How to Understand Your Credit Score

Your credit score is critical to your financial health. Knowing how to calculate your credit score is therefore critical as well. That’s because having a great credit score provides financial flexibility and the responsible use of credit can even provide cash back, travel, and other rewards. Like a lot of things in the financial realm, however, the calculation of credit scores can be confusing. Here’s what you need to know.

There are five primary factors that affect a person’s credit score. Each factor carries a different weight and will have more or less of an impact on your overall credit score, either positively or negatively. Knowledge is power – knowing how and why each factor is considered is the best way to understand your credit score and how to improve it. Having a higher score means a lower interest rate when borrowing money, whether that borrowing is on a credit card or through a mortgage lender. The lower your interest rate, the less expensive your loan or line of credit is, saving you money overall.

Your on-time payment history is the first thing lenders look to when considering you as an applicant. They’re essentially wanting to see how likely it is that you’ll make payments to them as agreed.

The payment history section on your credit report shows a list of all of your lenders and creditors along with a detailed breakdown of your payments to them, month by month. It will indicate all of your on-time payments, all late payments (indicating how late – 30 days, 90 days, etc.), any accounts that have gone to collections, and any bankruptcies or foreclosures you have experienced.

Your credit history also shows how many of your accounts have been delinquent in comparison to your total number of accounts. For example, if you’ve had late payments reported to 4 of your 8 accounts on file, that ratio will be considered as well and will negatively impact your credit score.

Making on-time payments is the most important thing you can do to raise or maintain your credit score.

Also important to lenders is how much credit you are using, as compared to how much credit is available to you. This is your credit utilization. If you have a credit card with a $5000 limit but you are close to maxing it out each month, your credit utilization will be considered a negative factor. Ideally, your credit utilization should be less than 30% – i.e. $300 or less on a card with a $1000 limit.

Whenever possible, don’t close accounts that you aren’t using. Keeping the account open helps keep your credit utilization rate lower and adds to the length of your credit history.

Your credit history includes information about how long each of your various credit accounts have been active. For the purpose of your credit score, lenders look to see how long your oldest account has been open and how recently you’ve opened your newest accounts. The longer your history, the better a creditor can assess your ability to manage credit and whether you are a high or low risk borrower.

The different types of credit you have also affect your credit score, including revolving debt (credit cards) and installment loans (such as mortgages and student loans).

Lenders want to know that you are responsible for and can manage multiple types of accounts. Someone with a positive payment history, multiple credit cards, a mortgage and car loan, may therefore be more attractive to lenders than someone who has only had credit card accounts.

Also factored into your credit score is the number of “hard” inquiries on your report. Multiple hard inquiries – applications for new credit – negatively impact your credit score. Hard inquiries remain on your report for 2 years, but only impact your score for the first 12 months.

• Hard inquiries occur when a lender or creditor checks your credit report because you applied for new credit. Each inquiry is listed on your credit report and multiple inquiries are considered negative. A caveat: If you’re applying for a new mortgage, multiple inquiries within the same time frame (typically between 2 weeks and 1 month) are generally counted as one inquiry for that time period.

• Soft inquiries are one of two things:

1. 1. A check of your credit that is not initiated by you. This is typically when a creditor requests to review your credit report in order to pre-approve you for a card (and then send you mailings with a credit card offer, for example). It can also be when creditors you have accounts with already do periodic reviews of your credit report (possibly looking for reasons to raise your interest rate).
   2. A check of your own credit report or score. Checking your own credit report and/or score DOES NOT negatively impact your credit.

Finally, your credit score ranges from 300-850 points. Like with most things, the higher the score the better.