To most people, explaining a credit score would be like explaining how our lungs work…

  • We know the basic idea
  • We know there are good and bad things that can affect it
  • And that’s about it

There are some experts out there that could explain all the ins-and-outs of each, but most of us couldn’t really explain them if we tried.

Credit scores are an important part of our lives, but unless you work in Finance, you probably haven’t spent too much time learning the intricate details behind what affects your credit score.

Since finances are difficult to discuss and conceptualize, we wanted to break down what a credit score is, how credit scores are calculated, and what factors into establishing your credit score. You don’t need to be an expert in finance to follow this article – this is information everyone needs to be aware of.

 

What is a Credit Score?

A credit score is defined by Investopedia.com as “a number between 300 – 850 that depicts a consumer’s creditworthiness.” Just like in most sports, a higher score is better, because the higher your score is, the better you look to potential lenders.

Think about opening a credit card or trying to get a loan for a business or house – your credit score tells the company how likely you are to pay back the money you have borrowed in the past. Low credit scores tell companies that you are a risk for repaying the money you borrow, so they could either deny your loan or charge you a higher interest rate for paying it back.

In general, a good credit score is between 670 – 739, and a score of 800 or above is considered as “Excellent.”

Now that we’ve covered what a credit score is – let’s talk about what factors affect your credit score.

Credit scores are sometimes referred to as FICO Scores because it is a tool and formula created by the data analytics company FICO. The factors are listed in the order of how much they impact your credit score (35% of your credit score depends on #1, and 10% of your credit score depends on #5).

 

  1. Payment History

 

 

 

 

 

 

Paying bills on time is one of the main factors in either increasing or decreasing your credit score. Making late payments on accounts shows lenders a potential pattern for not paying back the money you have borrowed.  This will make them hesitant in giving you a good deal (or even working with you at all).

 

  1. How Much You Owe

 

 

 

 

 

 

This factor is based on the amount you owe vs. how much credit you have available. For example, if I have a credit card with a $5,000 limit, and I owe $4,500 on it, then it looks unfavorable to lenders. If you are close to maxed out on the credit you have available, then lenders will think you cannot manage/pay off your credit effectively. The goal of how much you owe vs. how much you have available is below 30%.

For reference, of the above example…

  • I owe $4,500 of a $5,000 limit
  • 4,500 / 5,000 = 0.9
  • .9 x 100 = 90%, so my credit ratio is 90%. When a lender is looking for under 30%, that tells me I need to start working on paying down on the credit now before adding more credit to it.

 

  1. Length of Credit History

 

 

 

 

 

 

The first two factors were strictly based on amounts of money, and this next one is based on time. Specifically, this is how long you have had credit. The longer you have had credit and the better you have managed it is combined to give lenders a clear picture of your credit history. If you have had a credit account (or more) for 10 years and have never missed a payment, this factor will make you look better vs. someone who has never missed a payment for only one year.

 

  1. New Credit

 

 

 

 

 

 

If you are consistently opening credit cards, it can be a sign of financial immaturity or lack of self-control. Every time you open a new credit card, your credit score takes a slight hit. Your history of applying for credit shows lenders how much and how often you need credit. The more credit you open, the lower your score will be.

 

  1. Type of Credit Used

 

 

 

 

 

 

This factor shows the different types of credit you have on your account. Car loans, student loans, mortgages, and credit cards are all types of credit you could have on your credit history. There is no ideal mix of different types (at least 1 of these, at least 3 of those, etc.), so you shouldn’t worry about trying to find a specific ratio. However, if you only have one type of credit on your account, like only credit cards, your score will be lower. Lenders like to see you know how to manage different types of credits.

 

The above is the basic knowledge about credit scores that everyone should be aware of. Credit scores can hurt or help your financial plans, so you must understand the basics of how it is calculated so you can make smart decisions. Make sure to keep our site bookmarked, because one of our future articles will be about how to increase your credit score.