Most people know that it is better to have a high credit score as opposed to a low one. And last week we discussed why keeping a higher credit score matters. However, too many people are clueless about how a credit score is actually calculated. Today, in part 2 of our Credit series, we will be discussing the five areas that contribute to the calculation of your score: Payment History, Credit Usage, Average Age of Credit, Types of Credit, and Credit Inquiries. We will also talk about a few ways to increase your score in each area.
Payment History – 35%
Your payment history has the largest impact on your credit score and accounts for 35% of its calculation. There is only one thing that can negatively affect your payment history, a late payment. In my opinion, this is the least complex of the five areas and the easiest to stay on top of IF you plan properly. Planning properly means creating a budget and sticking to it so that you are able to make every payment. I personally suggest automating all of your monthly payments to prevent you from forgetting to make one and devastating your credit score. Also, when paying back debt, I’d suggest that you make small payments weekly rather than one large payment monthly. This will help you pay less interest in the long run. You can also pay slightly over the minimum to decrease the amount you pay in interest.
Credit Usage – 30%
The amount you owe in comparison to the amount that you have access to has the second largest impact on your credit. For instance, if you have a credit card limit of $20,000 and have used $15,000 of it, you currently owe $5,000 or 75% of your line of credit. The larger percentage of your credit that you have used, the lower your credit score. The simple solution to keeping this area from negatively impacting your score would be to use less credit. However, if you use your credit cards to pay for most things, you can do things like making multiple payments towards your credit throughout the month as opposed to one payment at the end of the month.
Average Age of Credit – 15%
This is very simple, the longer that you keep your credit, the higher your score. They take the average age of your credit. So when you apply for that new credit card, your score will be negatively impacted. Keep that in mind if you are going to apply for new credit or a loan. Anyways, if you have a three-year-old credit card, a two-year-old, and one-year-old, your average age of credit will be two years. The higher your average age the better. Therefore, NEVER close a credit card account. And if your lender threatens to close one because of lack of usage, use it once and don’t let them close it! To recap, in order to keep this area a positive, don’t apply for new credit too often and never let a credit card account close.
Types of Credit – 10%
Lenders like to see that you have a mix of credit cards and loans. They don’t want to see that you only have credit cards. On top of variation, the more accounts that you have open the better. If the lender sees that you are able to manage multiple accounts and sees the variety that they are looking for, they will trust you more. However, I personally do not stress this area much because it has such a low impact on the score. So don’t go out and apply for two credit cards and three loans tonight if you are lacking in this area. Doing that will hurt your average age of credit and your number of inquiries, discussed below, more than it will help this area.
Credit Inquiries – 10%
This final area was just mentioned above and also has a low impact on your score. A credit inquiry is basically when a lender checks your credit score before they lend you money. But keep in mind, there are two types of inquiries: hard and soft. A hard inquiry is what I just talked about. When you apply for a new credit card or car loan, a hard inquiry will go on your record. Hard inquiries stay on your record for two years. The more hard inquiries on your record, the lower you score. Therefore, do not apply too many times in a short period of time.
An example of a soft inquiry would be a website looking at your history to show you your credit score. These do not impact your credit score. Again, be cautious when applying for new credit because the more inquiries that you have, the lower your score.
These above five areas are the ones that are considered in the calculation of your credit score. One common belief is that you need to use your credit cards in order to build credit. However, none of these areas reward you for using your credit. The only time you may need to use your credit is if your lender threatens to your card. Anyways, always remember to make your payments on time, avoid using a large percentage of your available credit, never close a credit card account, and avoid applying for too many loans and credit cards in a short period of time. Next week we will discuss different types of credit cards. But don’t forget that I am not an advocate for acquiring debt, I just believe that it is important to know the ins and outs of credit and debt.