Your credit score is an all-important, three-digit number that determines much of your financial life. Too bad more of us don't understand how credit scores work.
See also: Having bad credit often costs you more.
Maintaining a healthy credit profile is important because your credit rating will impact everything from whether you get a much-needed loan to what your life insurance and auto insurance rates will be.
Here is a quick primer on what goes into your credit score, as well as tips you can use to positively impact your credit rating.
What Does FICO Mean Anyway?
Although there are several types of credit scores, such as the VantageScore or the PLUS score, the most popular credit score used by lenders is the FICO score.
The FICO score gets its name from the company that developed it, Fair, Isaac and Company. FICO scores range from 300 to 850 points, and to get a peek at yours you generally have to pay for it. You can get your scores from the website. They currently cost $19.95 each. Other credit scores can be obtained free. Unfortunately, though, you can't get a FICO score without paying for it. You can get a free score directly from Fair Isaac by signing up for a 10-day trial service for credit monitoring. The credit monitoring is $14.95 a month. FICO explains the deal in the fine print on their home page.
Photo by: Piotr Pawinski/Alamy
Your credit scores are calculated based on the information contained in your Equifax, Experian and TransUnion reports. To calculate your FICO credit scores, Fair Isaac look at the data in your credit reports and evaluates them like this:
Payment History — 35 percent
Amount of Debt Owed — 30 percent
Length of Credit History — 15 percent
Mix of Credit — 10 percent
Inquiries or New Credit — 10 percent
Next: Learn why your payment history is so important. >>
Here is what you need to know about each of these areas.
Payment history: 35 percent of your credit score
If you have no late payments in your credit files, that will have an overwhelmingly positive impact on your credit score since your payment track record is the single biggest determinant of your FICO score.
But even if you had one or two late payment in the past, all is not lost. The FICO scoring system takes "recency" into account in evaluating how responsible you are at paying your bills. Therefore, a late payment that happened three years ago won't have as much an impact on your credit scores as a slip up that occurred three months ago.
Bottom line: try to always make all payments on time. Even if you can only make minimum payments, this helps guard your credit rating.
Amount of debt owed: 30 percent of your credit score
When you're focused on eliminating your bills, you might think that debt is debt. But the credit scoring system doesn't treat all types of debt similarly.
The debt that can most likely lower your credit scores is credit card debt — not mortgages, car loans or student loan debt. So if you want to raise your credit scores, focus first on lowering your outstanding credit card balances.
As long as you make timely payments on your other debts, such as your home loan, having those types of debts won't negatively impact your credit scores in the way that existing credit card debt can.
Ideally, try to keep your credit card balances at or below 25 percent of your available credit. This is known as your "credit utilization ratio." If you can pay off your credit cards in full each month, that's even better.
Length of credit history: 15 percent of your credit score
All credit scoring models reward you for having a longer credit history. This can be a real plus to those age 50 and older, since you are likely to have a more established credit track record than someone in her 20s, 30s or 40s.
A word to the wise, though, about managing your credit cards in the context of your credit score. Even if you pay off a credit card in full, it's generally best to keep it open and not close the account. Closing credit cards can backfire on you, by decreasing the length of your credit history and raising your credit utilization ratio.
If you'll be applying for credit anytime in the next year, shutting down existing credit cards could hurt your FICO score. But if don't trust yourself with your credit cards, and they might tempt you, simply put them away — in the attic, basement, a safe or even the freezer!
As an even more drastic step, you can also cut up a credit card you won't be using, and still leave the account open. Just recognize, however, that taking the scissors to your Visa or MasterCard says more about you than it does about that piece of plastic. Credit cards aren't inherently bad or evil. It's our own inability to manage credit wisely that gets us into trouble.
Mix of credit: 10 percent of your credit score
The credit-scoring world also rewards you for showing that you can responsibly juggle multiple forms of credit. Thus, your score will be higher if your credit files include various types of credit, such as a mortgage loan, an installment loan (like a student loan or auto loan) and credit cards. Again, as long as you pay all these obligations on time, you'll boost your credit rating in this category.
Inquiries or new credit: 10 percent of your credit score
A "hard" inquiry is triggered on your credit report whenever you seek credit or apply for a loan. Inquiries remain on your credit reports for two years. For the purpose of calculating your FICO scores, inquiries count against you for one year.
Various experts have estimated that a single inquiry can lower your credit score by anywhere from five points to 35 points. I once had an inquiry lower my credit score by 14 points. So only apply for credit when you really need it. And skip those department store credit card offers; they just generate inquiries.
A "soft" inquiry, like checking your own credit report, does not hurt your credit score. You can — and should — check your credit reports from each of the three main credit bureaus at least once a year. You can get your Equifax, Experian and TransUnion credit reports free of charge annually at AnnualCreditReport.com.
You should also know that factors such as your income, race, age, gender or marital status play no role whatsoever in computing your credit scores. In fact, federal law prohibits the use of race, age, nationality, religion, sex or marital status in credit scoring.
Lynnette Khalfani-Cox, The Money Coach®, is a personal finance expert, television and radio personality, and a regular contributor to AARP. You can follow her on Twitter and on Facebook.
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