lenders will perceive you as low risk. That means you're more likely to get approved when applying for financing.
Auto dealerships, credit card companies, and mortgage bankers are types of lenders that will check your credit score before deciding how much they're willing to loan you and at what interest rate. Property owners and insurance companies can also check your credit score to see how financially responsible you're prior to renting you an apartment or issuing an insurance policy.
Unpaid parking tickets, medical bills, and cell phone bills are just a few little-known things that can affect your credit score. Here are more scenarios that affect your credit score:
Your Payment History
Your payment history is one of the most important components of your credit score. Lenders prefer clients who can handle their credit accounts or existing debt, and previous credit behavior is used to project future behavior.
Lenders are risk-averse and so will be more likely to reject potential clients with a worsening financial profile. Paying your bills in a timely fashion results in a good credit score, whereas missing payments or making late payments will negatively reflect on your report.
What's included in your payment history? Generally, your loans and credit cards are included, as well as these accounts:
- Car loans.
- Home mortgage.
- Cell phone bills.
- Student loans.
- Medical bills.
- Bank lines of credit.
- Store credit accounts.
Age of Your Credit History
The length of your credit history influences your credit score. A long history with a good track record of timely payments goes a long way toward determining your credit score. This is because it shows that you can take on and manage credit over time and that you aren't a future risk.
Number of Credit Inquiries
Every time you submit an application that necessitates a credit check, an inquiry is placed on your credit report indicating that you've made a credit-based application. Credit inquiries make up 10% of your credit score. One or two inquiries won't hurt your credit score, but multiple inquiries can cost you many points off your overall score, especially within a short time. Consequently, keep your applications to a minimum to preserve your credit score.
The good news is that only those inquiries made within the last year factor into your credit score. Inquiries disappear from your credit report after two years. Checking your credit report results in a soft inquiry, which doesn't affect your credit score.
Types of Credit
Just as a lengthy credit history indicates you can manage credit well, a mix of different types of credit account types improves your credit score. That means you're better off if you have installment loans and credit cards. So, the more unique types of loans, the higher your credit score.
However, that doesn't mean you should acquire a new loan just to improve your credit score. Rather, just apply for the credit you need and watch as your score slowly grows over time when you manage your loans well. Your credit mix makes up 10% of your credit score.
Your loan and credit card balances make up 30% of your credit score. This is generally based on the total amount you have in debt, the amount of money unpaid compared to how much credit you have available, and the type and number of accounts you have. Maxed-out credit cards and high loan balances reduce your credit score. New loans with little payment history lower your credit score momentarily, but loans that are almost paid off increase it. To keep your credit utilization low, you can try making extra payments during the month or setting up balance alerts.
What Doesn't Affect Your Credit Score?
While many things affect your credit score, there's also a lot of misinformation about credit ratings. Here's a list of common misconceptions — things that don't have any effect on your credit score:
- Accessing your credit score. You can check your score for free and as often as you like.
- Changes in income. If you get a pay raise or cut, it won't impact your credit score either way. A change of income can help if it enables you to clear debts or prevents you from missing bill repayments.
- Being denied credit. Your credit report won't show whether your credit application was rejected or accepted. It records hard inquiries, which only last for a short while.
- Personal information. While your credit report includes your name and address, it doesn't identify political views, religion, marital status, gender, or race.
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