Knowing your credit score and understanding what’s behind it are really important. The following discusses credit score basics and answers some frequently asked questions.
What is a credit score?
A credit score, or FICO score, is a number assigned to an individual that indicates to lenders their capacity to repay a loan. FICO is actually a company that aggregates credit data and sells that information to individuals, companies and banks. It’s a traditional model which helps banks decide whether to extend credit to consumers and at what interest rate. A person’s credit score ranges from 300 to 850, and the higher the score, the more financially trustworthy an individual is considered to be.
What’s a good credit score?
While every creditor defines its own ranges for credit scores (for instance, many lenders think anything over 720 is excellent), here is the average score range, according to credit.com:
- Excellent: 750 and above
- Good: 700 to 749
- Fair: 650 to 699
- Poor: 600 to 649
- Bad 599 and below
How is a credit score calculated?
While FICO does not give away exact details of a credit score calculation, they do share the general components that make up a credit score. There are five elements in total, and each are given a different weight.
- Payment history
- Credit utilization (total amount owed)
- Length of credit history
- Credit mix
- New credit
Payment History
Payment history makes up 35% of your credit score, making it the most important factor in a credit score. This element shows whether an individual has paid past credit accounts on time. One of the best ways for borrowers to improve their credit score is by making consistent, timely payments.
Credit Utilization
Total amount owed counts for 30% and takes into account the available credit that has been borrowed. This is known as credit utilization. FICO views borrowers who get close to their credit limits as people who cannot handle debt responsibly. Credit utilization is measured individually by card and also across multiple cards.
Example: If you have $1,000 in debt and a credit limit of $10,000 spread across two credit cards, then your credit utilization is 10%.
Length of Credit History
Length of credit history – the length of time each account has been open and the length of time since the account’s most recent action – makes up 15% of your credit score. People with longer credit histories are considered less risky because there’s more data available to determine payment history. To improve credit scores, individuals without a credit history should begin using credit, and those with credit should maintain long-standing accounts.
Credit Mix
Credit mix accounts for 10% of your credit score and shows whether an individual has a mix of installment credit (car loans or mortgage loans), and revolving credit (credit cards). It’s a somewhat vague category, but experts say that repaying a variety of debt products indicates the borrower can handle all sorts of credit.
New Credit
New credit also counts for 10%, and factors in how many new accounts a person has, how many new accounts have been applied for recently, and when the most recent account was opened.
How to Improve Your Credit Score
A credit score is a snapshot of your risk at a particular point in time. It changes as new information is added to your bank and credit bureau files. Here are some ways to improve your credit score:
- Pay your bills on time (impacts payment history) – this is the most important thing you can do but it will take several months of on-time payments before you notice a change in your credit score
- Up your credit line (impacts credit utilization) – if you currently own credit cards, call and request a credit increase. If your account is in good standing, the bank should agree to increase your credit limit. This will have a positive effect on credit utilization as long as you don’t spend to this new limit. You can also achieve this by applying for new credit, but this will lower your score temporarily as it will negatively impact the new credit element.
- Keep credit card balances low (impacts credit utilization) – this is the second way to impact credit utilization. While you can increase your credit limits it’s just as important to keep credit card balances low.
Credit Score FAQ
Will my score drop if I apply for a new credit card?
New credit only accounts for 10% of your overall credit score. While opening new credit accounts will impact your score, it will be minimal and temporary. According to FICO:
If it does, it probably won’t drop much. If you apply for several credit cards within a short period of time, multiple requests for your credit report information (called “inquiries”) will appear on your report. Looking for new credit can equate with higher risk, but most credit scores are not affected by multiple inquiries from auto or mortgage lenders within a short period of time. Typically, these are treated as a single inquiry and will have little impact on the credit score.
When should I close a credit card?
Many people mistakenly believe that closing credit cards will increase their credit score. In fact, you need to be strategic when it comes to closing credit accounts because it can work against you. Lenders like to see accounts that have been opened for a long time, so if you close an older account, it could have a negative impact. Closing an account can also increase your credit utilization because you’re decreasing the total amount of available credit.
Example: Say you have $2,000 in debt and a $10,000 credit limit split between two cards evenly. As the account is, your credit utilization rate is 20%, which is good. However, closing one of the cards would put your credit utilization rate at 40%, which will negatively affect your score.
If you are not using a certain credit card, then it’s best to just stop using it instead of closing the account. Cards with annual fees can be downgraded to a no-fee versions.
If you recently received a bonus on a credit card and you don’t want to keep the card, I’d recommend waiting at least 6 months before closing it. Credit card companies offer lucrative bonuses to bring on new customers that will make them money in the long run. If a credit card company sees you opening accounts to get bonuses and then immediately closing them, you may be banned from that company.
