Your credit score is one of the most important numbers in your financial life, yet many people don’t fully understand what goes into calculating it. Whether you’re applying for a mortgage, renting an apartment, or even setting up a new cell phone plan, that three-digit number can have a huge impact. The better your score, the more favorable terms you’ll receive on loans, and you may even have lower insurance premiums. So, let’s break down the mystery. In this post, we’ll dive deep into what actually affects your credit score, giving you a better understanding of how you can improve and protect it.
What is a Credit Score?
A credit score is essentially a report card of your creditworthiness. The most common type of score used by lenders is the FICO score, which ranges from 300 to 850. The higher your score, the less risky you appear to lenders. But what does this number mean, and more importantly, how is it calculated? The score isn’t just a random figure; it’s based on several key factors that reflect your financial habits and history.
The Key Factors That Affect Your Credit Score
Now that you know what a credit score is, let’s dive into the five main factors that impact it.
1. Payment History (35%)
Your payment history is the most significant factor affecting your credit score, accounting for 35% of the total score. This makes sense when you think about it—lenders want to know if they can count on you to pay back what you owe. Have you consistently made on-time payments on your credit cards, loans, and other debts? If so, great! That’s a positive mark on your credit report.
But, on the other hand, missing payments or making them late can have a major negative impact. Even one missed payment can lower your score. And worse, if a lender reports a delinquent account (usually after 30 days), the damage can stick around for up to seven years! So, setting up automatic payments or reminders to pay on time is a must.
2. Credit Utilization (30%)
Next up is your credit utilization ratio, which makes up 30% of your score. This factor looks at how much of your available credit you’re using. If you have a total credit limit of $10,000 across all your cards and you’re carrying a balance of $3,000, your utilization ratio is 30%. The lower this ratio, the better it is for your score.
Experts generally recommend keeping your utilization under 30% to avoid negatively impacting your score. Even better? Aim for under 10% if possible. But here’s a little tip—credit bureaus calculate your utilization based on your statement balances. So, if you’re someone who charges a lot to your card each month but pays it off right away, your utilization could still appear high. To avoid this, consider making a payment before your statement closes or split your payments across multiple cycles.
3. Length of Credit History (15%)
How long you’ve had credit accounts plays a significant role in determining your credit score. This is called the length of credit history and makes up 15% of your score. In general, the longer you’ve had an account open and in good standing, the more favorable this looks on your credit report. The age of your oldest account, the average age of all your accounts, and how long it’s been since you’ve used certain accounts are all part of this calculation.
One common mistake people make is closing old credit accounts, especially ones in good standing. While closing an account may reduce your temptation to use credit, it can also shorten your credit history, which could drop your score. If you have old credit cards with no annual fee, it’s often best to keep them open, even if you don’t use them regularly. Just keep an eye on them to make sure you don’t get hit with inactivity fees or surprise charges.
4. Credit Mix (10%)
Your credit mix accounts for 10% of your score, and it refers to the different types of credit accounts you have. Lenders like to see that you can manage a variety of credit responsibly. There are two primary types of credit: revolving credit (like credit cards) and installment loans (like mortgages, car loans, or student loans).
If you only have credit cards, adding an installment loan, or vice versa, could help improve your score. However, this doesn’t mean you should go out and open new accounts just to have a mix. It’s only 10% of your score, so if you’re lacking in credit diversity, it’s not worth taking on unnecessary debt to try and improve this part of your score.
5. New Credit Inquiries (10%)
Finally, new credit inquiries make up 10% of your score. Every time you apply for a new line of credit, a hard inquiry (or hard pull) is made on your credit report. Too many hard inquiries in a short period can lower your score, as it signals to lenders that you may be in financial trouble or desperate for credit.
Each hard inquiry typically drops your score by a few points, but multiple inquiries from mortgage or auto loan applications within a short period are generally treated as one inquiry (thanks to a process known as rate shopping). Soft inquiries, like when you check your own credit or when a company checks your credit for a pre-approval offer, do not affect your score. As a general rule, be selective when applying for new credit to avoid unnecessary hard inquiries.
Additional Factors to Consider
While the five factors above are the core of your credit score, other details can also play a role. These aren’t major components but are worth understanding.
1. Derogatory Marks
Things like bankruptcies, foreclosures, and accounts in collections can have a major negative impact on your credit score. These are known as derogatory marks and can stay on your credit report for seven to ten years. It’s best to avoid these situations by addressing financial problems before they spiral out of control.
2. Charge-offs and Settled Accounts
If you’ve had an account that was charged off by the lender (meaning they’ve decided it’s unlikely you’ll pay it back), it can severely damage your score. Settling a debt for less than you owe is another scenario that will hurt your score. Both of these events indicate to future lenders that you’re a risky borrower.
3. Public Records
Certain public records, like tax liens or civil judgments, can also show up on your credit report and lower your score. These records can stay on your report for years, depending on the nature of the issue.
How to Improve Your Credit Score
Now that you understand the key factors that affect your credit score, let’s talk about what you can do to improve it. It’s not as difficult as it seems, and small changes can make a big difference over time.
1. Pay Your Bills on Time
This might sound simple, but it’s the number one thing you can do to improve your credit score. Set up automatic payments or reminders to ensure that you never miss a due date. Even if you can’t pay the full amount, making at least the minimum payment on time will protect your score.
2. Keep Your Credit Utilization Low
Try to keep your balances low relative to your credit limits. If your utilization is creeping up, consider paying off part of the balance early or spreading your spending across multiple cards.
3. Don’t Close Old Accounts
As tempting as it may be to close old accounts, especially if you no longer use them, it’s often better for your credit score to keep them open. Closing accounts can shorten your credit history and increase your credit utilization ratio, both of which can hurt your score.
4. Avoid Applying for Too Much Credit at Once
Each hard inquiry can ding your score a few points, so avoid applying for multiple new credit accounts within a short period. If you’re shopping for a loan, try to do all your applications within a short window (usually 30 to 45 days), as these inquiries will often be treated as a single inquiry for scoring purposes.
5. Diversify Your Credit
If your credit mix is limited, adding a different type of credit account could help boost your score. For example, if you’ve only ever had credit cards, taking out a small personal loan or car loan (and managing it responsibly) could improve your credit mix.
6. Monitor Your Credit Report Regularly
Check your credit report at least once a year to ensure that all the information is accurate. You’re entitled to a free credit report from each of the three major credit bureaus once a year through AnnualCreditReport.com. If you spot any errors, dispute them right away.
Your credit score is a critical part of your financial life, and understanding what affects it gives you the power to improve it. By focusing on paying your bills on time, keeping your balances low, and being mindful of how often you apply for credit, you can maintain a strong credit score and unlock better financial opportunities. Keep an eye on your credit report, manage your accounts responsibly, and over time, you’ll see your score rise.