Yes, credit scores really do matter. They are the main factor that determines your ability to get a loan. They also influence the rate you’ll pay on the loan. But it doesn’t stop there. Your credit score impacts several other areas of your life too.
Your credit score is a three-digit number. It’s calculated based on the information on your credit report.
There are three main credit bureaus – Experian, TransUnion, and Equifax. Merchants report all credit transactions to these three bureaus. The bureaus use this information to generate your credit score. Main credit transactions include loan repayments, credit card payments, and types of credit you use. Different types of transactions add a different value to your credit score.
Five factors go into calculating your credit score – payment history, credit utilization ratio, length of credit history, credit mix, and new credit account.
1. Payment history – Payment history is the biggest determining factor, accounting for 35% of your total credit score. Making on-time payments consistently is the fastest way to add points to your score. Even one late payment can shave a few points off your score.
2. Credit utilization ratio – Credit utilization is the second biggest determining factor, accounting for 30% of your total score. Credit utilization refers to the amount you owe compared to the amount of credit you have. If you max your credit cards regularly your credit utilization will be high. This will impact you negatively. The key is to keep your credit utilization ratio low by using your credit card sparingly.
3. Length of credit history – Length of credit history is the third most important factor. It accounts for 15% of your credit score. Length of credit history considers how long you’ve had credit and whether you’ve handled it responsibly. Taking student loans for college can add to the length of your credit history. This works in your favor.
4. Credit mix – Credit mix adds 10% to your credit score. Lenders like to see how you handle different types of credit. Having a mix of installment credit (student loans, mortgage) and revolving credit (credit cards) will add points to your score. Credit mix doesn’t carry as much weight as the other factors. But it can add those few points that may make a difference when it matters.
5. New credit accounts – New credit accounts for 10% of your score. Applying for a new credit card or loan can improve your credit mix and boost your score. But your application will trigger a hard credit inquiry, which will cause your score to dip temporarily. This dip will recover quickly as long as you make the payments on time every month.
A credit score is a reflection of your credit health. It indicates how much of debt you have. Most importantly, it says a lot about whether or not you’re a responsible borrower. Do you make loan and credit card payments on time? Or do you miss payments regularly? Do you max your credit card every month?
Looking at your credit score is the fastest and easiest way for lenders to know more about you as a potential borrower.
An excellent score means you make all payments on time and are a responsible borrower. This increases your odds of getting approved for another loan or credit card. As an added bonus, you’ll also qualify for a lower interest rate.
On the other hand, a bad credit score means you’re a risky borrower. You’re more likely than not struggling financially. There are high chances you will default on your payments at some time. Lenders don’t want to deal with the hassle of trying to recover their money. Most lenders will reject your credit application outright. Very few lenders will approve. But they will offset the risk by charging you a higher interest rate.
It’s not just lenders and credit card companies who check credit scores. When you apply for a rental, some landlords will check your credit score first. They want to know whether they can trust you to pay the rent on time. Potential employers may also check and only hire you if you have a good score. This is because employees who are struggling financially are more likely to resort to fraudulent practices.
As we said earlier, your credit score is a 3-digit number. These are grouped into a different ranges. The higher the range, the stronger your creditworthiness and the better your chances of getting low-cost credit.
Here are 4 things you can do to improve your credit score steadily:
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