Credit scores de-mystified

Credit scores de-mystified
Photo by Element5 Digital / Unsplash

The importance of understanding your credit score

Have you ever wondered just how much your credit score influences your day-to-day life? From securing a low-interest mortgage, getting approved for a car loan or credit card, to even impacting auto insurance and job applications this three-digit number can open doors—or close them. Yet many of us might not fully grasp how these scores are calculated or the tangible steps we can take to improve them. This guide will explain the significance of your credit score in impacting the price you pay, or even ability to be approved, for many of your day-to-day needs.

Decoding the credit score

While there are a variety of credit scores in the market, calculated and issued by a number of providers, there is a lot of similarity in how scores are calculated. Understanding what goes into your credit score is the first step towards being able to improve or maintain higher, financially beneficial, scores. But do you know which factors carry the most weight or how minor adjustments in your financial habits can lead to significant improvements? We'll break down the five critical components of a credit score, offering insights into each and providing strategies for improvement. By demystifying these elements we empower you to take control, ensuring your credit score is an asset not an obstacle.

Top determinants of your score

  • Payment history: The heavyweight in score calculation. Unsurprisingly, payment history - how you have paid your bills in the past - is the most influential factor, accounting for 35% of your credit score. Consistently making payments on time is crucial. A single late payment can negatively impact your score, underscoring the importance of setting reminders or automating your payments to avoid such pitfalls.
  • Amount owed/credit utilization: Credit utilization – the ratio of your credit card balances to your credit limits – plays a significant role, making up 30% of your credit score. Keeping your utilization below 30% is generally advised. For instance, if you have a credit limit of $10,000, try to maintain a balance lower than $3,000. The importance of this metric also underscores why you should not close old accounts as keeping them open with a $0 balance improves your utilization ratio. This strategy helps keep ‘available credit’ high while keeping ‘amount owed’ the same.
  • Length of credit history: This factor accounts for 15% of your score. A longer credit history provides more data points and an established track record of repayment for lenders to evaluate your borrowing behavior. This factor is another reason to keep old accounts open as it will increase the average 'age' of your accounts while not adding to balances owed.
  • New credit: The effects of opening new accounts. Typically when you apply for a new credit line a hard inquiry is made which can temporarily lower your score. If you're considering applying for new credit, ensure it’s necessary and avoid multiple new credit applications within a short period.
  • Credit mix: The advantage of having a few different kinds of credit accounts. Comprising 10% of your score, having a mix of credit types, such as credit cards, personal loans, auto loans and a mortgage, can positively affect your score. This diversity shows lenders that you can manage different types of credit responsibly.

Age-specific insights and strategies

Different life stages call for tailored credit management strategies. Here’s how different age groups can approach credit score improvement, particularly those starting out in their adult lives and most in need of establishing and using credit:

  • Ages 18-25: Starting strong - foundational steps to build a robust credit score. For young adults, establishing credit is the first step. Consider starting with a secured credit card or becoming an authorized user on a family member's account. The average credit score for this group is 679, indicating room for growth as they build their credit history. Another potential approach is to borrow very small dollar figures that can be paid in full by the due date to establish a track record of repayment and low ‘utilization’
  • Ages 26-41: Overcoming financial hurdles and improving scores mid-career. This age group often faces significant financial decisions regarding careers, family, and homeownership. With an average score of 687, improving credit in this stage involves more than just timely payments; it’s about reducing outstanding debts and carefully managing new credit.

Practical steps to improve your credit score

Improving your credit score is a strategic process that involves specific actions tailored to the most impactful components of the score:

  • Make timely payments
    • Set up automatic payments for at least the minimum amount due
    • Use calendar reminders for manual payments
    • Regularly review your payment history to ensure accuracy
    • If you are going to be challenged to make a payment communicate with your lender who may be able to offer assistance
  • Keep your credit utilization in check
    • Monitor your balances regularly and make payments that are higher than the minimums owed (or pay in full) whenever possible
    • Request higher credit limits to improve your utilization ratio, provided you don’t increase your spending
  • Plan credit inquiries
    • Only apply for new credit when necessary
    • ‘Cluster’ inquiries as tightly as possible when shopping for a major purchase like an auto or home as many of the scoring algorithms will view multiple inquiries for auto and home loans within a short time period as a single ‘shopping’ instance
  • Longevity and variety
    • Keep older accounts open to extend the average length of your credit history
    • Consider diversifying your credit types by adding a mix of revolving credit (like credit cards) and installment loans (like auto or student loans) as-needed

By understanding and strategically managing these factors, you can significantly influence your credit score, opening up better offers when you need to borrow money for a major purchase or even when shopping for auto insurance or applying for a new job.

Mastering your credit score

This guide has unpacked the complexities of credit scores, highlighting how crucial they are in shaping your financial opportunities. We've explored the significant components that make up your score—payment history, credit utilization, length of credit history, new credit, and credit mix. Each element plays a role in either enhancing or limiting your financial opportunities. By adopting practices like timely payments, smart credit use, and thoughtful planning of credit inquiries, you can proactively manage and improve your score.

Understanding and improving your credit score involves unlocking opportunities and securing your financial future. Remember, your credit score impacts how ‘risky’ lenders view you to be, and therefore how much they will charge you in the form of interest rates to borrow money. It's a tool that, when managed wisely, can lead to favorable loan terms and lower interest rates, ultimately contributing to your financial freedom.