Created by Fair Issac and Company (FICO), the credit score is a tool used to determine one’s creditworthiness and likelihood of repaying his or her debts. Having a high credit score can save you hundreds of thousands of dollars over your lifetime. From securing loans with lower interest rates to getting approved quickly for apartments or homes, it pays to have a higher credit score.
While most people understand the formidable benefits of having a high credit score; earning one can be more complicated. The rating system can be difficult to understand and the quantified numbers aren’t necessarily common sense. For example, someone having one credit card and no debt may have a lower credit score than someone with multiple credit lines open with outstanding debt on each card.
The key to rebuilding your credit or increasing your rating is understanding how credit scores are determined and using strategic techniques to boost scores. In today’s post, we examine what you should know about building up your credit score.
How are credit scores calculated?
To begin the discussion, it’s important to understand exactly how credit scores are calculated. Credit scores are a numerical representation of one’s credit history and a future prediction on successful loan repayment. To determine this number, FICO scores take into consideration five different areas of financial history: payment history (35%), amount owed (30%), length of credit history (15%), new credit (10%), and type of credit used (10%). These five calculations help determine a person’s overall credit score.
The payment history section of the FICO score looks at how frequently a person repays loans and debts by the due date. The more frequently payments are made, the higher the rating. People with the highest credit ratings tend to pay off their balances every month; doing so means each month his or her credit card balance is reset at zero. This should be the goal for all credit card users, however, it’s not necessarily a reality for some. If you aren’t able to pay off the entirety of your monthly charges, then be sure to pay, at the very least, the minimum amount. If possible, try to pay more than the minimum each month. Paying just the minimum amount can mean you’re just paying down interest instead of knocking out the principal outstanding amount.
This area is where a lot of new credit card users can be dinged. Without a credit history to pull from, banks and credit companies cannot properly determine one’s likeliness to repay, and therefore often view these as higher risk accounts.
This section of the FICO score accounts for 30%, or the second largest portion, of the credit score. The amount owed on credit cards is an indicator as to a user’s repayment history. Users with large debts and outstanding amounts receive lower scores. Users who are able to pay off amounts owed on credit scores receive bumps in ratings. The goal is to continuously lower the amount owed on each loan each payment period. Meeting this goal, even when you have a high balance, can earn a higher credit rating.
The amount owed is also largely related to utilization. For example, if a user has a credit card with a $15,000 limit and the current balance is $10,000, the user only has spending power of $5,000 left on the card. In other words, he or she is close to maxing out the card and would therefore have a lower credit score. If the same user had two cards with $15,000 spending limits and the same balance – $10,000 – the user would be using a relatively smaller portion of the spending power (40% compared to 66%) and would have a higher score. The goal is to have no more than 30% of utilization on all available credit.
Length of Credit History, New Credit, and Type of Credit Used
The remaining criteria used to determine a person’s credit score are: length of credit history, new credit, and type of credit used. Users who open several credit cards don’t necessarily have higher rates of credit just because their utilization is increased. The key is to consistently demonstrate successful loan repayment over time. Different types of credit are also taken into consideration, for example loans via credit cards are treated differently than credit used for a mortgage or a car payment.
The key to maintaining and building a high credit score is relatively simple: pay your debts on time, consistently. Understanding how your credit score is configured can help you work towards increasing your rating.
7 Financial Rules to Follow
Use our checklist of 7 financial rules to follow to increase your credit score and improve your financial health below.
- Know your credit score and check your report for errors. You’re entitled to one free credit report every year from each of the three national credit reporting companies (Experian, TransUnion, and Equifax). Order online via the official FTC-sanctioned website: annualcreditreport.com or call 1-877-322-8228. Be sure to carefully check your report for errors. Contact your credit company directly if you find an error, the organizations have 45 days to either dispute the error or remove it from your record.
- Ensure payments are made on time. The easiest way to increase your credit score is to pay your monthly payments on time. Do this every month to build a solid credit history of successful payments.
- Keep balances low or paid off monthly. If you can, pay off your credit charges each month. Doing this will not only help your credit rating but it will also help keep your debt from spiraling out of control. At the very least, keep debt balances to absolute minimums.
- If you miss a payment, catch up and stay current. Missing a payment will ding in your credit. If you miss one, pay off late amounts immediately and get back on track as soon as possible.
- Be careful about closing and opening new accounts. People with great credit aren’t opening and closing multiple accounts regularly. The key is to keep a consistent amount of revolving credit. Even if you pay off a credit card, you don’t necessarily need to close that account; instead keep minimums low and payments regular.
- Having no credit cards isn’t necessarily the answer. In today’s financial world, you need to build credit. Going the ‘no credit card ever’ route isn’t the answer. Being responsible and careful with spending is the best way to harness the power of credit cards without succumbing to the harmful side effects.
- Keep utilization rates at 30 percent. Like we mentioned above, try to keep your utilization rate at 30% of your total credit line. Keep balances low.
For more information on building your credit and increasing your financial health, contact TrueNorth Wealth today. Our certified financial representatives can meet with you for a free consultation to create a financial plan for your specific needs and goals.