Did you know that a good credit score can save you thousands of dollars over your lifetime? It affects your ability to buy a home, take out a loan, and even impact how employers may view your job application. Your credit score is a key indicator of your overall financial health. In this guide, we will go over why your credit score is important and how it is calculated.
Why Is a Good Credit Score a Game Changer?
Before we dig into what influences your credit score, it helps to understand why it’s so important to begin with.
Lenders see your credit score as a snapshot of your financial reliability. They ask: “If I lend money to this person, what are the odds they will repay on time?” A low score paints you as high risk, often leading to higher interest rates, which can be costly.
Take a look at this chart to see how your credit score could affect the total interest paid on a mortgage.
There’s a huge gap between the rate for high and low credit scores. The difference in total interest paid is over $150,000.
So what determines your credit score and how can you improve it? Let’s dig in.
What Makes Up Your Credit Score?
Your credit score is not just a random figure; it’s a calculated summary of your credit risk based on several different factors. Let’s break down these components and unveil the story they tell to lenders:
Payment History (35%)
Your payment history is pivotal for your credit score. While punctual payments won’t guarantee an 850 FICO Score, it’s a great place to start.
Negative impacts to your scoring
- Late payments on the credit report.
- The tardiness of these payments (30 days, 60 days, 90 days, etc.).
- Their frequency and recency.
A singular 30-day delay might not devastate your score if the rest is solid, but it will dent it. Multiple or severe delays will lead to a steeper decline.
Negative marks like bankruptcies, charge-offs, or foreclosures can also hurt your score.
However, with time, the influence of past errors diminishes gradually.
Amounts Owed (30%)
The amount you owe and the percentage of your available credit in use play a role in shaping your credit score. This is called the credit utilization ratio — which is how much you owe divided by your total credit available.
For credit card users, maintaining a low ratio can enhance their credit score. Individuals with the highest credit score tend to keep their utilization rates below 10%. Rates above ~30% will negatively impact your credit score.
Length of Credit History (15%)
How old is your older account? What is the average age of all your accounts? Time is your friend in this category. Having a long credit history can help increase your credit score.
This is why we recommend keeping credit card accounts active even if they’re no longer in use. The age of the account can help boost your score. If you shut down your oldest account, it might lead to a dip in your overall score.
New Credit (10%)
You might have heard that reviewing your credit report can negatively impact your score. While there’s some truth to that, it’s not always the case.
Credit checks fall into two categories: soft and hard inquiries.
A hard inquiry occurs when a lender examines your credit for lending purposes, such as when you’re applying for a mortgage, credit card, or auto loan. Multiple hard inquiries in a short time can temporarily lower your score. This is because frequently applying for new credit can indicate financial distress or an inability to manage current credit.
On the other hand, a soft inquiry—like when you check your own credit report or when an employer conducts a credit check as part of a background investigation—doesn’t impact your score.
Credit Mix (10%)
The last fact the FICO formula examines when calculating your credit score is the variety of credit types you possess, including credit cards, store accounts, installment loans, and mortgages. It also considers the total number of accounts you hold.
Having experience managing multiple types of accounts can have a positive impact on your credit score.
The Bottom Line
Understanding the factors that influence your credit score can help you to enhance your financial standing. Though some factors might be beyond your control, there are actionable steps you can take immediately to boost your score. This not only improves your odds of securing favorable interest rates but also means more savings for you.
George Maroudas
847-550-6100
george@pmgwealth.com
Twitter @ChicagoAdvisor
Disclaimer / Sources:
Average mortgage rate from Business Insider.
Mortgage calculators from Bank Rate.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice.
