What makes up a credit score?
For whatever reason, it seems like a credit score is an elusive concept that few people fully grasp. Yet, it can have a significant impact on one’s ability to secure a home, a vehicle, a credit, to name a few. Hopefully, I can help demystify the plumbing that constitutes your credit score. Quite literally, some of life’s largest purchases rely on one’s credit!
In simplistic terms, the score is designed to discriminate rather quickly, the creditworthiness of an individual. The numerical value can be used as a proxy to gather someone’s history of obtaining, utilizing, and repaying debt. It allows institutions that provide lending, an opportunity to get a snapshot gauge of how you have handled credit in the past to ascertain your likelihood to repay the loan in the future.
Credit card issuers, auto dealerships, and mortgage lenders will typically check your credit score before deciding how much they will lend you and at what interest rate. Rates will differ amongst those who have a higher credit score than those with a lower one.
What is a Credit Score?
Imagine your credit score as a numeric representation of your financial habits. It's like a grade on how well you handle money matters. Ranging from 300 to 850, the higher your score, the more financially responsible you appear to lenders.
What Makes Up Your Credit Score (with % weighting)?
Payment History (35%):
Example: If you have a credit card with a $1,000 limit and you consistently pay the full balance by the due date, you're building a solid payment history.
Credit Utilization (30%):
Example: If your credit card limit is $1,000, try not to carry a balance higher than $300. This keeps your credit utilization below 30%, signaling responsible credit use.
Length of Credit History (15%):
Example: If you've had a credit card for five years, that's a positive factor. It shows you have a track record of managing credit over an extended period.
Types of Credit in Use (10%):
Example: Having a mix of credit, like a credit card, a student loan, and a car loan, showcases your ability to handle various credit responsibilities.
New Credit (10%):
Example: Opening multiple credit accounts in a short period may raise eyebrows. Aim for strategic credit moves and avoid applying for multiple credit cards within a few months.
Facts and Myths: Let's Bust Some Myths!
Myth #1: Checking Your Own Score Hurts It.
Fact: Checking your score through platforms like Credit Karma or your credit card company's app is a soft inquiry, leaving your score unharmed.
Myth #2: Closing Credit Cards Boosts Your Score.
Fact: Closing a credit card may lower your available credit, impacting your credit utilization ratio. Keeping that old card open, even if you rarely use it, can be beneficial.
Myth #3: Income Affects Your Credit Score.
Fact: Your income doesn't directly impact your score. It's about how responsibly you manage credit. Someone with a lower income but a flawless payment history can have a great score.
How to Improve Your Credit Score: Action Steps!
Pay Bills on Time: Set up automatic payments for your credit cards, loans, and utilities to ensure you never miss a due date.
Reduce Credit Card Balances:
Example: If you have a $1,000 balance on your credit card, aim to pay off $700 to keep your credit utilization below 30%.
Diversify Your Credit Mix:
Example: If you've only had credit cards, consider responsibly adding an installment loan, like a small personal loan or an auto loan, to your credit portfolio.
Keep Old Accounts Open:
Example: Even if you don't use your first credit card much, keeping it open maintains a longer credit history.
Check Your Credit Report Regularly:
Example: Obtain a free annual credit report and scrutinize it for errors. If you find any inaccuracies, dispute them with the credit bureau.
Don’t overlook these components: Items people overlook or underappreciate!
Credit Mix Matters:
Some individuals might focus solely on credit cards and neglect other types of credit, such as installment loans (e.g., car loans, student loans). A diverse credit mix can have a positive impact on your credit score.
Closed Accounts Stay on Your Report:
Closed accounts, whether closed by you or the creditor, can stay on your credit report for several years. They contribute to your credit history, affecting the length of your credit, but their positive impact may diminish over time.
Authorized User Accounts:
Being an authorized user on someone else's credit card can influence your credit score. If the primary account holder has a positive credit history, it can benefit your score. However, if they miss payments, it could hurt your score.
Hard Inquiries Impact Your Score (but not by much):
Applying for new credit leads to a hard inquiry, which can have a small, temporary impact on your score. While it's crucial not to apply for credit excessively, the effect is often minimal.
Not All Bills Affect Your Score:
While paying bills on time is crucial for your financial health, not all bills impact your credit score. Rent, utilities, and medical bills generally don't appear on your credit report unless they go to collections.
Employment and Income Aren't Considered:
Your job, salary, and employment history aren't factors in your credit score. While lenders may consider this information when assessing your financial stability, it doesn't directly impact your credit score.
Minimum Payments Aren't Ideal:
Making only the minimum payments on your credit cards might keep your account in good standing, but it can lead to high-interest charges and prolonged debt. Strive to pay more than the minimum to make a more significant impact on your credit utilization.
Credit Score Fluctuations Are Normal:
It's normal for your credit score to fluctuate slightly over time. Various factors, such as changes in credit utilization or opening new accounts, can cause these fluctuations. Consistent responsible financial habits will lead to long-term improvement.
Joint Accounts Affect Both Parties:
Opening a joint account with someone means that both individuals are equally responsible for the debt. Any activity on the joint account, positive or negative, affects both credit scores.
Credit Score Doesn't Reflect Wealth:
Your credit score reflects your creditworthiness, not your net worth or income level. High earners may have low credit scores if they mismanage credit, while those with modest incomes can have excellent scores with responsible financial habits.
By incorporating these examples into your financial playbook, you're not just building a credit score; you're crafting a financial narrative that speaks volumes about your money management prowess. Remember, your credit score is a journey, not a sprint – steady and consistent wins the race!
* This is a generic breakdown of the components of the credit score in Canada, for more details click here
Your savings account pays you 0.5% but the inflation rate is 5%, so your real rate of return is -4.5%, and you're wondering why you can't get ahead?