Demystifying Credit Scores: Factors That Matter and How to Build Credit

Credit scores were once a mysterious concept, but over time, people have come to understand their significance in determining eligibility for financing and the interest rates applied. So, what factors contribute to your credit score? In this post, we’ll explore the elements that make up a credit score and delve into related aspects of your FICO score.

Understanding the Factors That Affect Your Credit Score Your credit score is a three-digit number, typically ranging from 300 to 850, used by lenders to assess your ability to pay credit obligations on time. It plays a vital role in determining how much lenders are willing to offer you. Generally, a higher credit score indicates lower risk to lenders and increases your chances of qualifying for loans.

Knowing the key factors that impact your credit score gives you the knowledge needed to improve it over time. Here are the elements that contribute to your credit score:

1. Payment History (35%) Lenders prioritize your ability to pay your obligations promptly. Your payment history accounts for 35% of your credit score and reflects how you’ve managed bill payments in the past. It considers factors such as on-time payments, missed payments, late payments, and any accounts sent to collections.

While a single missed payment may not significantly damage your credit score if the rest of your report is positive, it can still have a noticeable impact. Other payment-related factors like charge-offs, repossessions, bankruptcies, and foreclosures can also lower your score significantly. A higher proportion of on-time payments contributes to a better score.

2. Amounts Owed (30%) Your credit utilization ratio, which compares the amount of debt you owe to your available credit limits, affects your credit score. Even if you consistently pay your obligations on time, carrying a high balance relative to your credit limits can raise concerns among lenders. Keeping your credit utilization ratio low is key to improving or maintaining your credit score. Aim to keep your credit balance below 30% of your credit limit.
3. Length of Credit History (15%) The length of time you’ve held credit accounts is the third most influential factor, accounting for up to 15% of your credit score. While FICO doesn’t consider your age, it looks at the age of your credit accounts—both the oldest and newest accounts, as well as the average age of all your credit accounts. A longer credit history, particularly with low credit utilization and no late payments, has a positive impact on your overall credit score.
4. New Credit (10%) Opening multiple new credit accounts within a short period, especially with a shorter credit history, can raise concerns and be viewed as a higher risk. Applications for new credit cards and hard inquiries can negatively impact your credit score.
5. Credit Mix (10%) The types of credit accounts you utilize make up the credit mix, accounting for up to 10% of your credit score. A diverse portfolio of well-managed credit accounts, including credit cards, finance company accounts, installment loans, mortgage loans, and retail accounts, demonstrates experience in managing various types of credit and can positively impact your credit score.

Factors That Can Harm Your Credit Score Your credit score is derived from the data in your credit report. Even if you have a good credit score, certain actions can still have a negative impact. Here are some things that may hurt your credit score:

• Making late payments or not paying bills on time
• Applying for numerous credit accounts within a short period
• Consolidating balances onto a single card
• Closing credit cards with zero balances
• Carrying high credit card balances
• Having an extended period of inactivity in credit-related activities
• Bankruptcy filings
• Collections and charge-offs
• Co-signing credit applications
• Having too little credit history
• Errors on your credit report

Being aware of how credit scores work empowers you to make informed decisions and avoid actions that may harm your score.

Building Credit from Scratch Building an excellent credit score doesn’t happen overnight, but starting the process is essential. Here are some tips for building your credit score from scratch to an excellent rating, ensuring you get the best terms on financial products like mortgages and credit cards:

1. Become an Authorized User If you have no credit history, becoming an authorized user on a family member’s credit card can help establish a credit score. With permission from the primary cardholder, you can use the card to make purchases. Over time, the credit account and payment history will be included in your credit score, facilitating credit establishment.
2. Apply for a Secured Card Applying for a secured credit card is a straightforward way to build credit from scratch. While you need to pay an upfront deposit, the amount secures your card and makes you a low-risk borrower.
3. Consider Store Cards If you frequently shop at a particular store that offers credit cards, applying for one can help you establish credit history. Your shopping activity is used to develop your credit score. Keep in mind that store cards may have slightly higher interest rates than other credit cards.
4. Report Rental Payments Although rent payments are typically not included in credit reports, you can request your property management company or landlord to report your timely rent payments. This reporting can contribute to the development of your credit score.
5. Pay off Installment Loans Taking manageable installment loans and consistently making timely payments helps build credit. Personal loans repaid in installments can also contribute to establishing a healthy credit score.

Final Thoughts Understanding the factors that influence your credit score allows you to make informed decisions and avoid actions that can harm your score. To improve your score, responsibly utilize loans and credit cards, and ensure timely payments. Building a good credit score takes time, but it’s a worthwhile endeavor that offers long-term financial benefits.