At this point we have already talked about what a credit score is. If you missed that blog, you can read it here.
Now, I want to talk about what makes a good credit score, and what you can do to avoid ruining yours. Here are the 5 things that make up your credit score:
Payment history (35% of credit score)
This is the most important factor in your credit score. Payment history reflects whether you paid debt in the past. If you miss a payment, it’s called a delinquency, and this can stay on your record for seven years. It is crucial you do not miss a credit payment, but if you do your score can drop by up to 35%. Get intouch with your bank or use your bank’s app to check when your statement balance is due to never miss a payment. I also recommend setting up auto-payments through your bank to pay your balance at the end of every month. This way you don’t have to remember to do it.
Credit utilization (30% of credit score)
This is the amount of your credit limit you use, expressed as a percentage. Credit limit is the most amount of debt a bank is allowing you to take out on a credit card. Experts recommend using no more than 30% of your available credit allotment. For example, if my credit limit is $5,000 a month, I would want to only spend at most $1,500 a month (30% of $5,000). Using more than 30% of my available credit may be a sign of financial hardship. If I am relying too much on credit, I might not have enough funds saved up to use. This is a risk for lenders. A real life example is when my credit score dropped 25 points. I noticed this was because my credit utilization ratio went over 50%.
Length of credit history (15% of credit score)
This considers the average age of all your credit accounts. Credit accounts are accounts where you owe debt. For example, let’s say I have two credit cards that I opened five years ago. The average age of my credit accounts is 5 years old. But, if I get another credit card this year, then the average age of my credit accounts is 5 years + 5 years + 0 years all divided by 3, which is 3.33 years. By opening a new credit card, my length of credit history dropped from 5 years to 3.33 years. This will negatively impact 15% of your credit score. It is best to avoid adding more lines of credit much later in your life (if possible) for this reason.
Hard inquiries (10%)
A hard inquiry is when a money lender, like a bank, cheks with a credit bureau to see what your credit score is. This happens when you apply for a new loan. Having a hard inquiry will lower your credit score by up to 10%. This is for two main reasons.
One, hard inquiries show that you may have acquired new debt that does not yet appear on your report. This is a risk for lenders since they don’t know if you can afford your new debt. This risk they are taking reduces your credit score.
Another reason for a hard inquiry; you may have opened new lines of credit during financial hardship. If you are dealing with financial hardship, this risk for lenders is reflected in your reduced credit score. “People with six hard inquiries or more on credit reports can be up to eight times more likely to declare bankruptcy (VanSomeren, Tarver, 2021). Bankruptcy here means the person doesn’t owe the bank any money anymore. For this reason, lenders protect themselves against this. When they see someone has gotten a hard inquiry, it raises a red flag! Limit the quantity of loans you apply for to avoid excess hard inquiries.
Credit mix (10%)
Credit mix refers to the different types of debt you have like credit cards, car payments, and mortgage payments. The more diverse your credit mix, the higher your credit score.. This is because your credit score rewards you for taking on debt and paying it back. If you have a diverse credit mix and you always pay back on time, it’s a sign to lenders that you have good money management skills. They would be happy to lend you money as well.
Summary
It’s important to know what impacts your credit score so that you can do all the right things to have good credit. Good credit allows you to borrow money at lower interest rates, which can save you thousands of dollars in the long run.
There are many finance experts out there that oppose taking out debt. They view credit scores as an irrelevant metric trying to entice people to take on debt. I agree, somewhat. I also realize that sometimes it’s necessary to take on debt, like if you need a car to get to work but don’t have any cash. Or if you need to take on student loans to go to college. I personally prefer Author and Finance expert Suze Orman’s take on debt and credit score. I highly recommend her book where you can learn about her expert opinions.
For the most part, there are ways of avoiding debt, with good reason.
If you’d like to see how much debt you can afford to take on a car, for example, you can learn more about it in this blog.