Credit scores have an enormous effect on our financial lives, helping determine eligibility for loans and credit card approvals, as well as impacting rates on car and home insurance policies.
Understanding your credit score calculation process and dispelling myths surrounding it will enable you to build a stronger financial profile and position yourself for future success.
Pay Your Bills on Time
Credit scores are used by lenders to assess how risky you are as a borrower. They’re calculated based on information in your credit report and factor in such aspects as: payment history (whether bills were paid on time), amount owed, length of credit history, mix of installment loans such as auto and mortgage loans versus revolving credit like credit cards), recent applications for new credit, etc.
Prospective lenders and service providers typically check your credit scores when you apply for loans or utility accounts, with one of the primary factors being whether or not you pay your bills on time – any missed payment can negatively affect it, making late payments often costly. Other key scoring factors may include:
Keep Your Credit Card Balances Low
Credit card balances are one of the key elements in determining your credit scores, so keeping them low as possible is crucial to improving them. Paying your bill off completely each month can also help reduce debt utilization rate (the ratio between how much debt you owe and your total credit limit) below 30% has been shown to significantly boost scores; but this rule of thumb doesn’t always hold true depending on your profile and individual factors such as debt-load.
Financial experts often suggest keeping your credit utilization rate below 10% in order to achieve optimal credit score results. Though this might prove challenging if your cards have reached maximum capacity, keeping this goal in mind could pay dividends when applying for future loans or mortgages requiring creditors review of credit reports is crucial in getting approved or denied by lenders.
Avoid Late Payments
Credit scores are determined using a statistical program which compares your financial behaviors against those of others. Businesses rely on these numbers as indicators of your likelihood to pay them back and use it when deciding if and at what rates to loan money or insurance to you.
Payment history makes up 35% of a credit score calculation, so it’s essential that bills are paid on time in order to avoid late payments and ensure an excellent rating for yourself and future loans.
Other factors that can have a direct bearing on your credit score include your debt utilization (how much of your available debt you are using), length of history and mix of revolving/installment credit accounts on report. Finally, having few recent inquiries for new credit can boost it significantly.
Apply for New Credit Only When Necessary
Under most scoring models, making payments on time and keeping credit card balances low are the keys to increasing your scores. Diversifying your accounts, such as having both revolving and installment loans open is also critical; adding new loans should only be added if needed and managed responsibly.
As a rule, when opening new accounts the amounts owed part of your score – which measures how much credit is being utilized compared to what’s available – increases slightly; however, any negative effect should usually be minimal and be outweighed by other considerations.
Lenders use your credit score to help assess whether or not lending you money would be worthwhile, and to set loan terms and interest rates. Credit reporting agencies sell your score directly to lenders such as banks, credit unions, mortgage and auto finance companies – typically the more they know about you, the greater their confidence that you’ll pay them back!