Introduction
Most of us have seen our credit score pop up on a banking app or credit card statement. We know that three-digit number is important, but for many people, what actually determines that number can be a mystery. At the end of the day, it can affect everything from your loan application being approved to the interest rate which is given to you.
Although there is no set formula for how someone’s score is calculated, there are 5 major factors which are used to determine that number.
- Payment History
- Total Debt
- Credit History
- Credit Mix
- New Credit Inquiries
Let’s take a closer look at each one in order of importance and how small habits can make a big difference over time
Payment History
This is ultimately the most important factor when it comes to determining your credit score. Your payment history lets lenders know if you are making your payments on time. Having a few late payments won’t break your credit, but if you are consistently missing payments or paying your bills late, this can significantly lower your score.
If you’re working on improving your credit, this is the primary area to focus on. Even if you are only making minimum payments on your monthly balances, automating those payments can help make sure you don’t miss a due date.
Total Debt
This takes a look at the total amount of credit made available to you, and how much of that credit you actively are carrying as a balance. For example, if you have 4 credit cards with a credit limit of $20,000 each, and each one has a $6,000 balance, that means your debt ratio is 30%. ($24,000 ÷ $80,000 = 0.30 or 30%)
The debt ratio is also known as your credit utilization rate. The higher your ratio is, the riskier of a lender you are seen as, and the general rule of thumb is to try and keep your score at or below 30%.
Credit History
Your credit history takes into account how long you have had your credit accounts, the age of your oldest account and the age of your newest account.
Let’s say you have had 2 credit cards your entire life. One you got when you turned 18, and now 10 years later, have decided to get a new card with better benefits. One might think it’s worth closing the old card, but doing this could negatively impact this factor of your credit score. Instead, consider keeping the account open and using it occasionally for small recurring expenses. This approach keeps your history intact and your account active.
Credit Mix
Different types of credit are categorized into two types of accounts, revolving and installment. Having a blend of both can generally improve your score, showing you are capable of handling different types of credit. While your mix doesn’t have a huge impact, maintaining both types of accounts can slightly strengthen your credit profile over time
Revolving Accounts – These include credit cards or lines of credit, where balances and payments vary on a month-to-month basis.
Installment Accounts – These include mortgages, auto loans, or student loans, which generally have fixed monthly payments.
New Credit Inquiries
Each time you apply for a new loan or credit card, a “hard inquiry” is added to your report. Too many of these inquiries in a short period can slightly lower your score, as it signals that you might be planning on taking more debt.
By contrast, there are “soft inquiries” which happen when you check your own credit or receive those pre-qualifying credit card offers in the mail. These do not affect your score.
Check your FREE Credit Report!
One of the easiest ways to get an idea of how all these different factors come together is by taking a look at a credit report that is generated by a credit reporting agency. There are three primary credit reporting agencies: Equifax, Experian & Transunion. A credit report is different than a credit score in that your score is like a “grade” whereas the report is a detailed breakdown of all of your accounts.
Every year, you are allowed to request one free credit report from each of the agencies. A strategy that I like to recommend is to separate your requests to one every four months so you can properly monitor your credit throughout the year. Using a reminder app or adding tasks to your calendar can ensure you are on top of checking these reports.
You can request your free report by using the following link
Summary
Your credit score isn’t fixed – it’s a reflection of habits built over time. Paying on time, keeping balances low, maintaining older accounts, and being mindful of new credit can all help improve your financial profile.
If you’d like to understand how your credit health fits into your broader financial goals, our team can help you make a personalized plan. Schedule a free introductory call to get started
Disclosure
This content is provided for informational and educational purposes only and should not be construed as personalized investment, tax, or legal advice. No advisory relationship is created by reading this article. Investment advisory & financial planning services are offered only pursuant to a written agreement through Noor Financial Services, a Registered Investment Adviser. Please consult with a qualified professional regarding your specific financial situation.
