Revealing the Makeup of That Oh-So-Important Number
When you borrow money, whether through a credit card or a car loan, you’re making a promise to the lender that you’ll pay back what you owe. But lenders need a little more reassurance than that. So, they use your credit score, a number created to reflect your borrowing habits.
“Think of your credit score like a GPA,” says Will VanderToolen, director of counseling services at AAA Fair Credit Foundation in Salt Lake City. “Your GPA is a number that illustrates how well you are doing in school. A credit score is a number that is used as a predictor of how likely you are to pay your credit lines on time next month."
Not only are credit scores used by lenders, but also by employers, service providers, and even landlords.
“Needing credit can be like a pop quiz,” says VanderToolen. “Suddenly, you find yourself in need of a new vehicle, a new place to live, or a variety of other wants. If your credit isn’t stable, you will find yourself needing a co-signor.”
Your Score Makeup
Here's a look at what score calculations consider*:
- What it looks at: The most important part of your score, it examines how responsible you are at paying what you owe—whether you’ve been late or on time, missed payments altogether, or been reported to a collection agency. It officially tracks back seven years, but weighs your past two years most heavily.
- What it means to lenders: Lenders look to your payment history as an indication of how you’ll handle future debts. If you've met your obligations responsibly, lenders will think you'll continue to be responsible paying back your debt.
- What it means to you: Pay on time, every time. If you've missed a payment, pay it off as soon as you can. If you’re having a hard time remembering due dates, set up reminders on your phone or use auto bill pay services.
- What it looks at: Nearly as important as your payment history, it keeps tabs on how much of your available credit you’re using. Known as your credit utilization ratio, it assesses how close you are to maxing out the credit that has been given to you.
- What it means to lenders: If you use a lot of your available credit, lenders may think you're overextended and that you may struggle to make future payments. Lenders like to see a credit utilization ratio of 25 percent.
- What it means to you: Try not to spend more than one-fourth of your credit limits. If you need to spend more, ask for a limit increase—but just to maintain a good ratio. Don't take it as a license to spend.
Length of Credit History
- What it looks at: It examines the age of all your accounts—individually and averaged together—and assesses how much time has passed since you opened the accounts.
- What it means to lenders: Lenders like to see borrowers with a long track record of repaying debts. The longer you’ve used credit wisely, the more lenders will trust your ability and determination to stay current on your accounts.
- What it means to you: If you're new to credit, you can't magically create a long-standing credit history. Move slowly, and don't open too many new accounts at once because you’ll lower your average account age. For credit veterans, consider keeping your oldest credit card, even if you're not using it, to keep your average account age high.
Types of Credit Used
- What it looks at: With a preference for variety, it considers the kinds of credit you have, from credit and store cards to installment loans such as car, student, and home loans.
- What it means to lenders: Lenders want to see you can manage different kinds of credit—both cards and loans.
- What it means to you: Don't get unnecessary credit, but pay attention to the mix of credit you are using, trying to establish diversity over time.
- What it looks at: New credit includes the number of accounts you’ve recently opened, in addition to the amount of inquiries that have been made lately by those checking your credit for the purpose of lending you money.
- What it means to lenders: Taking on too much new credit is a warning sign to lenders. They will want to know why you suddenly had such a need, presuming you might have needed new credit because you’re in financial trouble.
- What it means to you: Opening a new account can help your credit score, but each time you do, you’ll stamp your report with another inquiry that will remain there for 12 months. If you're planning to apply for a large loan, such as a mortgage, avoid opening smaller accounts beforehand.
*Sources: www.myfico.com/AAA Fair Credit Foundation
[Any reference to a specific company, commercial product, process, or service does not constitute or imply an endorsement or recommendation by the National Endowment for Financial Education.]