I never had a solid understanding of what a credit score was until I started working for a personal finance website. Now, I know all the factors that go into a credit score and how having good credit can make so many aspects of life easier.
From renting a new apartment to financing a car, I've been able to do all these things without having to rely on my parents or anyone else to co-sign with me. In this article, I'm going to cover the factors that determine your credit score and all the ways your credit score affects your life on the daily.
I know it seems like a boring subject, but it's an important one -- it will make your life easier in in the long run!
Why Do I Need A Good Credit Score?
Before I get into all the credit talk, I want to address the reasons why you need to have a good credit score.
The most obvious ones are renting an apartment or financing a car. The lower your credit score is, the more you'll have to pay. So, for example, you might have to pay a larger deposit for an apartment and have a higher interest rate for a car loan or mortgage.
A few reasons you might not have thought of? When you (finally) get off your parents' phone plan and get your own, they'll check your credit score. Utility companies will also run a credit check. While this won't stop you from getting service, if your score is low you may be required to pay a deposit.
Potential employers might also check your credit report to assess your responsibility and potential trustworthiness. While this is different than a credit check a bank runs, it still provides an overview of your credit history.
Now that we know how this three-digit number can have a pretty strong impact on your life, here's what actually goes into your score.
What Determines Your Credit Score?
There are five different factors that contribute to your credit score, and they all carry different levels of importance. These are the five factors that determine your score, from most to least important.
1. Payment History
This factor has the biggest impact on your credit score. Financial institutions want to know if you've made all your past payments on time. This takes into account credit cards and loans -- so any late payment could affect your credit score.
In addition to showing up as a late payment, factors such as how late the payment was, the amount owed, how recently it occurred and the number of other late payments are also on your record. This means that a 30-day late payment wouldn't do as much damage as a 60-day late payment.
One or two late payments won't kill your score, but it's important to always make payments on time.
2. Credit Usage
The second most important factor is your credit usage. While this looks at all types of open credit lines, such as a personal, student or car loans, it mainly looks at your credit utilization.
Credit utilization is the amount of credit you're using compared to your limit. Say you have a credit card with a $1,000 limit and you spent $500 on it, your credit utilization would be 50%.
Experts recommend keeping credit utilization under 30%. So, you shouldn't spend more than $300 on an card with a $1,000 limit. If you pay your balance off each month, it should be OK to spend a little more, but never keep more than a 30% balance. Your credit usage is looked at for each individual credit card you have, plus total utilization across all your cards.
3. Length of Credit History
This factor looks at the age of your oldest account, the age of your newest account and the average age of all your accounts.
The length of credit history also looks at whether or not you've used an account recently. Maybe you've had a credit card open for five years, but haven't used it in three. It's best to use a credit card every once in awhile, even if it's just a small charge, to show lenders you're still responsible with a credit card. And of course, pay off your credit cards in full each month.
4. Credit Mix
Credit mix is exactly what it sounds like: a combination of different credit types. Lenders like to see a mix of credit cards and loans. Basically, it shows them you're able to responsibly manage multiple kinds of accounts.
While it's good to have a healthy mix, you don't want to have too many accounts. It's not worth it to take out a personal loan just to increase your credit mix. But if all you've ever had are student loans, it might be a good idea to open a credit card and use it for small expenses.
5. New Credit
Opening multiple new accounts within a short period of time is a red flag, and your score will go down. Even just applying for too many cards, whether you get accepted or not, will ding your credit score.
There are two kinds of inquiries made to your credit: soft and hard. A soft inquiry happens when a person (like you, checking your credit score) or company checks your credit report. This one doesn't affect your score.
Hard inquiries are when a financial institution checks your credit when you apply for a credit card or loan. This can hurt your score, regardless of if you actually got approved. If there are too many hard inquiries on your account in a short period of time, that's a major red flag.
You shouldn't worry about this if you're only applying for one or two cards, but you should consider how opening the new accounts will affect your average credit age.
Credit doesn't have to be scary, but it is necessary to understand in order to make your life easier both now and in the future. If you're someone who is already in credit card debt and struggling to stay on top of it, look into making a side income from home and work on paying off those cards. Once your cards are paid off, use that extra cash to start saving money -- whether it's for an emergency fund, dream vacation, a new car or even retirement.
