We always hear that having a good credit score is important, but do we understand how it’s used or the best ways to build credit?
Credit is a powerful tool that, when handled correctly, may save us money and allow us to obtain loans, apartments and more. By further understanding credit, why it’s important and how to improve credit scores, you can better maintain an excellent credit score.
What Is Credit and a Credit Score?
Credit refers to the ability to borrow money with the promise of repayment in the future. Credit can be used as a tool for consumers to make purchases we otherwise may not be able to afford all at once like cars, homes and college tuition.
A credit score is a three-digit number that predicts risk, telling lenders how likely a person is to pay back what they borrowed.
Types of Credit
- Revolving credit. You receive a maximum credit limit, and you can charge purchases up to that limit. Each month you carry a balance, you are required to make a minimum payment. A credit card is the most common type.
- Charge cards. While charge cards are very similar to credit cards with a maximum credit limit, they differ in that you must pay the entire balance every month.
- Service credit. While it’s not the same kind of credit as the aforementioned types, your agreements with service providers such as electricity, water, cell phone, etc. are indeed credit arrangements. You agree to pay for the services each month.
- Installment credit. A creditor loans you a specific amount of money which you agree to repay including interest over a set amount of time at a fixed amount. Cars, mortgages and personal loans are common examples.
What Affects Your Credit Score?
There are many factors that affect credit score, which can vary slightly depending on the method used to score someone’s credit. One common way is VantageScore, a credit score developed by the three major credit bureaus to predict how likely you are to repay borrowed money. It is used by lenders, landlords and financial institutions to evaluate creditworthiness. Your VantageScore is a number between 300 to 850 (the higher, the better) and is made up of a combination of factors:
- Payment History – 41% of credit score. Payment history is a track record of on-time or late payments and is the most important factor in your credit score.
- Age and Type of Credit Accounts – 20% of credit score. Age and type of credit accounts (also known as depth of credit) looks at the age of your credit accounts and the types of credit accounts used. It essentially means that the longer you’ve had a credit account, the better.
- Credit Utilization Ratio– 20% of credit score. Credit utilization looks at how much credit you have used. With a credit card, for example, you have an available credit limit. Credit utilization is how much of that credit limit you are using.
- New Credit – 11% of credit score. New credit refers to how many hard inquiries you’ve had on your credit report and how many new credit accounts you’ve recently opened.
- Amounts Owed – 6% of credit score. The amounts owed portion of the VantageScore looks at the total balances or debit on all your credit accounts.
- Available Credit – 2% of credit score. This factor refers to how much credit you have available on your revolving credit accounts.
While payment history, depth of credit and credit utilization make up the bulk of your credit score, it’s important to remember that recent credit, balances and available credit, while a smaller percentage, are still factors affecting your credit score. Don’t overlook them!
Understanding Credit Reports and Credit Bureaus
Three major credit bureaus gather data about your credit use – Equifax, Experian and TransUnion. These credit bureaus collect this data to calculate credit scores, make lending decisions, evaluate lease applications and more. Since credit bureaus collect sensitive information, they are highly regulated by the Fair Credit Reporting Act (FCRA), which puts limitations on how they collect and share your data.
Not all three credit bureaus are the same. This is because creditors do not have to report payment history and other financial behaviors to all three credit bureaus. So, one credit bureau may have more information than the other two, which can cause slight differences in your credit scores. But this is not cause for alarm. Only when the scores are drastically different should there be a concern.
To check your credit score, you can use AnnualCreditReport.com to get the free yearly reports you’re entitled to. Be sure to check each report from each credit bureau to identify any mistakes. If you see an error, you should report it to the credit bureau.
Why Is a Credit Score Important?
Credit may seem like just a number, but it plays a key role in your financial power.
A good credit score (a VantageScore of 640 or more) can allow you to get loans at better rates, better premiums for homeowner’s coverage, an apartment or a preferable cell phone plan. In short, you may be able to leverage a better credit score into greater deals.
For example, someone with a lower credit score could end up paying $65,000 more on a $200,000 mortgage than someone with a higher credit score. Because credit scores impact loan rates, having good credit could save you money!
Also keep in mind that employers may perform a credit check during the hiring process to detect signs of financial distress that might indicate risk of theft or fraud.
How to Increase and Maintain Good Credit
We know credit is important, but how do you actually get a good credit score? Well, here are just a few credit building tips you can follow to help improve your credit score.
- Pay All Bills on Time – As we mentioned in the credit score breakdown, payment history makes up 41% of your credit score. Paying bills on time is the most important factor when building your credit score. Always aim to pay your bills on time. The later the payment, the worse effect it can have on your credit score.
- Credit Card – When used responsibly, credit cards can be good for building existing credit or starting credit history. As we mentioned, the amounts you owe contribute to 20% of your credit score. Keeping your credit utilization low can result in a better credit score. As a rule of thumb, keeping your utilization ratio below 30% of your total credit limit. For example, if you have a credit card limit of $600, you should try to only use $180 of it per month.
- Credit-Builder Loan – Credit-builder loans aren’t like traditional loans. They are designed to help build credit for those with poor or no credit history. These loans are usually for $1,000 or less and have repayment terms of six to twenty-four months. The money you borrow is set aside in a savings account while you make all monthly payments. Once you do, you receive the funds. The idea here is to show your on-time payment capabilities to the three major credit bureaus, subsequently increasing your credit score.
Credit is a powerful financial tool that can help you save money if managed correctly. For more information about understanding credit and how to establish it, listen to our episode of A Penny or Two For Your Thoughts, “Don’t be intimidated by credit!” or download How to Build, Maintain and Sustain Good Credit. You can also visit our Centris Financial Wellness Center to review more about credit and other financial wellness subjects.
