A good credit score allows people to buy their dream homes, rent nice apartments, get better terms on debt, and even secure employment in some industries, improving one's overall financial wellness.
But it's often difficult to determine why someone's credit score moves up or down.
Once you know what credit bureaus are looking for, though, it's much simpler than it seems. Five factors affect a person's FICO credit score (the most popular credit scoring model among lenders).
If a person makes the right moves to address these five factors, they'll make significant progress on their credit score over time.
1. Payment History
Payment history is the most impactful factor, making up 35% of a FICO score.
It's also the easiest to understand: payment history simply tracks how many payments a borrower makes on time.
A perfect record of on-time payments helps maximize credit score, whereas late and missed payments can do substantial credit score damage.
2. Credit Utilization
Credit utilization is nearly as important as payment history, making up 30% of a credit score.
This factor measures the usage of revolving credit, which is any credit that a borrower can draw on at any time and pay back at their leisure.
In other words, credit cards and credit lines.
FICO measures credit utilization by comparing the total balances to the total credit limit across all cards and lines.
This factor also weights balances on individual cards, so maxing out one card can hurt someone's credit even if their overall credit utilization isn't that high.
As for guidelines, a credit utilization ratio above 30% on average and/or on individual cards is a negative to lenders.
With that in mind, using credit cards but keeping their balances low (paying them off each month) is a surefire way to boost a credit score.
3. Credit History Length
Credit history length — which makes up 15% of a FICO score — measures how long a borrower has had credit.
Credit history length is important to lenders because payment history isn't always representative of creditworthiness.
A college student could open their first credit card, spend $5 once, pay their balance, and have a perfect payment history.
But that isn't enough data to show they're just as creditworthy as someone who's had perfect payment history on four credit cards for the past decade.
That's why credit history length considers the age of the borrower's oldest and newest accounts, as well as the average age of all their accounts.
Consequently, keeping accounts open as someone accumulates more credit cards and loans helps to increase their score.
4. Credit Mix
Credit mix makes up 10% of a FICO score. It evaluates how numerous and diverse a borrower's credit accounts are.
Lenders can reasonably assume that someone who can juggle several loans and credit cards is better at managing debt than someone with just one credit card.
This means that borrowers should expand the credit accounts they have — but wisely, of course. Having several account types — such as student loans, an auto loan, a mortgage, and some credit cards — will improve a FICO score.
5. New Credit
When a borrower applies for a loan or credit card, the lender performs a formal credit check. This is known as a hard inquiry, and hard inquiries account for the last 10% of a credit score.
Hard inquiries damage the borrower's score slightly, but the credit bureaus remove them after two years. This gives the score a slight bump.
It may seem confusing that the system punished borrowers for opening new accounts, but lenders have found that a borrower opening a new account is slightly riskier than one who isn't. The reason for this is that the borrower may be opening new accounts to alleviate financial turmoil.
In fact, lenders may even turn someone down if they incur several hard inquiries in a short period.
That's why borrowers should only apply for new credit when they need it and look for pre-approvals in the mail, which often times work via "soft credit check" that may not impact their credit.
Notice: Information provided in this article is for informational purposes only. Consult your attorney or financial advisor about your financial circumstances.
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Original Source: Advance America: The Quick and Dirty Guide to Understanding Credit Scores