Most people probably have a sense of what their credit score is and if their score is considered a “poor” score all the way to “exceptional.” Banks and credit cards will show you your credit score often updated on a monthly basis. However, there seems to be a lot of confusion on the factors that go into your score and ways to improve it. Having and maintaining an excellent credit score is worth its weight in gold. If lenders view you as a less risky borrower, you may get a lower interest rate on your loan, potentially saving you hundreds or even thousands of dollars in interest over the life of the loan. When you look at the factors that go into credit scores, think of them through the eyes of a lender. Would you lend to someone who didn’t pay bills on time, had a lot of debt already, and maybe didn’t have a long credit history? Probably not, right?
Payment history by far is the most important factor that goes into your credit score. Something as simple as forgetting to pay your credit card bill one month to more serious issues like bankruptcy and foreclosure can all affect your score. Try to develop a system that works for you to help you stay organized and on top of your bills each month.
Level of Debt
The next biggest factor is the level of debt you carry. Credit scoring calculations will look at the overall amount of debt you carry from all different sources (like mortgage, auto, credit cards, student loans, etc.). They will also look at something called a credit utilization ratio with respect to revolving debt like credit cards. To understand what that means, let’s consider two hypothetical people, Bob and Sally. Both Bob and Sally each have one credit card with a $10,000 credit limit. Bob currently charges $5,000 per month and sometimes doesn’t pay off his balance each month. Sally on the other hand, only charges around $1,000 per month to her credit card and pays it off each month. Bob’s credit utilization ratio hovers around 50% or more meaning he is using 50% or more of his available credit whereas Sally’s credit utilization is around 10%. From a lender’s perspective and only looking at their credit utilization ratio, Sally would appear to be the more creditworthy borrower. Long story short, utilizing a large portion of your available credit card limit each month and/or too much debt overall can affect your credit score.
Age of Credit History
Before you decide to cancel the first credit card you got in college, think again. The age of your credit accounts factor into your score. If you can show you’ve been making on time payments for a longer period of time, this may positively reflect on your score. So be aware of how long you’ve had various credit cards and how cancelling them may affect your score (especially if you have had the card for a long time).
Type of Credit
There are two general types of credit: revolving and installment. Installment is pretty easy to understand. Take your car loan as an example. The amount of the loan is predetermined at inception and you pay it back in set payments over the life of loan. Revolving (like credit cards) does not have a predetermined amount. For example, you have a credit limit, but you don’t necessarily spend up to your credit limit each month. Having a mix of both types in your credit history can potentially help your score since it shows you have experience managing both types of credit. Overall though, this factor usually isn’t a huge part of your score.
When you apply for credit, the lender is going to check your credit score and an inquiry will likely be placed on your credit report. One or two inquiries over a few years probably won’t affect your score that much. However, several inquiries in a short period of time can negatively affect your score. Again, think of it from the perspective of the lender. If you were looking to lend money to someone who had been seeking a lot a credit in a short period of time, the question would be why?
If you haven’t done so recently, we would encourage you to review a full credit report (not just your score). The first thing to look for is does it look right? Are there accounts you don’t recognize (i.e. potential identity theft)? Next, check the payment history. Are your payments being recorded correctly? Review your overall debt level as well as your credit utilization on revolving debt like credit cards. A credit report will also show you credit inquiries made in the last two years as well as the age of your credit accounts that are open. Lastly, please use credit responsibly.
Securities and Advisory Services offered through LPL Financial, a Registered Investment Advisor. Member FINRA & SIPC. LPL Financial and Croxall Capital Planning do not provide tax or legal advice. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.