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How Credit Score Affects You and How It Is Calculated: payment history, credit type mix, and more discussed
If you live in the US of A, you will be affected by "credit". When you get a credit card, you have credit, but nowadays, even applying to rent an apartment will trigger a credit check, or even applying for a job. Thus, it is necessary to know about what exactly is credit, and how you can check them.
So what exactly IS your credit score? Your credit score is a standardized system on how your credit history, how much debt you owe and to whom, how well you pay them back, and other factors are reduced to a number. The Fair Issacs Corporation, aka FICO, is the first to create such a system. In the FICO system, the lowest possible score is 300, and highest possible is 850.
FICO has licensed this algorithm to the three credit bureaus: Equifax, Experian, and TransUnion, who then modified the algorithm slightly to suit their own needs. Thus they each maintain their own version of your credit history, and as such, you have three different scores, one at each bureau. And their scores can vary a little. We will just call it "credit score".
So what constitutes a credit score? The exact formula is not known, but it does have FIVE components
Payment History (35%)
Total Debt (30%)
New Credit (10%)
Types of Credit (10%)
Payment History is 35% of your credit score. To evaluate your payment history, answer these questions: When was the last time you paid late? (not rent) how often do you pay late? How late are you?
The easiest way to improve your payment history is set up auto-billpay either via your bank's website, or via that account holder's website. As long as you have money in the bank, you won't be late, EVER. Cell phone plans, utilities, and more all offer auto-billpay.
This is very important as it's a MAJOR part of your score. Often, ONE late credit card payment can ding your score by like 100 points. Fortunately, the time horizon seems to be relatively short. If you pay on time for a few months your score should improve significantly.
Total Debt is simply how much debt and credit do you have that the credit bureaus know about. To evaluate it, simply ask these questions: How much debt do you have? How much credit do you have?
The more credit you have in relations to debt, the better your score. In other words, it's the RATIO of debt to credit that is important: the lower the better. When usage ratio is the same, then the bigger credit is better.
For example, if you have 10000 credit limit, but only hold 1000 balance, your usage ratio is 10%. You obviously have better credit than someone with 50% usage ratio. Generally, keep your usage ratio below 25% for best score, according to most credit experts.
Cancelling credit card you don't use may actually hurt your score as it reduces your overall credit limit, thus raising your usage ratio. For example, let's say one of your cards is $5000. If you cancel one card, your debt is still 1000, but your credit is now $5000, so your usage ratio is now 20%, making your credit look a lot worse.
Duration of debt can be evaluated by asking how long have you had the account? One late payment on a 1 year old account is going to hurt a lot more than an account you've held for 20 years.
Try NOT to cancel your oldest credit cards, and use each card for ONE item per month, and pay it off immediately. This keeps the card in use, giving the card company no excuse to cancel your card. For convenience, use it for automatic payment of cellphones or utilities or something. Then do online payment from your bank to the credit card.
Beware that some card issuers are starting to tack on "low activity fee". If you don't charge certain amount a year, they'll either jack up your rates, or charge you a special fee.
Have you applied for a lot of credit over the past year? Applying for a lot of new credit makes you a bigger credit risk. And that is a factor in your credit score.
Each "hard" inquiry, i.e. credit card application turned in will drop your score by a few points. However, multiple requests within 45 days actually only count as one ding on your credit score, so try to do it all at once, then don't do anything for a long while. Keep in mind that any sort of a credit, even those store credit card ("Would you like to sign up for a _______ charge card today?") counts as a credit application, even "instant" credit.
A "soft" inquiry, such as a pre-approved credit offer (i.e. they already checked your credit history) does NOT count against your score.
Types of Credit
What sort of credit do you have? Credit card is worth more on the score than a store card. Mortgage, car loans, and such secured debts are weighed less because unsecured debt is a better indicator of your ability to manage credit .
However, don't go overboard either. Having too many credit cards will create an "out of balance" debt mix, which will also hurt your credit score. Four or five credit cards is enough. Two or three is even better.
How to Improve Your Credit
Here are a few tips to manage your credit history and improve your credit score:
First, do NOT believe all those infomercials promising free credit reports. Usually, you need to join a credit monitoring program for like $12.95 a month. You can get one copy of your credit history once per year for free from each bureau. To maximize your coverage without paying some monthly fee, rotate the bureau you get it from, one every 4 months. You can get it from annualcreditreport.com, the only site authorized by the Federal government. Anything else is infomercial.
Second, DO get your reports every 4 months and look over it for mistakes and questionable debts, accounts, and so on. Some common mistakes are:
- account(s) you don't recognize -- the credit bureau may have combined your data with someone who have similar name, or typed in the wrong SSN. Or worse, you may be a victim of Identify Theft. Send off an request for further information and find out what's going on, be it phone or mail. Note very conversation, date, time, representative name and ID number, keep copy of outgoing letter and have delivery confirmation if possible. You're trying to establish a paper trail.
- account(s) you do recognize, but the amount is wrong -- double-check against your existing invoice / statement, then complain to the account holder. It is possible that they made a mistake and entered what's supposed to be CREDIT into the DEBT field, and vice versa, a phenomenon known as "flipping". Thus, if you have 1000 balance on 5000 credit, the flipped entry may say 5000 balance on 1000 credit, thus you've overdrawn by 4000!
Identify the potential mistakes, and write letters to the account holder(s), requesting further clarification, thus, "dispute" an existing entry. Do NOT dispute EVERY negative item, that's just dumb and will annoy the credit bureau, as that is what some unscrupulous so-called "credit repair" companies do. The truth is, they don't work. If it is legit, the item will simply reappear in a month or two.
If you can correct the mistakes you spotted and you followed the advice
given earlier for each component of the credit score, your credit score should improve in a few months. Just
keep on it. You may not reach perfect credit, but you can improve your