Your credit score is one of your most important personal financial measurements. Without a good credit score, it will be difficult to get approved for loans to buy real estate, cars, and other items, and it might even be tough to get approved to rent an apartment!
The Basics of Your Credit Score
Your credit score, which is also called your FICO score, is a number ranging between 300 and 850. The higher the number, the greater the likelihood that banks will be willing to lend to you because you are seen as a responsible borrower. The lower the number, the less likely because lenders will see you as a bigger risk.
Ultimately, lending is a people business. Banks typically will not lend to people who are measured unfavorably compared to the bank’s standards, at least not on favorable terms.
What makes up your FICO score?
There are 5 main categories that factor into your score. The 5 categories are your payment history, your utilization rate, your length of credit history, your credit mix, and any new credit.
Let’s look at each category individually:
1. Payment History
The largest contributing factor to your credit score is your payment history.
Your payment history identifies whether you have missed payments and if you are consistently making payments on time. Being the largest contributing category, it is imperative to make all debt payments on time or else your score could see huge negative drops, even from just one accidentally missed payment.
One fool-proof way to avoid missing payments is to set up automatic payments through your credit card provider. That way, if you forget to pay off the balance manually, it will get paid automatically at the end of your statement period.
2. Utilization Rate
The second largest contributing factor to your credit score is the total amount of credit that you have available compared to what you owe, also known as your credit utilization rate. This measures how much of your credit is in use in a given month.
For example, if you have a credit card with a $5,000 maximum limit and you carry a $1,000 balance, your utilization rate would be 20 percent.
The lower your utilization rate, the better. Generally, a good rule of thumb is to keep your utilization rate under 10 percent, if possible. Increasing your available credit (be it from new lines of credit or increasing your existing limits) can push your utilization rate down, assuming you do not raise your spending with it.
3. Length of Credit History
The third largest category is your length of credit history.
This one, naturally, takes the most time to build up. Sadly, you cannot go faster than time itself. The longer you have held a certain line of credit, the higher your score. Closing old credit cards, for example, can ding your score significantly since it would lower your length of credit history.
This category helps to explain why you should never close an old card that does not have an annual fee on it. It can only hurt your credit score. Even if the card offers no rewards, if it does not have any recurring fees, it is worth holding onto it to help prop up your average length of credit history.
If it does have fees, then you should figure out how dramatically it will effect your score before cancelling it. If it’s your oldest card by a lot, you might still want to hang on to it. You might be saving thousands on interest for other loans thanks to your higher score when compared to the nominal annual fee that you are paying on the card.
4. Credit Mix
The fourth category is your credit mix.
Your credit mix looks at the different types of loans that you currently have. Having a car loan and some credit cards might look better than just having credit cards and no other types of credit, since it shows lenders that you can handle different types of debt.
5. New Credit
The fifth and final category that makes up your credit score is any new credit that you have taken out.
This checks to see if you have applied for new credit recently. Having a lot of inquiries into your credit within the last year or two can worry lenders into thinking that you are trying to get as much credit as you possibly can very quickly. This can be an added risk in their eyes. A good rule of thumb is to avoid having more than 4 hard inquiries within any 12-month span. Hard inquiries drop off from your credit history officially after two years.
Maintaining Your Credit Score
Carefully make sure to always pay off your credit card balances each month. Lenders will see you as less of a risk if you show that you are being responsible and pay off your debts without missing payments.
Hanging onto your oldest cards is a great way to help out your score. This one is easy since all you have to do is let time pass without closing the account. If you do not use one of your cards very often, be sure to use it at least once every few months to avoid having it closed, since banks and credit card companies might close a card if they see it is not being used.
Getting an additional credit card can help you to increase your score by increasing your credit limit (and thus your utilization rate) and your number of accounts. Even so, be careful not to get a bunch of new cards at once. Having lots of recent hard inquiries on your credit report can ding your score significantly. Spacing out your credit applications so that you have a few months between each one can be a good strategy while you build your credit.
It is imperative that you take good care of your credit score. Without a decent score, it is unlikely that you will be able to get the best terms on future loans, assuming you are able to get approved at all! Lenders do not want to have to deal with the high costs of default, so they try to make calculated decisions for as to who to lend to. Boosting your score can make their decision to lend to you much easier!
Simply put, the key to building and maintaining a good credit score is to be responsible.
Pay off your credit cards each month by not spending more than you can afford. Pretend like the credit card is your own money, not someone else’s, and you will be fine. In time, once your credit builds over many years, you will unlock bigger and better offers with better rates, rewards, or other perks. You might be able to take advantage of advanced strategies like travel-hacking.
Always be careful, regardless, as just one step too far can send everything toppling down. Thankfully, it is increasingly easy to monitor your credit balances, schedule payments, and check your score to keep sending it upwards.
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